Journal of Financial and Quantitative Analysis

Research Article

Pricing European and American Derivatives under a Jump-Diffusion Process: A Bivariate Tree Approach

Jimmy E. Hilliarda1 and Adam Schwartza2

a1 hilliar@lsu.edu, Louisiana State University, College of Business Administration, CEBA 2163, Baton Rouge, LA 70803

a2 aschwartz@bus.olemiss.edu, University of Mississippi, School of Business Administration, 320 Holman Hall, University, MS 38677.

Abstract

We develop a straightforward procedure to price derivatives by a bivariate tree when the underlying process is a jump-diffusion. Probabilities and jump sizes are derived are derived by matching higher order moments or cumulants. We give comparisons with other published results along with convergence proofs and estimates of the order of convergence. The bivariate tree approach is particularly useful for pricing long-term American options and long-term real options because of its robustness and flexibility. We illustrate the pedagogy in an application involving a long-term investment project.

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