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A copula-based approach for generating lattices

Tianyang Wang (), James Dyer () and Warren Hahn ()

Review of Derivatives Research, 2015, vol. 18, issue 3, 263-289

Abstract: Discrete approximations such as binomial and trinomial lattices have been developed to model the intertemporal dynamics of variables in a way that also allows contingent decisions to be included at the appropriate increments in time. In this paper we present an approach for developing these types of models based on copulas. In addition to ease of implementation, a primary benefit of this approach is its generality, and we show that various binomial and trinomial approximation methods for valuing contingent claim securities in the literature are special cases of this approach, each based on a choice of a particular set of probability and/or branching parameters. Because this approach encompasses these and other cases as feasible solutions, we also show how it can be used to optimize the construction of lattices so that discretization error is minimized, and we demonstrate its application for an option pricing example. Copyright Springer Science+Business Media New York 2015

Keywords: Stochastic processes; Discrete models; Option pricing; Copulas; G13; C10 (search for similar items in EconPapers)
Date: 2015
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DOI: 10.1007/s11147-015-9111-x

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