Option pricing: a yet simpler approach

Jarno Talponen and Minna Turunen ()
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Jarno Talponen: University of Eastern Finland
Minna Turunen: University of Eastern Finland

Decisions in Economics and Finance, 2022, vol. 45, issue 1, No 3, 57-81

Abstract: Abstract We provide a lean, non-technical exposition on the pricing of path-dependent and European-style derivatives in the Cox–Ross–Rubinstein (CRR) pricing model. The main tool used in this paper for simplifying the reasoning is applying static hedging arguments. In applying the static hedging principle, we consider Arrow–Debreu securities and digital options, or backward random processes. In the last case, the CRR model is extended to an infinite state space which leads to an interesting new phenomenon not present in the classical CRR model. At the end, we discuss the paradox involving the drift parameter $$\mu $$ μ in the Black–Scholes–Merton model pricing. We provide sensitivity analysis and an approximation of the speed of convergence for the asymptotically vanishing effect of drift in prices.

Keywords: Derivatives; Lattice model; CRR model; Backward process (search for similar items in EconPapers)
JEL-codes: C61 G13 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1007/s10203-021-00338-7

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