Chapter 18

The Lognormal
Distribution

The Normal Distribution

Normal distribution (or density)

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1
( x; , )
e
2

1 x

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
1 2
be less than a. [P(z<a)]

x
a
1
2
N (a )
e
dx
2
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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

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18-5

The Normal Distribution (contd)

Converting a normal random variable to
standard normal:

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

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

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

18-6

The Normal Distribution (contd)

The sum of normal random variables is
also
n

i 1

i 1

i xi ~ N i i , i j ij

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 = ijij

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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=ex and y2=ex are lognormal

The product of y1 and y2: y1 x y2 = ex x ex = ex +x
1

Since x1+x2 is normal, ex +x is lognormal

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18-8

The Lognormal Distribution (contd)

The lognormal density function
1
g ( S ; m, v , S0 )
e
Sv 2

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

2
v

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
m v
If x ~ N(m,v2), then
x
E (e ) e 2

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18-9

The Lognormal Distribution (contd)

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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)] = nh , and Var[R(0,T)] = nh2
If returns are iid, the mean and variance of the
continuously compounded returns are proportional
to time

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18-11

A Lognormal Model of
Stock Prices (contd)
If we assume that

In(St / S0 ) ~ N[( 0.5 2 )t, 2t]

then In(St / S0 ) ( 0.5 2 )t tz
and therefore

St S0 e

( 0.5 2 )t tz

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 , the true expected return on

the stock in place of r, the risk-free rate

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18-12

Lognormal Probability Calculations

Prices StL and StU such that Prob (StL < St ) = p/2 and
Prob (StU > St ) = p/2
StL S0

1
( 2 ) t t N 1 ( p / 2 )
e 2

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StU S0

1
( 2 ) t t N 1 ( p / 2 )
e 2

18-13

Lognormal Probability Calculations

(contd)
Given the option expires in the money, what is
the expected stock price? The conditional
expected price
E ( St | St K ) Se

( )t

N (d1 )
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 )
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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

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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

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18-16

How Are Asset Prices Distributed?

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18-17

How Are Asset Prices Distributed? (contd)

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18-18

How Are Asset Prices Distributed? (contd)

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18-19