Reading 64: LOS c ～ Q 1- 3

1.Which of the following is NOT one of the assumptions of the Black-Scholes-Merton (BSM) option-pricing model?

A)   There are no taxes.

B)   Any dividends are paid at a continuously compounded rate.

C)   There are no transaction costs.

D)   Options valued are European style.

The correct answer was B)

The BSM model assumes there are no cash flows on the underlying asset.

2.Which of the following is NOT one of the assumptions of the Black-Scholes-Merton option-pricing model?

A)   The risk-free rate of interest is known and does not change over the term of the option.

B)   Changes in volatility are known and predictable.

C)   There are no cash flows on the underlying asset.

D)   The options are European style.

The correct answer was B)

The BSM model assumes that volatility is known and constant. The term predictable would allow for non-constant changes in volatility.

3.Which of the following is NOT one of the assumptions of the Black-Scholes-Merton option-pricing model?

A)   There are no cash flows over the term of the options.

B)   The yield curve for risk-free assets is fixed over the term of the option.

C)   The volatility is known and remains constant over the term of the option.

D)   There are no taxes and transactions costs are zero for options and arbitrage portfolios.

The correct answer was B)

The yield curve is assumed to be flat so that the risk-free rate of interest is known and constant over the term of the option. Having a fixed yield curve does not necessarily imply that the yield curve is flat.