Quantitative Finance

Chapter 3

Lattice models for option pricing

Lattice methods are among the most common and long–established methods for the pricing of derivative financial instruments, going back to the seminal work of Cox, Ross and Rubinstein (1979), who introduced the binomial lattice model1 for option pricing. Almost all fundamental results of pricing by arbitrage arguments can be illustrated in this model, and lattice models are also effective numerical methods in their own right.

In this chapter, two broad classes of models will be considered: binomial models for a single underlying and models for the term structure of interest rates. The pricing of standard and exotic derivatives in these models is discussed. The common concepts linking all lattice models ...