Question
The question is: Suppose that the spread between the yield on a 3-year zero-coupon riskless bond and a 3-year zero coupon bond issued by a
The question is: Suppose that the spread between the yield on a 3-year zero-coupon riskless bond and a 3-year zero coupon bond issued by a corporation is 1%. By how much does Black-Scholes-Merton overstate the value of a 3-year European option sold by the corporation?
The answer is: When the default risk of seller of the option is taken into account, the option value is the Black-Scholes-Merton price multiplied by e-0.01*3 =0.9704.
My question is: why is that? Could you explain from the Black-Scholes-Merton formula?
Step by Step Solution
There are 3 Steps involved in it
Step: 1
The BlackScholesMerton formula assumes a riskfree market meaning theres no chance of default for the issuer of the option However when the issuer carr...
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Step: 3
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Risk Management and Financial Institutions
Authors: Hull John
4th edition
1118955943, 978-1118955949
