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Answer: The interest rate changes randomly over time.
## Explanation The Black-Scholes model makes the following key assumptions: 1. **Stock prices follow a geometric Brownian motion with constant volatility** (Option C) 2. **No dividends are paid during the option's life** 3. **Markets are efficient** (Option D) 4. **No transaction costs** (Option D) 5. **Risk-free interest rate is constant** (NOT Option B) 6. **Returns are normally distributed** 7. **Options are European-style and can only be exercised at expiration** **Option B is the incorrect assumption** because the Black-Scholes model assumes that the **risk-free interest rate is constant**, not that it changes randomly over time. **Analysis of other options:** - A: Correct assumption - stock prices move continuously - C: Correct assumption - constant volatility - D: Correct assumption - perfect markets with no frictions
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Which of the following is not an assumption of the Black-Scholes options pricing model?
A
The price of the underlying moves in a continuous fashion.
B
The interest rate changes randomly over time.
C
The instantaneous variance of the return of the underlying is constant.
D
Markets are perfect, i.e. short sales are allowed, there are no transaction costs or taxes, and markets operate continuously.