Implied Trees: Valuing Exotic Options
13 Oct 08
Author: Jim Clark, Les Clewlow and Chris Strickland

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The basic idea of implied tree approaches is to construct a trinomial tree that is consistent with, whether exactly or to some approximation, currently traded energy derivatives prices. Once the local volatility function is determined, the trinomial tree can then be used to price any other derivative on the same underlying energy asset with the same or earlier maturity. In particular, market implied information embodied in the constructed tree enables the pricing of OTC and exotic options consistent with the prices of all liquid options with the same underlying.

In this article we will calibrate the tree to the market prices of fixed strike Asian options and then show how to price floating strike Asian options as our example of an alternative derivative.