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

1 Expert Approved Answer

Step: 1 Unlock

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 full answer

Question Has Been Solved by an Expert!

Get step-by-step solutions from verified subject matter experts

Step: 2 Unlock

Step: 3 Unlock

Students Have Also Explored These Related Finance Questions!

Managing Scope Changes Case Study Scope changes on a project can occur regardless of how well the project is planned or executed. Scope changes can be the result of something that was omitted during...

KYC's stock price can go up by 15 percent every year, or down by 10 percent. Both outcomes are equally likely. The risk free rate is 5 percent, and the current stock price of KYC is 100. (a) Price a...

Let A, B be sets. Define: (a) the Cartesian product (A B) (b) the set of relations R between A and B (c) the identity relation A on the set A [3 marks] Suppose S, T are relations between A and B, and...

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...

6. Suppose that the observed spread between the yield on a 3-year zero-coupon riskless bond and the yield on a 3-year zero-coupon bond issued by a corporation is 1.55%. By how much (as a percentage)...

Suppose that the spread between the yield on a three-year zero-coupon riskless bond and a threeyear zero-coupon bond issued by a corporation is 1%. By how much does Black-Scholes overstate the value...

Suppose that the observed spread between the yield on a 4-year zero-coupon riskless bond and the yield on a 4-year zero-coupon bond issued by a corporation is 1.35%. By how much (as a percentage)...

Suppose that the observed spread between the yield on a 2-year zero-coupon riskless bond and the yield on a 2-year zero-coupon bond issued by a corporation is 1.85%. By how much (as a percentage)...

Consider the company you currently work for (or one you have worked for in the past). What initiatives could it start to be more socially responsible? How would you propose such changes?

1). Mars Corporation uses the percentage-of-completion method. At the end of the first year of a $9,000,000 contract, the following information is available: Costs to date: $2,000,000 Estimated costs...

Which of the following best describes a "committed cost"? a . A future cash flow resulting from a prior decision ( e . g . , long - term lease ) . b . A cost that fluctuates with production volume. c...

Charles Diggs began his new business, called Diggs Systems Company, on January 1. 20xx. The company writes computer programs with special applications for businesses that own small computers. During...

Find the general solution to the DEs below: (f) () 4y = +1 8 - da e2x+1 y = Ge2t + cze-2t +(-2t +e-2t + In(1 e2t))e2t In(e2t 1)e-2t

Compare +B + amd t-e by using + connect drawing- Y XY plane P(2,4) (4,2)

How do weak acids and strong acids affect electrolytic activity? Draw a diagram representing a strong acid in a weak acid insulation using acidic acid and Hydroiodic acid.

Susan has now been running the bank's wealth-management division for a year. It has been hard work and she is very conscious that most team members have supported her all the way, staying late and...

A bank has written European a call option on one stock and a European put option on another stock. For the first option, the stock price is 50, the strike price is 51, the volatility is 28% per...

The expected return on the market is 12% and the risk-free rate is 7%. The standard deviation of the return on the market is 15%. One investor creates a portfolio on the efficient frontier with an...

When the partial durations are as in Table 9.5, estimate the effect of a shift in the yield curve where the ten-year rate stays the same, the one-year rate moves up by 9e, and the movements in...

a. Write vector C in component form. b. Draw a coordinate system and on it show vectors c. What are the magnitude and direction of vector Let

Draw each of the following vectors. Then find its x- and y-components. a. = (3.5 m/s 2 , negative x-direction) b. = (440 m/s, 30 below the positive x-axis) c. = (12 m, 40 above the positive x-axis).

Draw each of the following vectors, label an angle that specifies the vectors direction, and then find the vectors magnitude and direction. a. b. c. d.