Document Date: November 2, 2006

An Introduction To Derivatives And Risk Management, 7th Edition

Don Chance and Robert Brooks
Technical Note: Derivation of Up Probability Converging to 50 Percent, Ch. 4, p. 117
This technical note supports the material in the Alternative Specifications of the
Binomial Model section of Chapter 4 Option Pricing Models: The Binomial Model.
Caution, this technical note is somewhat mathematically advanced. The objective here is
to provide more details on the alternative specification and to demonstrate that under this
alternative specification, the probability of an up jump converges to ½ as the time step
gets smaller. This convergence is a useful property for some applications, particularly
interest rate options which are covered later in the book.

Binomial Probability Specifications

Note that the per period interest rate is computed as:
r = (1 + ra )
T n
−1

where ra denotes the annual compounded risk-free interest rate, T denotes the fraction of
the year until the option matures, and n denotes the number of binomial steps. We will
apply continuously compounded interest rates, hence,
T
rc  
1 + r = (1 + ra )
Tn
=e n
.
Based on the properties of exponentials and natural logs, we have
T T
ln (1+ ra )  rc  
e ln (1+ r ) = e n
=e n
.
The traditional specification of the binomial model for stock options given in this
chapter is:
σ T n
u=e
1 −σ T n
d= =e
u

1 + r − d e ln (1+ r ) − e
−σ T n
p= = σ Tn .
u−d e −e
−σ T n

An alternative specification also given in this chapter is:

 σ2  T 
 ln (1+ ra )−  + σ T n
 2   n 
u=e
  σ2  T 
 ln (1+ ra )−  −σ T n
 2   n 
d=e
 σ2  T 
T
ln (1+ ra )   ln (1+ ra )−   −σ T n T
σ2   2
 2   n  −σ T n
1+ r − d e n
−e e n
−e
p= = =
u−d   T    T  σ T n −σ T n
2 2
σ σ
 ln (1+ ra )−
2
 + σ T n  ln (1+ ra )−   −σ T n e −e
   n   2   n 
e −e

Lognormal Distribution
We briefly review the lognormal distribution with a focus on its application to
asset prices. Almost any intermediate or advanced statistics book will offer more details.
For more advanced materials, see Stuart and Orr (1988) or Aitchison and Brown (1957).
First, we define the lognormal distribution for some generic variable, ~x , where
randomness is depicted with the tilde (~) on the top. The tilde beside the random variable
is read as “is distributed.” Assume ~x is distributed as a normal distribution, that is,
x ~ N(µ, σ ) , where N(•,•) denotes the normal distribution, µ is the mean, and σ is the
~

standard deviation. If ~y = exp{~x} , then ~y ~ Λ(µ, σ ) , where Λ(•,•) denotes the lognormal
distribution.
In the context of rates of return on stocks, suppose
~ ~
ST = St exp RT . { }
~
If R ~ N(µ, σ ) , then
~
(
ST ~ Λ ln (S0 ) + µT, σ T . )
From the properties of the lognormal distribution we have the expected terminal value
and variance of the asset price expressed as,

[ ]
~ 
E ST = S0 exp µ +

σ 2  
T 
2  
~
[ ] [ {(
Var ST = S20 exp 2 µ + σ 2 T − exp 2µ + σ 2 T . )} {( ) }]
Alternatively, the normal distribution parameters can be expressed as a function of the
lognormal distribution parameters.
~
 E St 
µ = ln 
[ ]
 T
 S0 

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 [ ]
 var ~
S 
σ 2 = ln  ~ t 2 + 1 T .
{ [ ]}
 E St 

Binomial Convergence Theorems

From the material in this chapter, we know that option prices are based on the
present value of the expected terminal option price, where the underlying asset is
assumed to grow at the risk-free interest rate. That is,
~
[ ]
E ST = S0 exp{rc T} .

From the previous section, we know one property of the lognormal distribution is,

[ ]
~ 
E ST = S0 exp µ +

σ 2  
T  .
2  

Setting these two expectations equal and solving for the mean, we have
σ2
µ =r c − .
2
We now turn to the general specification of the binomial process. Assuming the
probability of an up jump, p, must be positive and less than one, if
m̂ (T n )+ σ T n
u=e
m̂ (T n )− σ T n
d=e

  σ2  
 c r −  − m̂ 
1 2 
p = 1 +  T n
2 σ 
 
 

where T n denotes a discrete change in time, m̂ is a free parameter sometimes referred

to as the revealed preference parameter, u and d are the multiplicative parameters used to
compute future values of S ( Sn , j = u jd n − jS0 ), where n denotes periods in the future and j

denotes the number of times up occurs). Then as n → ∞ (interpret, getting larger) or

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T n → 0 (interpret, getting smaller), the binomial process will converge to the lognormal

distribution.1
Both the traditional specification and the alternative specification are special cases
of the general specification, where:
Traditional specification: ˆ =0
m

σ2 σ2
Alternative specification: ˆ = ln (1 + ra ) −
m = rc −
2 2
We now turn our attention to the probability of the up jump converging to ½ for
the alternative specification. Clearly, substituting for m̂ , we have
  σ2     σ2   σ2  
 c r −  − m̂   c r −  −  r −  
1 2  1 
2    c
2  1
p = 1 +  T n  = 1 +  T n = .
2  σ  2  σ  2
   
   

Recall the alternative specification for the probability of an up jump is

T
σ2   2
−σ T n
e n
−e
p= σ T n −σ T n
≈ 1/ 2 .
e −e

Let z = σ T n and based on Taylor series approximation (see appendix below) where

higher order terms than T n are ignored,2 we have ( ≅ denotes approximately)

z2
ez ≅ 1 + z +
2

z2
e −z ≅ 1 − z +
2
2
ez 2
≅ 1.
Therefore, the probability can be represented as

1
See Nawalkha and Chambers (1995).
2
Higher order terms involve T n raised to a power greater than 1. As T n → 0 then these higher order
terms converge to zero fast.
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  σ 2 (T n ) 
T
σ2   2 1 −  1 − σ T n + 
e −e
n −σ T n  2 
p= σ Tn ≅  
e −e
−σ T n 
1 + σ T n +
σ 2
(T n )  
 − 1 − σ T n +
σ 2 (T n ) 

 2   2 
   .
 σ Tn
σ T n 1 − 
 2  1 σ T n 
=   = 1 − 
2σ T n 2  2 

Clearly, as T n → 0 , then p → 1 2 .3

Appendix: Taylor Series

Assume a continuous function f (x ) , where − ∞ < x < ∞ and − ∞ < f ( x ) < ∞ . Also
assume at f ( x 0 ) has derivatives of all orders. Then the Taylor series of f about the

number x0 can be expressed as

∞
f ( i ) ( x0 )
f (x ) = ∑ (x − x0 )i
i =0 i!
The nth Taylor polynomial pn of f about x0 is

f ' '(x0 ) f (n)

(x )
p n ( x ) = f ( x 0 ) + f ' ( x 0 )( x − x 0 ) + (x − x ) (x − x )
2 0 n
0 +L+ 0
2! 2!
The nth Taylor remainder rn of f about x0 is

rn ( x ) = f ( x ) − pn ( x )
It can be shown than
f ( n + 1)
(x )
rn ( x ) =
(n + 1)!
z
(x − x )
0
n +1

for some x0 < x z < x .4

3
Alternatively, the exact proof that this probability converges to ½ without using the Taylor series
approximation for the exponential function can be found by evaluating the limit of the probability as N →
∞. This result gives the ratio (0 – 0)/(0 – 0), which can only be legitimately evaluated by applying
L’Hôpital’s rule that requires that we take the limit of the ratio of the derivatives. Doing so gives the result
that the probability converges to ½.
4
The univariate Taylor series can be found in just about any calculus book. See, Ellis and Gulick [1982],
477.
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References
Aitchison, J. and J. A. C. Brown, The Lognormal Distribution with special reference to
its uses in economics, (Cambridge University Press, 1957).

Black, Fischer, Emanuel Derman, and William Toy. “A One-Factor Model of Interest
Rates and Its Application to Treasury Bond Options.” Financial Analysts Journal 46(1),
(January/February 1990), 33-39.

Black, Fischer, and Myron Scholes. “The Pricing of Options and Corporate Liabilities.”
Journal of Political Economy (May 1973), 637-659.

Cox, J. C., S. A. Ross, and M. Rubinstein. “Option Pricing: A Simplified Approach.”

Journal of Financial Economics 7 (1979), 229-263.

Crow, E. L. and K. Shimizu, Eds., Lognormal Distributions: Theory and Applications,

(New York: Dekker, 1988).

Ellis, Robert and Denny Gulick, Calculus With Analytic Geometry Second Edition (New
York: Harcourt Brace Jovanovich, Inc., 1982).

Galton, F., Natural Inheritance (London: Macmillan, 1889).

Jarrow, R., and A. Rudd. Option Pricing (Homewood, IL: Dow Jones-Irwin, 1983 and
1991).

Limpert, E., M. Abbt, and W. A. Stahel, Lognormal Distributions across the sciences –
keys and clues (2000, submitted) www.inf.ethz.ch/~gut/lognormal/.

McAlister, D., Proceeding of the Royal Society 29 (1879), p. 367.

Merton, Robert C. “Theory of Rational Option Prices.” Bell Journal of Economics and
Management Science 4, (Spring 1973), 141-183.

Nawalkha, Sanjay K. and Donald R. Chambers, “The Binomial Model and Risk
Neutrality: Some Important Details,” The Financial Review, 30(3), (August 1995), 605-
615.

Stuart, Alan and J. Keith Ord, Kendall’s Advanced Theory of Statistics Volume 1
Distribution Theory, Fifth Edition (New York: Oxford University Press, 1987).

Trigeorgis, Lenos, “A Log-Transformed Binomial Numerical Analysis Method for

Valuing Complex Multi-Option Investments,” Journal of Financial and Quantitative
Analysis 26(3), (September 1991), 309-326.
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