Calibrating Trees to the Market Price of Options
14 Aug 08
Author: Jim Clark, Les Clewlow, Chris Strickland

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In this article, published in Energy Risk Magazine's Masterclass Series, we outline an approach for calibrating a local volatility surface single factor model to market prices of average price (Asian) options. Due to the numerical algorithm used to implement these models, they are often called ‘implied trees’. Trinomial trees are a convenient way of valuing option contracts with complex, path dependent payoffs such as for indexed Swing options. Market implied information embodied in the constructed tree thus enables the pricing of OTC and exotic options on the same underlying process.