Pricing Discrete Knock-Out Options with Tree Methods

This paper investigates the pricing of discrete knock-out options with tree methods. As is well known, the naive application of the binomial model can result in erroneous prices, even if the number of time steps is large. We develop a correction technique for the binomial and trinomial model which is applicable to a wide range of barrier options. The results of our simulations show that, using this technique, a small number of time steps suffices to obtain accurate option prices. According to the accuracy and speed criteria the modified tree method turns out to be superior to a commonly used version of the trinomial model serving as our benchmark (e.g. Tian, 1997).