In the Black-Scholes Framework, Return Volatility Is Assumed to Be

question 8

Multiple Choice

In the Black-Scholes framework, return volatility is assumed to be constant over the life of the option. This is not theoretically appropriate for pricing options on (default-risk-free) bonds because

• A) Empirically, interest rates are known to change over time, so bond volatility will change over time.
• B) Even if interest rates are constant over time, the duration of the bond will change over time, and duration is a measure of volatility.
• C) Constant return volatility on a zero-coupon bond is possible only if the bond price does not change over time.
• D) The bond price at maturity is known for certain, so volatility must go down as maturity approaches.

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