ESG-valued discrete option pricing in complete markets

TL;DR

This paper introduces ESG considerations into discrete binomial option pricing models, emphasizing the importance of discrete compounding and market realism over continuum models, with applications including yield enhancement and market history effects.

Contribution

It presents a novel framework integrating ESG factors into discrete option pricing using binomial trees, highlighting the significance of discrete compounding and market history.

Findings

ESG valuation can be incorporated into binomial models

Discrete compounding is essential for accurate pricing

Market history impacts option valuation

Abstract

We consider option pricing using replicating binomial trees, with a two fold purpose. The first is to introduce ESG valuation into option pricing. We explore this in a number of scenarios, including enhancement of yield due to trader information and the impact of the past history of a market driver. The second is to emphasize the use of discrete dynamic pricing, rather than continuum models, as the natural model that governs actual market practice. We further emphasize that discrete option pricing models must use discrete compounding (such as risk-free rate compounding of $1+r_f \Delta t$) rather than continuous compounding (such as $e^{r_f \Delta t})$.