Skip to content

IAI Actuarial Core Principles · Economic Modelling · Black-Scholes derivative-pricing model

An actuary uses Black-Scholes to value a 1-year European call on a share that will pay a large known dividend in 6 months, ignoring the dividend. Compared with the correct value, the computed call price will be:

The computed call price will be too high. The share falls by about the dividend when it is paid and the call holder does not receive it, so the model should use the share price less the present value of the dividend.

  1. AToo low, because the dividend raises the share price
  2. BToo high, because the share price falls by the dividend when it is paidCorrect
  3. CUnchanged, because calls are unaffected by dividends
  4. DToo low, because volatility is understated
  5. Correct, because Black-Scholes is independent of the share price path

Explanation

The share price drops by about the dividend when paid, so the holder of a call does not receive it. Using the current price S0 overstates the effective starting value; one should use S0 less the present value of the dividend. The call is therefore overvalued.

Did you get it right without looking?

One question tells you little. A timed set on Black-Scholes derivative-pricing model shows your real accuracy, how long you take and where you lose marks.

Practise Black-Scholes derivative-pricing modelFree diagnostic mock

More Black-Scholes derivative-pricing model questions