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Risk Neutral Pricing and Financial Mathematics: A Primer by John L. Teall, Peter M. Knopf

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Figure 2.4 The lognormal density curve.

The lognormal random variable is particularly useful when security returns or interest are compounded over time. First, consider the non-random model based on compound interest. Suppose that a security with value Y(t) at time t pays interest at a rate r compounded continuously. This means that the instantaneous rate of change of Y(t) is equal to rY(t):

dYdt=rY

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We know from integral calculus that the solution for Y(t) is:

Y(t)=Y0ert

where Y0 is the value of Y at time 0. Observe that ln(Y(t)/Y0)=rt. Of course, ...

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