Binomial option pricing with stochastic parameters: A beta distribution approach |
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| Authors: | Jack C Lee Cheng F Lee K C John Wei |
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| Institution: | (1) Statistics and Econometrics Research Group, Bell Communication Research, 435 South Street, 07960 Morristown, NJ;(2) Department of Finance, School of Business, Rutgers University, Avenue D and Rockafeller Road, 08903 New Brunswick, NJ;(3) Department of Finance, School of Business Administration, Indiana University, 46202 Indianapolis, IN |
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| Abstract: | This research extends the binomial option-pricing model of Cox, Ross, and Rubinstein (1979) and Rendleman and Barter (1979)
to the case where the up and down percentage changes of stock prices are stochastic. Assuming stochastic parameters in the
discrete-time binomial option pricing is analogous to assuming stochastic volatility in the continuous-time option pricing.
By assuming that the up and down parameters are independent random variables following beta distributions, we are able to
derive a closed-form solution to this stochastic discrete-time option pricing. We also derive an upper and a lower bounds
of the option price. |
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| Keywords: | binomial option pricing stochastic parameters beta distribution |
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