Numerical Method (2): Binomial and Trinomial Trees

As a lattice approach, tree methods, pioneered by Cox, Ross, and Rubinstein in 1979 (Cox et al., J. Financ. Econ. 7(3):229–263, 1979), employ a discrete multi-period representation for future possible asset prices for option pricing. Tree methods are easy to understand and to implement for simple options, in particular for American options, although its application scope in practice is limited. The tree approach provides a good introduction to the more powerful and efficient lattice approach—PDE finite difference method.