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Digital prices under matched normal and lognormal models

Question

A normal model and a lognormal model are each calibrated so that they give the same price for a vanilla call at a particular strike. Which model gives the higher price for a digital call at that strike, and why?

Short answer

The normal model gives the higher digital price. A digital is −∂C/∂K-\partial C/\partial K. Viewed through Black-Scholes, a normal model corresponds to implied vols that fall as strike rises. Differentiating C=CBS(K,σ(K))C=C_{BS}(K,\sigma(K)) gives digital == lognormal digital −- vega ×σ′(K)\times\sigma'(K), and with σ′(K)<0\sigma'(K)<0 the extra term adds value.

Adapted from Joshi, Denson & Downes, Quant Job Interview Questions and Answers, Q2.18, p.18; question and answer rewritten by SelfMadeQuant.com.

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