Question #71

of 111 In order to compute the implied asset price volatility for a particular option, an investor: A) must have the market price of the option. B) must have a series of asset prices. C) does not need to know the risk-free rate. Susan Smith is analyzing the stock of FDL Inc. She has found the following quotations (all prices in dollars per share) on 91-day European options: Exhibit 1 Option Strike Price Call Premium Put Premium 50 5.28 1.54 55 2.64 3.33 60 1.14 X Other Information Risk-free interest rates 6% Annual volatility 30% FDL Inc share price $53 *FDL Inc currently does not pay dividends Smith wants to value the equity call options of FDL Inc. using the Black-Scholes-Merton (BSM) model. She wants to understand the assumptions and the limitations of the model and asks David Wang for help. Wang provides the information shown in Exhibits 2 and 3. Exhibit 2 Assumptions of BSM Model Assumption 1 The underlying asset returns follow a normal distribution Assumption 2 Options are European style Exhibit 3 Assumptions of BSM Model Implications The risk-free rate is known and constant over the options life Implication 1 Useful for pricing options on bond prices and interest rates The continuously compounded yield on the asset is constant Implication 2 BSM model can be modified to account for cash flows on the underlying