Univariate Distributions

The Lognormal Distribution

Univariate Distributions

School of Risk & Actuarial Studies

UNSW Business School

Video lecture notes

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 Univariate Distributions
Lognormal Distribution

Lognormal Distribution

I Continuous distribution.
I Consider X ∼ Lognormal µ, σ 2 (F&T book, page 14).

I If Y ∼ N µ, σ 2 and X = e Y then X is lognormal; or

log(X ) ∼ N(µ, σ 2 ), i.e., “log is normally distributed”.

I X = exp (Y ) ∼ Lognormal µ, σ 2 is said to have a lognormal

distribution with parameters µ and σ 2 .

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 Univariate Distributions
Lognormal Distribution

Lognormal Distribution

I Probability density function:

 2 !
1 1 log(x) − µ
fX (x) = √ exp − · , x > 0.
x · σ · 2π 2 σ

I Parameter constraints: −∞ < µ < ∞, 0 < σ < ∞.

 
1 2
E[X ] = exp µ + σ
2
2
 2 
Var (X ) =e ( 2µ+σ ) · eσ − 1 .

I Note: parameter µ is not E[X ], also σ 2 is not Var (X )!

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 Univariate Distributions
Lognormal Distribution

Lognormal Distribution

LogNormal p.d.f. LogNormal c.d.f.

0.8 1
µ= 0, σ= 1
µ= 0, σ= 0.5 0.9
0.7
µ= −1, σ= 0.5 0.8

cumulative density function

probability density function

0.6
0.7
0.5
0.6

0.4 0.5

0.4
0.3
0.3
0.2
0.2 µ= 0, σ= 1
0.1 µ= 0, σ= 0.5
0.1
µ= −1, σ= 0.5
0 0
0 5 10 0 5 10
x x

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 Univariate Distributions
Lognormal Distribution

Calculating with the Lognormal distribution

I Applications:
1 Models of stock prices (or returns in general) are often based
on the lognormal distribution (in the Geometric Brownian
motion model).
2 This distribution is also often used to model claim sizes.
I Properties:
1 Product of independent lognormal random variables are
lognormal (can you explain why?).
2 To calculate probabilities for a lognormal random variable,
restate them as probabilities about the associated normal
random variable.
Pr(X ≤ a) = Pr(log(X ) ≤ log(a))
 
log(X ) − µ log(a) − µ
= Pr ≤
σ σ
 
log(a) − µ
= Pr Z ≤ .
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σ
 Univariate Distributions
Lognormal Distribution

Exercise Lognormal Distribution

I Losses from large fires can often be modelled using a

lognormal distribution.

I Suppose that the average loss due to fire for buildings of a

particular type is $25 million and the standard deviation of the
loss is $10 million.

I Question: Determine the probability that a large fire results in

losses exceeding $40 million.

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 Univariate Distributions
Lognormal Distribution

Exercise Lognormal Distribution

Solution: Let X be the loss, we have
E[X ] = 25m, Var (X ) = (10m)2 . Then we can calculate µ and σ 2 ,
 
2 Var (X ) 100
σ = log 1 + 2
= log(1 + ) = log(1.16),
E[X ] 625
1 log(1.16)
µ = log(E[X ]) − σ 2 = log(25) − .
2 2
This yields the probability

Pr(X > 40) = 1 − Pr (Y ≤ log (40))

log(1.16)
!
log (40) − log (25) + 2
= 1 − Pr Z ≤ p
log(1.16)
= 1 − Φ(1.4126) = 0.0789
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