PT  - JOURNAL ARTICLE
AU  - Shuxin Guo
AU  - Qiang Liu
TI  - A Simple Accurate Binomial Tree for Pricing Options on Stocks with Known Dollar Dividends
AID  - 10.3905/jod.2019.26.4.054
DP  - 2019 May 31
TA  - The Journal of Derivatives
PG  - 54--70
VI  - 26
IP  - 4
4099  - https://pm-research.com/content/26/4/54.short
4100  - https://pm-research.com/content/26/4/54.full
AB  - Known discrete dollar dividends lead to non-recombining binomial trees (NR-BT) with an explosion of nodes, and make the pricing of options much more complex. This article proposes a novel method for constructing a recombining binomial tree via balanced dividend adjustments (BDA). BDA is proved to converge to NR-BT for European options. Furthermore, BDA is shown heuristically to approximate NR-BT superbly for American options; for American calls, an error formula for BDA is derived and can be used to reduce further the pricing error. In a numerical illustration for American options, BDA turns out to be quite accurate, outperforming several existing approaches. A new insight emerges that BDA can be a competitive, yet simple, alternative to the industry practice of interpolating for dividends under binomial-tree or finite difference.TOPICS: Options, statistical methods, performance measurement