Hi All,
P2.T6.R43
I am trying to conceptually understand how the DD value is calculated statistically. The numerator is the expected value of the price, and the denominator is the standard deviation. My question relates to the numerator.
Assume T-t=1
ln(Vo/K) is the current log "return" at T=0. We then add what I assume is the expected drift until maturity (r-(sig^2)/2). How am I supposed to understand the second term. Intuitively, I would have thought the expected drift to simply be r. What is the rationale behind scaling it down by (sig^2)/2?
Note: I understand the math and can complete the problems, I'm simply trying to add to my grasp of the underlying logic.
Thanks,
The Great Khan
P2.T6.R43
I am trying to conceptually understand how the DD value is calculated statistically. The numerator is the expected value of the price, and the denominator is the standard deviation. My question relates to the numerator.
Assume T-t=1
ln(Vo/K) is the current log "return" at T=0. We then add what I assume is the expected drift until maturity (r-(sig^2)/2). How am I supposed to understand the second term. Intuitively, I would have thought the expected drift to simply be r. What is the rationale behind scaling it down by (sig^2)/2?
Note: I understand the math and can complete the problems, I'm simply trying to add to my grasp of the underlying logic.
Thanks,
The Great Khan
