Question #106
Reading: Reading 31 Valuation of Contingent Claims
PDF File: Reading 31 Valuation of Contingent Claims.pdf
Page: 50
Status: Unattempted
Correct Answer: A
Question
A bond analyst decides to use the BSM model to price options on bond prices. This model will most likely be inadequate because:
Answer Choices:
A. BSM cannot be modified to deal with cash flows like coupon payments
B. the price of the underlying asset follows a lognormal distribution
C. the risk free rate must be constant and known
Explanation
The BSM model is not useful for pricing options on bond prices and interest rates. In those
cases, interest rate volatility is a key factor in determining the value of the option. BSM can
be modified to deal with cash flows like coupon payments. The assumption that "the price
of the underlying asset follows a lognormal distribution" is not applicable.