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 . Viewed through Black-Scholes, a normal model corresponds to implied vols that fall as strike rises. Differentiating gives digital lognormal digital vega , and with 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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Open the worked solutionLessons behind this question
- Reading the Implied Vol Surface — Moneyness, Term Structure, and Quoting Conventions
- Option Mechanics: Calls, Puts, Moneyness, Intrinsic Value, and Exchange vs. OTC Markets
- Option Trading Strategies: Spreads, Combinations, and Payoff Engineering
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