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Document Date: November 2, 2006
 An Introduction To Derivatives And Risk Management 
, 7
th
EditionDon Chance and Robert BrooksTechnical Note: Probability of Call Expiring in-the-Money, Ch. 5, p. 138
This technical note supports the material in the Characteristics of the Black-Scholes-Merton section of Chapter 5 Option Pricing Models: The Black-Scholes-MertonModel. This note shows that under the assumption that investors are risk neutral the probability of the call expiring in-the-money is N(d
2
). If investors are not risk neutral, anadjustment to the expected return is required, as explained later.The standard model for capturing movements in the stock price is called alognormal diffusion or geometric Brownian motion process:
000
t 
dS S dt S dz 
α σ 
= +
 Where S
0
is the current stock price, dt is an infinitesimally short period of time,
α
is theexpected return on the stock,
σ
is the volatility, and dz
t
is a random variable that capturesthe uncertainty in the stock price. The variable dz
t
is driven by a standard normalvariable,
ε
t
, such that
t t 
dz dt 
ε 
=
. Of course,
ε
t
has an expected value of zero and avariance of 1. Given that
ε
t
is normally distributed and is the source of all of theuncertainty, we should be able to use normal probability theory to derive the probabilityof the option expiring in-the-money. We shall need to express the stochastic process insuch a manner that the return on the asset is normally distributed. In GeometricBrownian Motion the log return on the asset is normally distributed, so we will need thestochastic process for the log of the asset return.Define dS
0
+ S
0
as the asset price at an instant, dt, later. Thus, we can write thestochastic process as dS
0
+ S
0
= S
0
[1 +
α
dt +
σ
dz]. Working with the term in brackets,note that we can write it in the following, seemingly complex, way:
( ) ( )
( )
222
1122
t t 
dt dz dt dz dt dz 
α σ α σ σ α σ σ 
+ + = + − + + − +
/2
t 
.By multiplying out the terms on the right hand side, it is easy to verify that the abovestatement is true. Now define
µ
=
α
-
σ
2
/2 and the above can be written as 1 + [
µ
dt +
σ
dz
t
+ (
µ
dt +
σ
dz
t
)
2
/2]. The term in brackets is equivalent to a second-order Taylor series expansion of the function . A second-order expansion is sufficient, because
t 
dt dz 
e
µ σ 
+
 
all terms higher than second order will involve powers of dt greater than 1.0 and bydefinition, these terms approach zero in the limit. Now we can write out the stochastic process as . Dividing byS
000
t 
dt dz 
dS S S e
µ σ 
+
+ =
0
we obtain . Taking natural logs, we have the stochastic process of the log return on the asset,
00
/1
t 
dt dz 
dS S e
µ σ 
+
+ =
000
ln
t 
dS S dt dz S 
µ σ 
+= +
.This result confirms that the log return is normally distributed with mean
µ
and volatility
σ
. For our purposes here, we use the following version,
000
.
t 
dt dz 
dS S S e
µ σ 
+
+ =
 The point of this Technical Note is to determine the probability that the optionwill expire in-the-money. Noting that the time increment until expiration is T, we havethe asset price at expiration as S
T
and the stochastic process for z as
*
T 
 z 
ε 
T 
∆ =
. Thus,
*
0
T T T 
S S e
µ σε 
+
=
 with
∆
z
T
normally distributed with mean zero and variance T, per the central limittheorem.We want to know
( ) ( )
Pr.
T T  X 
ob S X f S dS 
∞
> =
∫ 
T 
 Let us first evaluate the second term on the right-hand side. By definition,
[ ]
*
0
PrPr 
T T T 
ob S X ob S e X 
µ σε 
+
> = >
. Note that
*
0
T T 
S e X 
µ σε 
+
>
is equivalent to
( )
*0
ln
S X T T 
µ σε 
+ +
or 
( )
0*
ln
S X T T 
µ ε σ 
+ > −
.Recall that
α
is the expected simple return on the asset and
µ
is the expected logarithmicreturn on the asset where
µ
=
α
-
σ
2
/2. Under the equivalent martingale/risk neutralityapproach, we can let
α
= r so that
µ
= r -
σ
2
/2 so that
IDRM7e, Chance-Brooks Probability of Call Expiring in-the-Money
2
of 00

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