RT Journal Article
SR Electronic
T1 American Basket and Spread Option Pricing by a Simple Binomial Tree
JF The Journal of Derivatives
FD Institutional Investor Journals
SP 29
OP 38
DO 10.3905/jod.2012.19.4.029
VO 19
IS 4
A1 S.A. Borovkova
A1 F.J. Permana
A1 J.A.M. van der Weide
YR 2012
UL https://pm-research.com/content/19/4/29.abstract
AB The return on a portfolio is the weighted average of the returns on the individual assets in the portfolio. But the dynamics of portfolio returns are not so simple. The standard assumption that the underlying asset for an option follows geometric Brownian motion is convenient for individual stocks, but it runs into trouble for combinations of stocks, because a linear combination of lognormal returns does not have a lognormal distribution. Luckily, the true portfolio return distribution can be closely approximated by a generalized lognormal using the technique of matching moments, even when some weights are negative, as in a spread trade. This makes it easy to price European options on baskets of stocks or spreads. In this article, the authors show how to extend the same basic idea to construct a binomial tree for the portfolio return, which allows for efficient pricing of contracts with American exercise.TOPICS: Options, VAR and use of alternative risk measures of trading risk