Abstract
In this paper we propose a new approach to identify the binomial process of the underlying asset price by using a simultaneous backward and forward induction algorithm. The model prices perfectly fit the strike and the term structure of the volatility smile given by traded benchmark options. The resulting implied binomial tree is semi-recombining and arbitrage-free. The model can be used to price and hedge a wide range of plain-vanilla and exotic options. Furthermore, the model allows to construct arbitrage-free multinomial trees.
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