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The Lognormal Model
for Stock Prices

Aimi Syairah

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1.1 The Binomial Model
St + h = St e ( r − ) h  h

ln(St + h / St ) = (r −  )h   h

▪ ln(𝑆𝑡+ℎ Τ𝑆𝑡 ) is the continuously compounded return from 𝑡 to 𝑡 +

ℎ
▪ The binomial model is simply a particular way to model the
continuously compounded return
▪ That return has two parts,
▪ one of which is certain, (𝑟– 𝛿)ℎ,
▪ the other of which is uncertain and generates the up and down stock
prices moves (±𝜎 ℎ)
▪ The binomial tree approximates a lognormal distribution, which is
commonly used to model stock prices
1.1 The Binomial Model
▪ The lognormal distribution is the probability distribution that
arises from the assumption that continuously compounded
returns on the stock are normally distributed
▪ When we traverse the binomial tree, we are implicitly adding
up binomial random return components of 𝑟 − 𝛿 ℎ ± 𝜎 ℎ
▪ As 𝑛 → ∞ (or ℎ → 0) the sum of the binomial random
variables is normally distributed. Thus, continuously
compounded returns in a binomial tree are approximately
normally distributed, which means that the stock is
lognormally distributed.
▪ With the lognormal distribution, the stock price is positive,
and the distribution is skewed to the right, that is, there is a
chance that extremely high stock prices will occur
1.2 The Lognormal Distribution
▪ Let 𝑋~𝑁(𝑚, 𝑣 2 )
▪ Let 𝑌 = 𝑒 𝑥
▪ Then 𝑌 has a lognormal distribution with parameters
𝑚 and 𝑣 , 𝑋 = ln𝑌 has a normal distribution with
parameters 𝑚 and 𝑣
▪ A lognormal distribution is skewed to the right
m + 0.5 v 2
E[Y ] = e
2 m + v2
var[Y ] = e (e − 1)
v2

km + 0.5 k 2 v 2
E[Y ] = e
k
1.3 The Lognormal Model
▪ Let 𝑆𝑡 be the price of a stock at time 𝑡
▪ Let 𝛼 be the continuously compounded annual rate of
return and assume 𝛼 is normally distributed
▪ Since 𝛼 is normally distributed, 𝑆𝑡 Τ𝑆0 is lognormally
distributed
▪ Assume that the stock pays dividends at a continuous
rate proportional to its price, denoted by 𝛿
▪ The total rate of return of the stock is 𝛼, but part of this
return is paid out as dividend
▪ Hence, the price of the stock increases at the rate 𝛼 − 𝛿
1.4 The Lognormal Model
▪ Hence, 𝐸[𝑆𝑡 Τ𝑆0 ] = 𝐸[𝑒 (𝛼−𝛿)𝑡 ]
▪ For a 1-year period: 𝛼 − 𝛿 = ln 𝐸[𝑆1 Τ𝑆0 ]
▪ Therefore, 𝛼 − 𝛿 = 𝑚 + 0.5𝑣 2
▪ For a 𝑡-year period, the parameters of the lognormal
distribution 𝑆𝑡 Τ𝑆0 are
𝑚 = 𝜇𝑡 = 𝛼 − 𝛿 − 0.5𝜎 2 𝑡 and 𝑣 = 𝜎 𝑡
▪ The standard normal cdf at 𝑥 is the probability that a
standard normal random variable 𝑋 is less than or equal to 𝑥
▪ It is denoted by Φ(𝑥) but in financial economics it is
traditional to denote it by 𝑁 𝑥
1.5 Probability of Exercise
▪ The payoff on a European option is conditional on
the stock price being above or below a certain price
at a certain time
▪ We first calculate the probability that an option will
pay off
▪ For a put option, the probability that it pays off:
 St K   ln( K / S0 ) − ( −  − 0.5 2 )t  ˆ
Pr( St  K ) = Pr    = N   = N (−d 2 )
 S0 S0    t 
where
ln( S / K ) + ( −  − 0.5 2
)t
dˆ2 = 0

 t
▪ For a call option, the probability that it pays off:
Pr( St  K ) = 1 − Pr( St  K ) = 1 − N (−dˆ2 ) = N (dˆ2 )
Example 1.5
▪ A stock’s price follows a lognormal model. You are given
▪ 𝑆0 = 60
▪ 𝛼 = 0.15
▪ 𝜎 = 0.2
▪ 𝛿 = 0.05
A European call option on the stock with strike price 70
expires in 3 months. Calculate the probability that the option
pays off.
Solution 1.5
1.6 Partial Expectation
▪ The partial expectation is a piece of the total expectation
over a given interval
▪ The partial expectation of a lognormal random variable
with parameters 𝑚 and 𝑣 given that it is less than 𝑘 is

ln 𝑘 − 𝑚 − 𝑣 2
𝑷𝑬 𝑋 𝑋 < 𝑘 = 𝐸 𝑋 𝑁
𝑣
1.6 Partial Expectation
▪ Recall that 𝑆𝑡 Τ𝑆0 is lognormal.
𝑆𝑡 𝐾
▪ The probability Pr(𝑆𝑡 < 𝐾) is the same as Pr <
𝑆0 𝑆0
ln 𝑘−𝑚−𝑣 2
▪ So let 𝑘 = 𝐾 Τ𝑆0 in the formula 𝐸 𝑋 𝑁
𝑣
▪ The partial expectation of 𝑆𝑡 is
 ln( K / S0 ) − m − v 2 
m + 0.5 v 2
PE[ St | St  K ] = S0e N 
 v 
( − ) t  ln( K / S0 ) − ( −  − 0.5 2 )t −  2t 
= S0 e N 
  t 
= S e( − )t N (−dˆ )
0 1

where
E ( X ) = E(St ) = S0e m + 0.5v = S0e ( − )t
2

ˆ ln( S0 / K ) + ( −  + 0.5 2 )t
d1 =
 t
Exercise 1.6
What is the relationship between the formulas for 𝑑መ1 and
𝑑መ 2 ?
ln( S / K ) + ( −  + 0.5 2
)t
dˆ1 = 0

 t
and
ˆ ln( S / K ) + ( −  − 0.5 2
)t
d2 = 0

 t

Hence, 𝑑መ 2 =?
1.7 Conditional Expectation
▪ By dividing the partial expectation conditional on an
interval by the probability of the interval, you obtain the
conditional expectation conditional on the interval

𝑃𝐸[𝑋|𝑌]
𝐸𝑋𝑌 =
Pr(𝑌)
1.7 Conditional Expectation
▪ For a put option, the partial expectation of 𝑆𝑡 given that
𝑆𝑡 < 𝐾:
𝑆0 𝑒 𝛼−𝛿 𝑡 𝑁(−𝑑መ1 )
𝐸 𝑆𝑡 𝑆𝑡 < 𝐾 =
𝑁(−𝑑መ 2 )
▪ For a call option, the partial expectation of 𝑆𝑡 given that
𝑆𝑡 > 𝐾:
𝑆0 𝑒 𝛼−𝛿 𝑡 𝑁(𝑑መ1 )
𝐸 𝑆𝑡 𝑆𝑡 > 𝐾 =
𝑁(𝑑መ 2 )
Example 1.7
▪ A stock’s price follows a lognormal distribution. You are
given:
▪ 𝛼 = 0.15
▪ 𝛿=0
▪ 𝜎 = 0.3
The stock’s price is currently 50. Determine the conditional
expected value of the stock’s price after 3 months, given that
it is higher than 75.
Solution 1.7
1.8 Expected Payoff
1.8.1 European put
▪ One who owns a European put option will have the
following cash flows at expiry:
▪ Receipt of K if the stock price is below K.
▪ Payment of the stock if the stock price is below K times
the probability that the stock price is below K.
▪ The expected payoff of a put option:

𝐸 max 0, 𝐾 − 𝑆𝑡 = 𝐾𝑁 −𝑑መ 2 − 𝑆0 𝑒 𝛼−𝛿 𝑡 𝑁(−𝑑መ )

1
1.8 Expected Payoff
1.8.2 European Call
▪ One who owns a European call option will have the
following cash flows at expiry:
▪ Payment of K if the stock price is above K.
▪ Receipt of the stock if the stock price is above K times the
probability that the stock price is above K.
▪ The expected payoff of a call option:

𝐸 max 0, 𝑆𝑡 − 𝐾 = 𝑆0 𝑒 𝛼−𝛿 𝑡
𝑁 𝑑መ1 − 𝐾𝑁 𝑑መ 2
1.9 Summary
▪ To calculate the value of an option, we need to discount
the expected payoff of the option
▪ What will be an appropriate discount rate? The problem
is solved the same way we solved the problem for
binomial trees
▪ We use the risk-neutral distribution (use 𝑟 in place of 𝛼)
and discount the risk-neutral expected value using the
risk-free rate
▪ Doing this gives the Black-Scholes formula which uses
the unhatted 𝑑1 and 𝑑2 , which are defined with 𝑟’s
instead of 𝛼’s
Next Agenda
▪ The Black-Scholes Formula, Option Greeks, The Black-
Scholes Equation