CFA Level I · CFA Level I Exam · Pricing and Valuation of Options
Which of the following statements about the assumptions of the Black-Scholes-Merton (BSM) model is most accurate?
The BSM model assumes the underlying's volatility is constant over the option's life. It also assumes a constant risk-free rate and European-style exercise, so allowing early exercise or random changes in rates and volatility contradicts the model's assumptions.
- AOptions can be exercised early
- BVolatility of the underlying is constant over the option's lifeCorrect
- CThe risk-free rate and the underlying's volatility change randomly over time
Explanation
BSM assumes the underlying follows a lognormal process with constant, known volatility and a constant risk-free rate, and it values European-style options. Early exercise is not modeled, and random changes in rates or volatility violate the model's assumptions.
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