These are just some quick notes about returns under the Black-Scholes-Merton model.

These notes correspond to chapters 13.113.3 in Hulls Fundamentals of Futures and Options Markets 7e.

Normal Random Variables

One of the most common assumptions about random variables is that they are normally distributed. This is the bell curve youve probably seen many times. Our general problem sounds like this. If x is normally distributed with a mean and standard deviation , what is the probability that x is below some cuto level A. The value A depends on the problem at hand. Unfortunately, the probabilities of the normal distribution are not easy to calculate. Therefore, we get stuck using a normal table to calculate probabilities. To use a normal table, we need to standardize our random variable. Standardizing means we re-cast a problem in terms of standard deviations from the mean or average instead of physical units. This allows us to look up probabilities using a table. z= A M ean . Standard Deviation (1)

Suppose peoples heights are normally distributed. The mean height is 175cm, and the standard deviation is 10cm. I am 185cm tall. Is that unusual? In one sense it is because Im taller than average. In another sense though, Im not nearly so unusual as someone 205cm. In order to say anything, we use probabilities. How unusual am I?1 For this problem A is 185cm. Thats my height, and the value Im trying to evaluate. The z-score for my height is z= 185 175 = 1. 10 (2)

The z-score tells me that I am one standard deviation above the mean height. I look that up on a normal tablelike the one at the back of your bookand nd that the probability that someone is my height or less 0.8413. So theres an 84.13% chance that a person is my height or less. That means about 15.87% of people are taller than me. Thats sort of unusual, but in a room of 20 people, Id expect about 3-4 people taller than me. The normal distribution is symmetric ; it looks the same above the mean as below the mean. To see the probability that someone is above my height, I ask the probability of being my height or
1

We will answer this question only with respect to height.

shorter. One minus the probability that someone is shorter than me is the probability that theyre taller than me. Because of symmetry, being unusually tall is the same as being unusually short. So we can also use N (z ) = 1 N (z ) to calculate probabilities. From the normal table, there is a 0.1587 probability that someone is one standard deviation below the mean or shorter. Once again, I get that 15.87% of people are taller than me. Both approaches always work. How unusual is someone 205cm? For this problem, A is 205cm. The z-score is z= 205 175 = 3. 10 (3)

I look that up on a normal table and nd that the probability of being 205cm or below is 0.9986. Alternatively, you have only a 0.0014 probability of falling three standard deviations or more below the average height. Either way you look at the problem, there is almost a 100% probability that a person is shorter than 205cm. If you are 205cm, you expect only one person in a thousand taller than you.

We Assume Returns are Normal Random Variables

We assume that returns are normally distributed. We assume that the mean return using risk2 neutral probabilities is Rf T . So z-scores will use that as the mean. We assume the 2 standard deviation is T . So, really we have enough information to gure out z-scores. Heres an example. Suppose the risk-free rate is 5% and the standard deviation of Telstra returns is 20% per year. Whats the risk-neutral probability that the return was 10% or greater over the next six months? The mean return is (0.05 so the z-score for a 10% return is z= 0.10 0.015 = 0.60. 0.2 0.5 (5) 0.202 ) 0.5 = 0.015, 2

(4)

Looking that up on a normal table, N (0.60) = 0.7257. That means theres a 73% chance that a return is 10% or below given our average return. If theres a 73% chance that the return is below 10%, there is a 27% chance that the return is above 10%. Alternatively, we could look up N (0.60) to nd a probability of 0.2743. Once again, either approach gives the same answer. 2

Exercising a Call Option Requires a High Enough Return over the Life of the Option

Suppose that the price of Telstra stock is currently $3.00. You have a six month call option on Telstra stock with a strike price of $3.05. Suppose the risk-free rate is 5% and the standard deviation of Telstra returns is 20%. Whats the risk-neutral probability that you exercise the option? Well, exercise depends on the stock return. If the current price is $3.00, we need a continuously3.05 compounded return of at least ln = ln[3.05] ln[3] = 0.0165 before wed exercise. If the 3.00 return is not at least that big, the stock price ends up below $3.05 and we dont exercise. So what is the probability that the return is at least that high? The mean return is (0.05 so the z-score for a 1.65% return is z= 0.0165 0.015 = 0.01. 0.2 0.5 (7) 0.202 ) 0.5 = 0.015, 2

(6)

Looking that up on a normal table, N (0.01) = 0.5040. There is about a 50.4% chance that the return is lower than that number, which means theres about a 49.6% chance that the return is higher than that number. Alternatively, we could look up N (0.01) to nd a probability of 0.4960. Once again, either approach gives the same answer. In general, the z-score we looked up is:
M ean A

2 ln[K ] ln[S0 ] Rf 2 z= T
Standard Deviation

T . (8)

while d2 is dened as

2 ln[S0 ] ln[K ] + Rf 2 d2 = T

T = z. (9)

Thus, d2 is the z-score wed look up to answer the following question: What is the probability that a return big enough to make our call option end up above the strike price? That means N (d2 ) tells us the probability that well exercise the call option because the return was high enough. 3