I was pricing a option with big dividend in the underlying. However, I got negative transition probability in a trinomial tree. Will it cause arbitrage? Does anyone have reference paper or book chapter can share?Can anyone help? Thanks a lot. Also can anyone share the paper? Mayhew, S. On Estimating the Risk-Neutral Probability Distribution Implied by Option Prices.Working Paper, Purdue University, 1995.

  • $\begingroup$ Hi Fiona Haas, welcome to quant.se! Can you make your question more precise in order to get better answers? What exactly are you doing to get negative transition probabilities in a trinomial tree? Can you give us an example? And what do you mean when you say 'Can anyone share the paper?' $\endgroup$ – muffin1974 Oct 20 '15 at 12:44
  • $\begingroup$ Thanks a lot, Muffin. The purpose is to price an American equity option. Since the trinomial tree, one has three transition probabilities. One is to go up. The other two are either keep the same or go down. Due to large dividend yield, I found the probability to go down be negative. I am looking for the paper but can't find it anywhere. $\endgroup$ – Fiona Haas Oct 23 '15 at 6:56
  • $\begingroup$ I got very contradictory comments. Some textbook says negative probability opens arbitrage opportunity and others says negative probability is allowed especially in finite difference. $\endgroup$ – Fiona Haas Sep 30 '17 at 14:18

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