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The power of deterministic option-implied trees in pricing European options

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  • Elyas Elyasiani
  • Silvia Muzzioli

Abstract

The aims of the current article are threefold. First, to investigate the power of deterministic option-implied trees, constructed either by forward or by backward induction, in pricing European options, in order to assess the proper representation of the smile. Second, to investigate and contrast the power of deterministic option-implied trees during tranquil and volatile market conditions. Last, to assess the correctness of the representation of the smile in different parts of the risk-neutral distribution. Three main results are obtained. First, the pricing performance of the Enhanced Derman and Kani model (EDK), based on forward induction, is superior to that of the Rubinstein model, based on backward induction. Second, the EDK model produces better results (smaller errors) on the left tail of the distribution, i.e. it is better in pricing out-of-the-money put options. Third, it performs better in turmoil periods where correct pricing a challenge, and accuracy is of greater importance than in tranquil periods. Diebold and Mariano test of equal predictive accuracy confirms the superiority of the EDK model in both sub-periods.

Suggested Citation

  • Elyas Elyasiani & Silvia Muzzioli, 2022. "The power of deterministic option-implied trees in pricing European options," Applied Economics, Taylor & Francis Journals, vol. 54(22), pages 2596-2609, May.
    • Handle: RePEc:taf:applec:v:54:y:2022:i:22:p:2596-2609
    DOI: 10.1080/00036846.2021.1998330
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    Cited by:

    1. Gambarelli, Luca & Marchi, Gianluca & Muzzioli, Silvia, 2023. "Hedging effectiveness of cryptocurrencies in the European stock market," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 84(C).

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