Performance Enhancement of Trinomial Option Pricing Model

Option pricing is used in the greater part of commonly traded instruments in the financial market that predicts the future stock price. The option’s fair price can be found either analytically or by applying suitable numerical techniques. Black-Scholes (B-S) seminal approach is one of them, but it has less accuracy in pricing all types of options. Therefore, a lattice model, namely a trinomial model, was developed to overcome these valuation problems for American or European option pricing. However, Trinomial model is not capable of providing maximum accuracy for option pricing as the system of equations used in the model involves a non-linear growth of the stock price. It is, therefore, important to develop a new system of equations to enhance the performance of trinomial framework in contemplation of American or European options. This study aims to improve the performance of the trinomial model for American option by developing a new system of equations with a linear growth rate of the stock price in different states of the regime so that all the data can be stored in the amalgamation of a trinomial tree. The performance was assessed by comparing the trinomial model to the binomial and Black-Scholes (B-S) pricing for the American option. The results demonstrated that the trinomial option pricing gives higher accuracy than Black-Scholes (B-S) pricing and is faster than the binomial pricing.