Chapter 18

The Lognormal
Distribution
The Normal Distribution
1 x 2
1
2
Normal distribution (or density) ( x; , ) e
2

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-2

The Normal Distribution (contd)

Normal density is symmetric: ( x; , ) ( x; , )

If a random variable x is normally distributed with
mean and standard deviation, x ~ N ( , 2 )
z is a random variable distributed
standard normal: z ~ N (0,1)
The value of the cumulative normal distribution
function N(a) equals to the probability P of a
number z drawn from the normal distribution to
be less than a. [P(z<a)] a 1
1 2
x
N (a ) e 2 dx
2
Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-3
The Normal Distribution (contd)

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-4

The Normal Distribution (contd)

The probability of a number drawn from the standard

normal distribution will be between a and a:
Prob (z < a) = N(a)
Prob (z < a) = N(a)
therefore
Prob (a < z < a) =
N(a) N(a) = N(a) [1 N(a)] = 2N(a) 1

Example: Prob (0.3 < z < 0.3) = 20.6179 1 = 0.2358

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-5

The Normal Distribution (contd)

Converting a normal random variable to

standard normal:
x
If x ~ N ( , 2 ) , then z ~ N (0,1) if z

And vice versa:
If z ~ N (0,1) , then x ~ N ( , 2 ) if x z

Example 18.2: Suppose x ~ N (3,5) and z ~ N (0,1)

x3
then ~ N (0,1) , and 3 5 z ~ N (3,25)
5

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-6

The Normal Distribution (contd)

The sum of normal random variables is

also
n n n n
i xi ~ N i i , i j ij
i 1 i 1 i 1 j 1

where xi, i = 1,,n, are n random variables,

with mean E(xi) = i, variance Var(xi) =i2,
covariance Cov(xi,xj) = ij = rijij

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-7

The Lognormal Distribution

A random variable x is lognormally distributed if ln(x) is

normally distributed
If x is normal, and ln(y) = x (or y = ex), then y is lognormal
If continuously compounded stock returns are normal then
the stock price is lognormally distributed

Product of lognormal variables is lognormal

If x1 and x2 are normal, then y1=ex1 and y2=ex2 are lognormal
The product of y1 and y2: y1 x y2 = ex1 x ex2 = ex1+x2
Since x1+x2 is normal, ex1+x2 is lognormal

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-8

The Lognormal Distribution (contd)

The lognormal density function

1 ln( S ) [ln( S 0 ) m 0.5v 2 ]
2

1 2
g ( S ; m, v , S0 ) e v
Sv 2
where S0 is initial stock price, and ln(S/S0)~N(m,v2),

S is future stock price, m is mean, and v is standard
deviation of continuously compounded return
1 2
If x ~ N(m,v ), then
2 m v
E (e ) e 2
x

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-9

The Lognormal Distribution (contd)

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-10

A Lognormal Model of Stock Prices

If the stock price St is lognormal, St / S0 = ex, where

x, the continuously compounded return from 0 to t
is normal
If R(t, s) is the continuously compounded return from t
to s, and, t0 < t1 < t2, then R(t0, t2) = R(t0, t1) + R(t1, t2)
From 0 to T, E[R(0,T)] = nah , and Var[R(0,T)] = nh2
If returns are iid, the mean and variance of the
continuously compounded returns are proportional
to time

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-11

A Lognormal Model of
Stock Prices (contd)

If we assume that
In(St / S0 ) ~ N[(a 0.5 2 )t, 2t]
then In(St / S0 ) (a 0.5 2 )t t z
(a 0.5 2 ) t t z
and therefore St S0e
If current stock price is S0, the probability
that the option will expire in the money, i.e.
Prob( St K ) N (d2 )
where the expression contains a, the true expected return on
the stock in place of r, the risk-free rate

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-12

Lognormal Probability Calculations

Prices StL and StU such that Prob (StL < St ) = p/2 and
Prob (StU > St ) = p/2
1 1
( a 2 ) t t N 1 ( p / 2 ) ( a 2 ) t t N 1 ( p / 2 )
StL S0 e 2 StU S0 e 2

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-13

Lognormal Probability Calculations (contd)

Given the option expires in the money, what is

the expected stock price? The conditional
expected price
N (d1 ) (a )t
E ( St | St K ) Se
N (d2 )
where the expression contains a, the true expected
return on the stock in place of r, the risk-free rate

The Black-Scholes formulathe price of a call

option on a nondividend-paying stock
P( S , K , , r , t , ) Ke rt N ( d 2 ) e t SN ( d1 )
Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-14
Estimating the Parameters of a
Lognormal Distribution

The lognormality assumption has two implications

Over any time horizon continuously compounded
return is normal
The mean and variance of returns grow proportionally
with time

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-15

Estimating the Parameters of a
Lognormal Distribution (contd)

The mean of the second column is 0.006745 and the

standard deviation is 0.038208
Annualized standard deviation
0.038208 52 0.2755
Annualized expected return
0.006745 52 0.5 0.2755 0.2755 0.3877

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-16

How Are Asset Prices Distributed?

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-17

How Are Asset Prices Distributed? (contd)

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-18

How Are Asset Prices Distributed? (contd)

Copyright 2006 Pearson Addison-Wesley. All rights reserved. 18-19