A Question About Discounting in a Binomial Option Tree

Summary

The post questions where the discount factor belongs in a binomial option-pricing recurrence. The cited implementation discounts the expected value of holding the option at a node, then compares that value with immediate exercise value and zero. The author proposes applying the discount after taking the maximum of continuation value, exercise value, and zero, and asks whether that change is correct.

This is a focused question about valuing an American-style option, where early exercise can matter. The post does not include a reply or resolution, so it does not establish that the proposed change is valid. In standard backward induction, discounting applies to the risk-neutral expected continuation value; the immediate exercise payoff is already valued at the current node and is not discounted from a future step. The document supplies no further model assumptions or numerical example.

Key ideas

• The post compares two placements of a discount factor in a binomial option valuation recurrence.
• The recurrence considers both continuation value and immediate exercise value at each node.
• The proposed alternative discounts the maximum of continuation and exercise values.
• No answer or numerical example is provided to resolve the question.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.