A consolidated, efficient and practical model for American options with discrete dividends

Summary

The binomial model for pricing American option is well developed with a tremendous volume of research on the topic.  The original model does have several shortcomings which have been addressed by improvements and modifications.

However majority of the research has focused on independently analyzing one particular area or issue with the model, for example convergence, accuracy of greeks and handling of discrete dividends.

While each of these issues have several reasonable independent solutions, the goal of this paper is to construct one consolidated model that is efficient and accurate. The various models that fix single issues cannot be blindly “stitched” together without possible unintended affects.

Several approaches mentioned below, in particular while addressing the discrete dividend issue, rely on a large number of iterations.  The definition of efficiency is a practical model, that can be used in real time trading and risk applications to calculate options value, greeks and implied volatilities fast.

In this paper, the consolidated model developed will address several issues and suggest a practical, efficient and accurate model.

Click here to download the paper. Consolidated Binomial Model RJ 2015