1

Preliminaries

Denition 1. (Binomial Distribution)

A random variable X is dened to have binomial distribution if the discrete function of X is given by
 
n x

p (1 p)n x
x
fx (x) =

, f or x = 0, 1, . . . , n
.
, otherwise

Theorem 2. If X has a binomial distribution, then

E[X] = np

V ar[X] = np(1 p).

and

Denition 3. (Normal Distribution)

A random variable X is dened to be normally distributed if its density is given by

F x (x) =

1
2 2


exp


(x )2
,
2 2

where the parameters and satisfy < < and > 0. Any distribution dened by a density
function given above is called a normal distribution.

Theorem 4.

(Central Limit Theorem)

Let f () be a density with mean and nite variance 2 , i.e., 2 < . Let Xn be the sample mean of a
random sample of size n from f (). Let the random variable Zn be dened by
Xn E[Xn ]
Xn
.
Zn = p
=
/ n
V ar[Xn ]

Then, the distribution of Zn approaches the standard normal distribution as n .

Denition 5.

(Geometric Brownian Motion)

We say that Sy , 0 y < t, follows a geometric Brownian Motion if:

St+y
is independent of all prices up to time y;
Sy


St+y
ln
N (t, 2 t)
Sy

PROOF

Consider the multi-period Binomial Model with periods of length

t
. Now, the pathing process equation
n

(also called stock price after n periods) is

St = S0 u Yt dn Yt
 u P Y t
= S0
dn
d
P

u
St
=
S0
d


ln

St
S0


= ln

Yt

u X
d

dn

Yt + n ln(d)

(1)

(2)

(3)

where,
St :=stock price at time t
S0 :=stock price at time 0
u := increase of stock price
d := decrease of stock price
n :=
frequency of payments

1 , if St = uSt1
Yt =
, t = 1, 2, . . . .

0 , if St = dSt1
r
r
t
t

n and d = e
n.
Choose u = e

Substituting the values of u and d on equation(3), we have


ln

St
S0


= ln

t !
n


t
Yt + n ln e n

e n
r

t X
= 2
Yt nt.
n

Now, recall the risk-neutral probability,

p=

1+rd
.
ud

(4)

If we modify this equation, we have

p=

Let X = ln

1 + rt
n d rt
,
:= one period risk f ree interest rate.
ud
n


St
.
S0

Hence, from equation(4), we have

r
X = 2

t X
Yt nt.
n

It can be shown that the mean and variance of X are

E[X] =2 ntp nt

and
V ar[X] = 4 2 tp(1 p)

, respectively.
Now,

p=

1 + rt
n d
ud

t
n
1 + rt
n e
t
= t
e n e n

Let a =

(5)

t
n.

This will imply,

p=

By Taylor Series expansion, ea 1 + a +

a
1 + rt
n e
.
a
a
e e

a2
.
2

Hence, from equation(6),

(6)



2
1 a + a2
p
2

2

1 + a + a2 1 a + a2
1+

rt
n

+a
2a
q
r

rt
n

a2
2

(7)

t
n

1
+

2
2

t
n

t
1 r nt n
Using the approximation of p +

, the approximate value of mean is

2
2
4

E[X] = 2 ntp nt


2
r
t.
2

(8)

Furthurmore, the approximate value of the varaiance is

V ar[X] = 4 2 tp(1 p)

(9)

2 t.

By T heorem 4,

ln

St
S0


N

2
r
2


t, t
2

as n .
By this time, the multi-period Bionial model becomes geometric Brownian motion when n .
Recall that
C=


n   P
+
Yt
rt
u
1+
E So
dn K
.
n
d

Then, for suciently large n,

+

C = ert E [(e K)]

where N (t, 2 ).
The equation above will now lead to Black-Schole equation which is


C = So () Kert ( t).