The accuracy and efficiency of alternative option pricing approaches relative to a log-transformed trinomial model

Abstract

This article presents a log-transformed trinomial approach to option pricing and finds that various numerical procedures in the option pricing literature are embedded in this approach with choices of different parameters. The unified view also facilitates comparisons of computational efficiency among numerous lattice approaches and explicit finite difference methods. We use the root-mean-squared relative error and the minimum convergence step to evaluate the accuracy and efficiency for alternative option pricing approaches. The numerical results show that the equal-probability trinomial specification of He (12) and Tian (25) and the sharpened trinomial specification of Omberg (21) outperform other lattice approaches and explicit finite difference methods. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:557–577, 2002