DEFINITION of 'Lattice-Based Model'

A lattice-based model is used to value derivatives; it employs a binomial tree to show different paths the price of the underlying asset may take over the derivative's life. 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. Derivatives that can be priced using lattice models include stock options and futures contracts on commodities and currencies, for example.

Lattice models can take into account expected changes in various parameters such as volatility over the life of the options, providing more accurate estimates of option prices than the Black-Scholes model. The lattice model is particularly suited to the pricing of employee stock options, which have a number of unique attributes.

BREAKING DOWN 'Lattice-Based Model'

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. This assumption can be factored into a lattice model, enabling more accurate option 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 it used to price derivatives. Black-Scholes is considered a closed-form model. Closed-form models assume that the derivative is exercised at the end of its life. That is, in pricing stock options, for example, the Black-Scholes model assumes that if an employee has options that expire in 10 years, he/she will not exercise them until the expiration date. This is considered a weakness of this model since in real life owners of options are likely to exercise them well before they expire.

  1. Option Pricing Theory

    An option pricing theory is any model or theory-based approach ...
  2. Binomial Option Pricing Model

    An options valuation method developed by Cox, et al, in 1979. ...
  3. Binomial Tree

    A binomial tree is a graphical representation of possible intrinsic ...
  4. Bjerksund-Stensland Model

    Bjerksund-Stensland model is a closed-form option pricing model ...
  5. Heston Model

    The Heston Model is a type of stochastic volatility model used ...
  6. Robert C. Merton

    Robert C. Merton is a Nobel Prize-winning economist renowned ...
Related Articles
  1. Trading

    Breaking Down The Binomial Model To Value An Option

    Find out how to carve your way into this valuation model niche.
  2. Investing

    Understanding the Black-Scholes Model

    The Black-Scholes model is a mathematical model of a financial market. From it, the Black-Scholes formula was derived. The introduction of the formula in 1973 by three economists led to rapid ...
  3. Trading

    The "True" Cost Of Stock Options

    Perhaps the real cost of employee stock options is already accounted for in the expense of buyback programs.
  4. Trading

    The Anatomy of Options

    Find out how you can use the "Greeks" to guide your options trading strategy and help balance your portfolio.
  5. Investing

    Examples To Understand The Binomial Option Pricing Model

    Binomial option pricing model, based on risk neutral valuation, offers a unique alternative to Black-Scholes. Here are detailed examples with calculations using Binomial model and explanation ...
  6. Trading

    Dividends, Interest Rates and Their Effect on Stock Options

    Learn how analyzing dividends and interest rates is crucial to knowing when to exercise early.
  1. How is implied volatility used in the Black-Scholes formula?

    Learn how implied volatility is used in the Black-Scholes option pricing model, and understand the meaning of the volatility ... Read Answer >>
  2. How is the price of a derivative determined?

    Learn how different types of derivatives are priced, including how futures contracts are valued and the Black-Scholes option ... Read Answer >>
  3. What is the difference between financial forecasting and financial modeling?

    Understand the difference between financial forecasting and financial modeling, and learn why a company should conduct both ... Read Answer >>
  4. What is the difference between financial forecasting and financial modeling?

    Understand the difference between financial forecasting and financial modeling, and learn why a company should conduct both ... Read Answer >>
  5. What Does It Mean to Be Long or Short a Derivative?

    Find out more about derivative securities and what it indicates when traders or investors establish a long or short position ... Read Answer >>
  6. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
Hot Definitions
  1. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  2. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  3. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  4. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  6. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
Trading Center