Implied Binomial Trees

Abstract

This article develops a new method for inferring risk‐neutral probabilities (or state‐contingent prices) from the simultaneously observed prices of European options. These probabilities are then used to infer a unique fully specified recombining binomial tree that is consistent with these probabilities (and, hence, consistent with all the observed option prices). A simple backwards recursive procedure solves for the entire tree. From the standpoint of the standard binomial option pricing model, which implies a limiting risk‐neutral lognormal distribution for the underlying asset, the approach here provides the natural (and probably the simplest) way to generalize to arbitrary ending risk‐neutral probability distributions. 1994 The American Finance Association