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If I assume that stock returns follow normal distribution with drift = 0% and S.D. = 10%.

In the long, if I keep investing in this stock for a year with the same capital every year for a consecutive 100 years, my expected return would be 0% per year (equal to the zero drift).

Put this another way, If I invest in a sea of stocks that have identical return distribution (drift = 0% and S.D. = 10%) for a year, my average return would be 0% (equal to the zero drift).

Do I get it right?

In case that I got it right, what if I change from investing in stock to option on that stock. What expected return should I see?

I have tried to elaborate my problem in an excel file. The example in the file illustrates return distribution of a stock and an option of the stock which are based on normal distribution. I calculate expected price of stock and option by sumproducting probability and price. As you will see, the option price calculated from BS formula (Cell C8) is not equal to expected value got from the table (Cell C9).

I expect that BS price should be equal to my expected price, why is it not the case?

I have included the link of my Excel file here Expected Price of Option

Any contribution will be greatly appreciated.

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2 Answers 2

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Black--Scholes takes log-normal stock price movements whereas your model gives normal price movements.

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You have a "variance drag" problem ;-)

Create a new spreadsheet. Model your 0 drift, 10 vol with "=NORMSINV(RAND()) * 10%" and compound those returns for say 1000 years. You should find your investment's value declining by ~0.5% per annum.

Put simply, an investment that halves or doubles with equal probability every period should have a zero long-run expected return. Except a 50:50 between +100% and -50% is a +25% expected return in any single period...

The difference between the two (ie the arithmetic and the geometric retuns) is 0.5 * sigma^2. Put this into your model for the drift, to give you a zero long-term drift, and the anomaly should (fingers crossed) disappear.

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