Trinomial Option Pricing Model

What is Trinomial Option Pricing Model?

The trinomial option pricing model is an option pricing model consolidating three potential values that an underlying asset can have in one time span. The three potential values the underlying asset can have in a time span might be greater than, equivalent to, or not exactly the current value.

The trinomial model purposes an iterative system, considering the detail of hubs, or points in time, during the time frame between the valuation date and the option's expiration date.

Figuring out Trinomial Option Pricing Model

Of the many models for pricing options, the Black-Scholes option pricing model and the binomial option pricing model are the most well known.

The Black Scholes model, otherwise called the Black-Scholes-Merton model, is a model of price variation over the long run of financial instruments, for example, stocks that can, in addition to other things, be utilized to decide the price of an European call option. The binomial option pricing model, which was developed in 1979, utilizes an iterative strategy, considering the determination of hubs, or points in time, during the period of time between the valuation date and the option's expiration date.

A trinomial model is a valuable instrument while pricing American options and embedded options. Its simplicity is its advantage and disadvantage simultaneously. The tree is not difficult to model out mechanically, however the problem lies in the potential values the underlying asset can take in one period of time. In a trinomial tree model, the underlying asset must be worth precisely one of three potential values, which isn't realistic, as assets can be worth quite a few values inside some random reach.

The trinomial option pricing model, proposed by Phelim Boyle in 1986, is viewed as more accurate than the binomial model, and will register similar outcomes, however in less steps. Be that as it may, the trinomial model has not acquired as much ubiquity as different models.

Trinomial versus Binomial Models

The trinomial option pricing model varies from the binomial option pricing model in one key perspective by consolidating one more conceivable value in one time span. Under the binomial option pricing model, it is assumed that the value of the underlying asset will either be greater than or not exactly, its current value.

The trinomial model, then again, consolidates a third conceivable value, which integrates a zero change in value throughout a time span. This assumption makes the trinomial model more pertinent to real life circumstances, as it is conceivable that the value of an underlying asset may not change throughout a time span, like a month or a year.

For exotic options, or an option that has highlights that makes it more complex than generally traded vanilla options like calls and puts that trade on an exchange, the trinomial model is some of the time more stable and accurate.

Features

• The trinomial option pricing model values options utilizing an iterative approach that uses numerous periods to value American options.
• The model is natural, however is utilized more habitually in practice than the notable Black-Scholes model or the binomial model that utilizes just two potential results for every step.
• With the model, there are three potential results with every emphasis — a move up, a drop down, or no change — that follow a trinomial tree.