Thetrinomial tree is alattice-basedcomputational model used infinancial mathematics to priceoptions onequity. It was developed byPhelim Boyle in 1986. It is an extension of thebinomial options pricing model, and is conceptually similar. It can also be shown that the approach is equivalent to theexplicitfinite difference method for option pricing.^[1]

Trinomial treesare also deployed^[2] forfixed income andinterest rate derivatives; see underLattice model (finance).

Under the trinomial method, theunderlying stock price is modeled as a recombining tree, where, at each node the price has three possible paths: an up, down and stable or middle path.^[3] These values are found by multiplying the value at the current node by the appropriate factor${\displaystyle u}$,${\displaystyle d}$ or${\displaystyle m}$ where

${\displaystyle u=e^{\sigma \sqrt{2\mathrm{\Delta }t}}}$

${\displaystyle d=e^{-\sigma \sqrt{2\mathrm{\Delta }t}}=\frac{1}{u}}$ (the structure is recombining)

${\displaystyle m=1}$

and the corresponding probabilities are:

${\displaystyle p_u={\left(\frac{e^{(r-q)\mathrm{\Delta }t/2}-e^{-\sigma \sqrt{\mathrm{\Delta }t/2}}}{e^{\sigma \sqrt{\mathrm{\Delta }t/2}}-e^{-\sigma \sqrt{\mathrm{\Delta }t/2}}}\right)}^2}$

${\displaystyle p_d={\left(\frac{e^{\sigma \sqrt{\mathrm{\Delta }t/2}}-e^{(r-q)\mathrm{\Delta }t/2}}{e^{\sigma \sqrt{\mathrm{\Delta }t/2}}-e^{-\sigma \sqrt{\mathrm{\Delta }t/2}}}\right)}^2}$

${\displaystyle p_m=1-(p_u+p_d)}$.

In the above formulae:${\displaystyle \mathrm{\Delta }t}$ is the length of time per step in the tree and is simply time to maturity divided by the number of time steps;${\displaystyle r}$ is therisk-free interest rate over this maturity;${\displaystyle \sigma }$ is the correspondingvolatility of the underlying;${\displaystyle q}$ is its correspondingdividend yield.^[4]

As with the binomial model, these factors and probabilities are specified so as to ensure that the price of theunderlying evolves as amartingale, while themoments – considering node spacing and probabilities – are matched to those of thelog-normal distribution^[5] (and with increasing accuracy for smaller time-steps). Note that for${\displaystyle p_u}$,${\displaystyle p_d}$, and${\displaystyle p_m}$ to be in the interval${\displaystyle (0,1)}$ the following condition on${\displaystyle \mathrm{\Delta }t}$ has to be satisfied.

Once the tree of prices has been calculated, the option price is found at each node largelyas for the binomial model, by working backwards from the final nodes to the present node (${\displaystyle t_0}$). The difference being that the option value at each non-final node is determined based on the three – as opposed totwo – later nodes and their corresponding probabilities.^[6]

If the length of time-steps${\displaystyle \mathrm{\Delta }t}$ is taken as an exponentially distributed random variable and interpreted as the waiting time between two movements of the stock price then the resulting stochastic process is abirth–death process. The resultingmodel is soluble and there exist analytic pricing and hedging formulae for various options.

The trinomial model is considered^[7] to produce more accurate results than the binomial model when fewer time steps are modelled, and is therefore used when computational speed or resources may be an issue. Forvanilla options, as the number of steps increases, the results rapidly converge, and the binomial model is then preferred due to its simpler implementation. Forexotic options the trinomial model (or adaptations^[8]) is sometimes more stable and accurate, regardless of step-size.

• Binomial options pricing model
• Valuation of options
• Option: Model implementation
• Korn–Kreer–Lenssen model
• Implied trinomial tree
• Lattice model (finance) § Interest rate derivatives

• Phelim Boyle, 1986. "Option Valuation Using a Three-Jump Process",International Options Journal 3, 7–12.
• Rubinstein, M. (2000)."On the Relation Between Binomial and Trinomial Option Pricing Models".Journal of Derivatives.8 (2):47–50.CiteSeerX 10.1.1.43.5394.doi:10.3905/jod.2000.319149. Archived fromthe original on June 22, 2007.
• Paul Clifford et al. 2010.Pricing Options Using Trinomial Trees,University of Warwick
• Tero Haahtela, 2010."Recombining Trinomial Tree for Real Option Valuation with Changing Volatility",Aalto University, Working Paper Series.
• Ralf Korn, Markus Kreer and Mark Lenssen, 1998. "Pricing of european options when the underlying stock price follows a linear birth-death process", Stochastic Models Vol. 14(3), pp 647 – 662
• Peter Hoadley.Trinomial Tree Option Calculator (Tree Visualized)

• Mathematical finance
• Options (finance)
• Models of computation
• Trees (data structures)
• Financial models

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