Robust Option through Binomial Tree Method

Abstract

This study proposes a robust approach for pricing a European option using the binomial tree method. This method considers stock up and down prices in a closed and convex region, called the uncertainty region, defined by the covariance matrix of high and low stock prices. The option model uses this uncertainty region for pricing instead of spot prices. The method proposes an interval of prices for an option considering incidences of the worst and the best states of the stock price. The interval is flexible as it takes into account the covariance of the historical data of a stock's high and low prices and the radius of an uncertainty region.