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

Elyas Elyasiani and Silvia Muzzioli

Applied Economics, 2022, vol. 54, issue 22, 2596-2609

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.

Date: 2022
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DOI: 10.1080/00036846.2021.1998330

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