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?

 

Answer rating: 100% (QA)

The BlackScholesMerton formula assumes a riskfree market meaning theres no chance of default for the issuer of the option However when the issuer carr... View the full answer