Lattice model (finance)

Lattice model (finance)

In finance, a lattice model can be used to find the fair value of a stock option. The model divides time between now and the option's expiration into "N" discrete periods. At the specific time "n", the model has an infinite number of outcomes at time "n" + 1 such that every possible change in the state of the world between "n" and "n" + 1 is captured in a branch. This process is iterated until every possible path between "n" = 0 and "n" = "N" is mapped. Probabilities are then estimated for every "n" to "n" + 1 path. The outcomes and probabilities flow backwards through the tree until a fair value of the option today is calculated. A simple lattice model for options is the binomial options pricing model.


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