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Doubly-Binomial Option Pricing with Application to Insurance Derivatives

Author

Listed:
  • Carolyn W. Chang

    (Department of Finance, California State University, Fullerton, USA)

  • Jack S. K. Chang

    (Department of Finance & Law, California State University, Los Angeles, USA)

Abstract

We generalize the standard lattice approach of Cox, Ross, and Rubinstein (1976) from a fixed sum to a random sum in a subordinated process framework to accommodate pricing of derivatives with random-sum characteristics. The asset price change now is determined by two independent Bernoulli trials on information arrival/non-arrival and price up/down, respectively. The subordination leads to a nonstationary trinomial tree in calendar-time, while a time change to information-time restores the simpler binomial tree that now grows with the intensity of information arrival irrespective of the passage of calendar-time. We apply the model to price the CBOT catastrophe futures call spreads as a binomial sum of binomial prices, which illuminates the information conveyed by the randomness of catastrophe arrival. Numerical results demonstrate that the standard binomial formula that ignores random claim arrival produces largest undervaluation error for out-of-money short-maturity options when a small number of significant catastrophes may strike during the option's maturity.

Suggested Citation

  • Carolyn W. Chang & Jack S. K. Chang, 2005. "Doubly-Binomial Option Pricing with Application to Insurance Derivatives," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 8(03), pages 501-523.
    • Handle: RePEc:wsi:rpbfmp:v:08:y:2005:i:03:n:s0219091505000439
    DOI: 10.1142/S0219091505000439
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    Keywords

    Doubly-binomial tree; random information arrival; subordinated process; catastrophe insurance derivatives; information-time option pricing; JEL Classification: G13;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services
    • G3 - Financial Economics - - Corporate Finance and Governance

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