Why N(d2) is the probability that a call option finishes in the money in Layman’s terms…

The Black-Scholes formula for a call option is given by: C = S * N(d1) - K * e^(-rt) * N(d2). In this formula, C represents the price of the call option, S is the current stock price, and K is the strike price of the option. The term N(d1) and N(d2) come from the Cumulative Distribution Function (CDF) of the standard normal distribution, where the CDF indicates the probability that a variable will be less than or equal to a particular value, summarizing the accumulation of probabilities up to that point.

Focusing on N(d2), it represents the probability, under the risk-neutral measure, that the stock price will exceed the strike price (K) at the time of expiration. This is crucial as it calculates the likelihood of the option being "in the money" at expiration.

A higher N(d2) suggests a greater probability of the option being exercised profitably. The term K * e^(-rt) * N(d2) in the formula adjusts the expected cost of exercising the option to the present value, factoring in the likelihood of the option actually being exercised.

This risk-neutral measure is essential in option pricing as it assumes all investments grow at a risk-free rate, focusing on the mathematical probabilities without accounting for individual risk preferences.

The concept of the risk-neutral measure in option pricing, particularly in the context of the Black-Scholes model, is fundamental in ensuring that there are no arbitrage opportunities. In simpler terms, it means pricing the option in such a way that no one can make a risk-free profit by exploiting price differences in the market.

When N(d2) is high, it means there’s a greater chance that exercising the option will be profitable (the stock price will be above the strike price at expiration). The term K * e^(-rt) * N(d2) represents the expected cost of exercising the option, discounted to the present value, and adjusted by the probability of actually exercising the option. A higher N(d2) increases this term, indicating a higher expected cost due to the increased likelihood of exercising the option.

When considering the impact of an increasing N(d2) the second term in the formula, K * e^(-rt) * N(d2), represents the expected cost of exercising the option at its expiration, discounted to present value.

As N(d2) increases, this second term becomes larger. Since it's subtracted from the first term, a larger N(d2) actually reduces the net present value of the call option.

However, while a higher N(d2) increases the expected cost (thus reducing the immediate payoff of the call option), it also signifies a higher probability of the option being valuable enough to exercise. The overall impact on the call option's price is a balance of these factors - the increased likelihood of exercising the option and the higher expected cost of doing so.

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