Quadrinomial Trees to Value Options in Stochastic Volatility Models

Abstract

This article describes in detail the multiplicative quadrinomial tree numerical method with nonconstant volatility, based on a system of stochastic differential equations of the GARCH-diffusion type. The methodology allowed for the derivation of the first two moments of the proposed equations to estimate the respective recombination between discrete and continuous processes and, as a result, a numerical methodological proposal is formally presented to value, with relative ease, both real and financial options, when the volatility is stochastic. The main findings showed that in the proposed method, when volatility approaches zero, the multiplicative binomial traditional method is a particular case, and the results are comparable between these methodologies, as well as to the exact solution offered by the Black–Scholes model. Finally, the originality of the methodological proposal is that it allows for the emulation in a simple way of the presence of a nonconstant volatility in the price of the underlying asset, and it can be used to value all kinds of options both in the real world and in risk-neutral situations. TOPICS: Options, derivatives