Answer: Borrowing and lending is allowed at the risk-free rate.

## Explanation The correct answer is **C: Borrowing and lending is allowed at the risk-free rate**. Let's analyze each option: **Option A: The underlying must pay a dividend.** - **Incorrect**. The standard Black-Scholes-Merton model actually assumes **no dividends** are paid during the option's life. There are modified versions for dividend-paying stocks, but the basic model assumes no dividends. **Option B: Asset prices are normally distributed.** - **Incorrect**. The model assumes that **returns** (not prices) are log-normally distributed. Asset prices themselves follow a log-normal distribution, which means they cannot be negative and have a right-skewed distribution. **Option C: Borrowing and lending is allowed at the risk-free rate.** - **Correct**. This is one of the key assumptions: - Investors can borrow and lend unlimited amounts at the same risk-free interest rate - This enables the creation of riskless portfolios through dynamic hedging - It's essential for the no-arbitrage pricing framework Other key assumptions include: - No transaction costs or taxes - Continuous trading - Known and constant volatility - European-style options (no early exercise) - Short selling permitted with full use of proceeds

Author: LeetQuiz Editorial Team