Document Date: November 2, 2006

An Introduction To Derivatives And Risk Management, 7th Edition

Don Chance and Robert Brooks
Technical Note: Probability of Call Expiring in-the-Money, Ch. 5, p. 138
This technical note supports the material in the Characteristics of the Black-
Scholes-Merton section of Chapter 5 Option Pricing Models: The Black-Scholes-Merton
Model. This note shows that under the assumption that investors are risk neutral the
probability of the call expiring in-the-money is N(d2). If investors are not risk neutral, an
adjustment to the expected return is required, as explained later.
The standard model for capturing movements in the stock price is called a
lognormal diffusion or geometric Brownian motion process:
dS0 = S0α dt + S0σ dzt

Where S0 is the current stock price, dt is an infinitesimally short period of time, α is the
expected return on the stock, σ is the volatility, and dzt is a random variable that captures
the uncertainty in the stock price. The variable dzt is driven by a standard normal
variable, εt, such that dzt = ε t dt . Of course, εt has an expected value of zero and a
variance of 1. Given that εt is normally distributed and is the source of all of the
uncertainty, we should be able to use normal probability theory to derive the probability
of the option expiring in-the-money. We shall need to express the stochastic process in
such a manner that the return on the asset is normally distributed. In Geometric
Brownian Motion the log return on the asset is normally distributed, so we will need the
stochastic process for the log of the asset return.
Define dS0 + S0 as the asset price at an instant, dt, later. Thus, we can write the
stochastic process as dS0 + S0 = S0[1 + αdt + σdz]. Working with the term in brackets,
note that we can write it in the following, seemingly complex, way:

(
1 + α dt + σ dzt = 1 + (α − σ 2 2 ) dt + σ dzt + (α − σ 2 2 ) dt + σ dzt ) / 2 .
2

 
By multiplying out the terms on the right hand side, it is easy to verify that the above
statement is true. Now define µ = α - σ2/2 and the above can be written as 1 + [µdt +
σdzt + (µdt + σdzt)2/2]. The term in brackets is equivalent to a second-order Taylor
series expansion of the function e µ dt +σ dzt . A second-order expansion is sufficient, because
all terms higher than second order will involve powers of dt greater than 1.0 and by
definition, these terms approach zero in the limit.
Now we can write out the stochastic process as dS0 + S0 = S0 e µ dt +σ dzt . Dividing by

S0 we obtain dS0 / S0 + 1 = e µ dt +σ dzt . Taking natural logs, we have the stochastic process of
the log return on the asset,
 dS + S0 
ln  0  = µ dt + σ dzt .
 S 0 
This result confirms that the log return is normally distributed with mean µ and volatility
σ. For our purposes here, we use the following version,
dS0 + S0 = S0 e µ dt +σ dzt .
The point of this Technical Note is to determine the probability that the option
will expire in-the-money. Noting that the time increment until expiration is T, we have
the asset price at expiration as ST and the stochastic process for z as ∆zT = ε * T . Thus,
*
ST = S0 e µT +σε T

with ∆zT normally distributed with mean zero and variance T, per the central limit
theorem.
We want to know
∞
Pr ob ( ST > X ) = ∫ f ( ST ) dST .
X

Let us first evaluate the second term on the right-hand side. By definition,

Pr ob [ ST > X ] = Pr ob  S0 e µT +σε > X.

*
T
 

> X is equivalent to ln ( S0 X ) + µT + σε * T or
*
Note that S0 e µT +σε T

ln ( S0 X ) + µT 
ε* > −  .
σ T
Recall that α is the expected simple return on the asset and µ is the expected logarithmic
return on the asset where µ = α - σ2/2. Under the equivalent martingale/risk neutrality
approach, we can let α = r so that µ = r - σ2/2 so that

IDRM7e, Chance-Brooks 2 Probability of Call Expiring in-the-Money

 ln ( S0 X ) + ( r − σ 2 2 ) T 
ε* > −   .
σ T
You should recognize this as ε* > -d2 or ε* < d2. So we have
Pr ob [ ST > X ] = N ( d 2 ) .

Of course, this expression is one of the terms in the Black-Scholes model. To

interpret N(d2) as the probability that the option expires in-the-money, however, requires
that we assume investors are risk neutral or that we assume the expected return on the
stock is the risk-free rate. These two assumptions are permissible within the Black-
Scholes model. They do not violate any accepted norms of economic theory, and they
guarantee the correct arbitrage-free price. But if what we want is the true probability of
exercise, we must replace the risk-free rate with the expected return on the stock.

References
Hull, J. Options, Futures and Other Derivatives, 6th ed. Upper Saddle River, New
Jersey: Prentice-Hall (2006), Ch. 13.
Jarrow, R. and A. Rudd. Option Pricing. Homewood, Illinois: R. D. Irwin (1983), Ch. 7.

IDRM7e, Chance-Brooks 3 Probability of Call Expiring in-the-Money