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Answer: Option D
This question tests understanding of Black-Scholes model assumptions. The key insight is that in risk-neutral valuation, the drift rate is set equal to the risk-free rate, not the real-world expected return. This is because: - Under risk-neutral pricing, all assets earn the risk-free rate - The real-world expected return is not an input to the Black-Scholes model - Options are priced based on risk-neutral probabilities, not real-world probabilities Options A, B, and C represent valid Black-Scholes assumptions (constant volatility, no dividends, continuous trading), but the statement about the drift rate being the real-world expected return is incorrect.
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While the drift rate (%) is assumed constant, per the risk-neutral valuation, we let drift rate equal the riskless rate. The real-world rate of return is not required, is not an input in the Black-Scholes, and as Hull explains, is not an increasing function of the option (as a higher implied discount rate offsets the higher expected growth rate).
In regard to (A), (B) and (C), EACH is TRUE as a key assumption underlying the Black-Scholes OPM.
A
Option A
B
Option B
C
Option C
D
Option D
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