Walter Nordström: Adaptive tree techniques in option pricing

When pricing american option with discrete cash dividends standard tree techniques are insufficient. J. W. Nieuwen-huis and M. H. Vellekoop have presented a new tree technique involving interpolation to solve the problem. At ORC it has been observed that when using an adaptive mesh to increase the resolution of the tree around the dividends the speed of convergence is improved.

In this paper we isolate the sources of errors in the tree model and explain why the adaptive mesh has a good effect. Using that knowledge we further improve the algorithm. We found that we could both improve the accuracy and reduce execution time for the algorithm.