Underwater Option Exchanges: Developing Expected Term in a Lattice for Input to the Black-Scholes-Merton Formula

This Issue Brief reviews the implementation challenges and considerations associated with developing an expected term for underwater options (subject to an exchange) using a lattice model, and then using the expected term from that lattice model as an input to the Black- Scholes-Merton formula. Whereas using the lattice model in its entirety is a generally “cleaner” approach, some companies have stated a preference for using the Black-Scholes-Merton formula to value their options. The nuances and unexpected complications of this approach are discussed throughout this Issue Brief.

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