What Is a Lattice-Based Model
A lattice-based model is used to value derivatives, which are financial instruments that derive their price from an underlying asset such as a stock. A lattice model employs a binomial tree to show the different paths the price of an underlying asset, such as a stock, might take over the derivative's life. A binomial tree plots out the possible values graphically that option prices can have over different time periods.
Examples of derivatives that can be priced using lattice models include equity options as well as futures contracts for commodities and currencies. The lattice model is particularly suited to the pricing of employee stock options, which have a number of unique attributes.
- A lattice-based model is used to value derivatives, which are financial instruments that derive their price from an underlying asset.
- Lattice models employ binomial trees to show the different paths the price of an underlying asset might take over the derivative's life.
- Lattice-based models can take into account expected changes in various parameters such as volatility during an option's life.
Understanding a Lattice-Based Model
Lattice-based models can take into account expected changes in various parameters such as volatility over the life of the options. Volatility is a measure of how much an asset's price fluctuates over a particular period. As a result, lattice models can provide more accurate forecasts of option prices than the Black-Scholes model, which has been the standard mathematical model for pricing options contracts.
The lattice-based model's flexibility in incorporating expected volatility changes is especially useful in certain circumstances, such as pricing employee options at early-stage companies. Such companies may expect lower volatility in their stock prices in the future as their businesses mature. The assumption can be factored into a lattice model, enabling more accurate options pricing than the Black-Scholes model, which assumes the same level of volatility over the life of the option.
A lattice model is just one type of model that is used to price derivatives. The name of the model is derived from the appearance of the binomial tree that depicts the possible paths the derivative's price may take. The Black-Scholes is considered a closed-form model, which assumes that the derivative is exercised at the end of its life.
For example, the Black-Scholes model–when pricing stock options– assumes that employees holding options expiring in ten years will not exercise them until the expiration date. The assumption is considered a weakness of the model since, in real life, option holders often exercise them well before they expire.