Recombining binomial tree for constant elasticity of variance process

Abstract

The theme in this paper is the recombining binomial tree to price American put option when the underlying stock follows constant elasticity of variance(CEV) process. Recombining nodes of binomial tree are decided from finite difference scheme to emulate CEV process and the tree has a linear complexity. Also it is derived from the differential equation the asymptotic envelope of the boundary of tree. Conducting numerical experiments, we confirm the convergence and accuracy of the pricing by our recombining binomial tree method. As a result, we can compute the price of American put option under CEV model, effectively.