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

Question

Quizplus · Accepted Answer

The Black-Scholes formula assumes that the price of the underlying asset follows a lognormal random walk, investors can adjust their hedge ratio continuously and at no cost, the risk-free rate is known, and the underlying asset does not pay dividends. These assumptions are necessary to derive the formula for the price of a European call or put option. Without these assumptions, the formula may not provide accurate pricing estimates.

Important Assumptions Justifying the Black-Scholes Formula Include the Following