Important assumptions justifying the Black-Scholes formula include:
I.The price of the underlying asset follows a lognormal random walk.
II.Investors can adjust their hedge ratio continuously and at no cost.
III.The risk-free rate is known.
IV.The underlying asset does not pay dividends.
A)I only
B)I and II only
C)I, II, III, and IV
D)III and IV only

Question

Quizplus · Accepted Answer

The Black-Scholes formula, a fundamental model used for option pricing in financial markets, is based on several key assumptions: I) The price of the underlying asset follows a lognormal distribution, allowing for the continuous compounding of returns. II) Investors can adjust their portfolios continuously without incurring any transaction costs, which is crucial for the dynamic hedging strategy implied by the model. III) The risk-free rate, which is used to discount the option's payoff, is known and constant over the option's life. IV) The model assumes that the underlying asset does not pay dividends during the life of the option, as dividends would affect the price of the underlying asset and thus the option pricing.

Important Assumptions Justifying the Black-Scholes Formula Include