LO 11.10: Evaluate the appropriateness o f the Black-Scholes-Merton model when

LO 11.10: Evaluate the appropriateness o f the Black-Scholes-Merton model when valuing derivatives on fixed income securities. * 1
The Black-Scholes-Merton model is the most well-known equity option-pricing model. Unfortunately, the model is based on three assumptions that do not apply to fixed-income securities:
1. The models main shortcoming is that it assumes there is no upper limit to the price of the underlying asset. However, bond prices do have a maximum value. This upper limit occurs when interest rates equal zero so that zero-coupon bonds are priced at par and coupon bonds are priced at the sum of the coupon payments plus par.
2.
3.
It assumes the risk-free rate is constant. However, changes in short-term rates do occur, and these changes cause rates along the yield curve and bond prices to change.
It assumes bond price volatility is constant. With bonds, however, price volatility decreases as the bond approaches maturity.
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Topic 11 Cross Reference to GARP Assigned Reading – Tuckman, Chapter 7
B o n d s W i t h E m b e d d e d O p t i o n s

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