Backward induction (pricing tree)
Definition · Level 11 · Pricing toolkit
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Solving a problem from the last step back to the first. In a pricing tree: value each final node from its payoff, then each earlier node as the discounted q-weighted average of the two nodes after it.
Example
Two steps, r = 0: payoffs 21, 0, 0 give 10.5 and 0, then 5.25 today.
Where Tradecraft teaches it
Level 11 · Pricing toolkit, in the lesson “The binomial tree: a coin-flip map of prices”: Price an option in a tree where the stock moves up or down: by copying it with shares and a loan, or with risk-neutral weights.
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