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Rev Fin 1995; 8:1125-1152
© 1995 the Society for Financial Studies

Article

Multivariate binomial approximations for asset prices with nonstationary variance and covariance characteristics

T-S Ho1, RC Stapleton1 and MG Subrahmanyam2
1 Department of Accounting and Finance, The Management School, Lancaster University, Lancaster LA1 4YX, UK
2 New York University, New York, USA

Abstract

In this article, we suggest an efficient method of approximating a general, multivariate log-normal distribution by a multivariate binomial process. There are two important features of such multivariate distributions. First, the state variables may have volatilities that change over time. Second, the two or more relevant state variables involve may covary with each other in a specified manner, with a time-varying covariance structure. We discuss the asymptotic properties of the resulting processes and show how the methodology can be used to value a complex, multiple exerciseable option whose payoff depends on the prices of two assets.


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