medium · FRM Part 1
A risk analyst is comparing a 10-step tree and a 100-step tree to value an American option.
Why is the 100-step tree generally preferred despite the higher computational cost?
- Volatility can only be correctly modeled with a large number of steps
- The risk-free rate r must be zero for small trees to work
- It provides a better approximation of the continuous price process and the early-exercise boundary
- The risk-neutral probability p is only valid for trees with more than 50 steps
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