Lattice-Based Model
Categories: Financial Theory
A lattice is a design where a bunch of shapes intersect. The obvious practical example comes from the garden department at Home Depot...those lattice-shaped wood structures that look nice when you let roses grow on them.
For our purposes here, it's just important that the shape involves a lot of intersections. A lattice-based model involves a pricing system that takes into account different possible outcomes.
The most commonly discussed version of this type of model has to do with derivative pricing. A lattice-based system takes into account that derivatives, like options, might not get exercised. It prices in the fact that circumstances could play out in different ways. Like a Choose Your Own Adventure book.
The lattice-based model provides an alternative to so-called closed-form models, which make certain assumptions about what will happen. Lattice-based models can provide more realistic pricing, because they weigh a more complicated set of potential outcomes.