Which of the following is not an assumption underlying the BSM options pricing model?
A. The underlying asset does not generate cash flows.
B. Continuously compounded returns are lognormally distributed.
C. The option can only be exercised at maturity.
D. The risk-free rate is constant.
Answer: B
No arbitrage is possible, and:
- Asset price (not returns) follows a lognormal distribution.
- The (continuous) risk-free rate is constant.
- The volatility of the underlying asset is constant.
- Markets are “frictionless.”
- The asset has no cash flows.
- The options are European (i.e., they can only be exercised at maturity).