Question #89 - Reading 31 Valuation of Contingent Claims

Reading: Reading 31 Valuation of Contingent Claims

PDF File: Reading 31 Valuation of Contingent Claims.pdf

Page: 42

Status: Unattempted

Shared Context

- The one-year call option on Dale Corporation: A) is underpriced. B) is overpriced. C) may be over or underpriced. The given information is not sufficient to give an answer.

Question

Bingly's sentiments towards the Black-Scholes-Merton (BSM) model regarding a lognormal distribution of prices and a variable risk-free rate are:

Answer Choices:

A. correct for both reasons

B. correct concerning the distribution of stocks but incorrect concerning the risk-free rate

C. incorrect for both reasons

Explanation

The model requires many assumptions, e.g., the distribution of stock prices is lognormal and the risk-free rate is known and constant. Other assumptions are frictionless markets, the options are European, and the volatility is known and constant.

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