A flexible lattice model for pricing contingent claims under multiple risk factors

We propose a flexible lattice model for pricing contingent claims in a market characterized by multiple risk factors. Indeed, working in a stochastic interest rate framework, it is able to evaluate derivatives written on assets showing stochastic volatility patterns, by allowing different dynamics specifications. The model is based on the forward shooting grid method where both the original interest rate and volatility processes are discretized by recombining binomial trees. Then, the asset price dynamics is discretized by generating subsets of asset price realizations to cover the range of possible asset prices at each time slice. Finally, we develop a trivariate binomial lattice presenting eight branches for each node, where joint probabilities computed for the possible jumps embed the proper pairwise correlation. Since the model works on representative asset values, a linear interpolation technique is used when solving backward through the lattice to compute the contingent claim price.