SUBORDINATED BINOMIAL OPTION PRICING

Abstract

We extend the binomial option pricing model to allow for more accurate price dynamics while retaining computational simplicity. The asset price in each binomial period evolves according to two independent and successive Bernoulli trials on trade occurrence/nonoccurrence and up/down price movement. Subordination leads to a trinomial tree with stochastic volatility in calendar time. We derive utility-dependent valuation results incorporating the leverage effect and test the model empirically. 2006 The Southern Finance Association and the Southwestern Finance Association.