In the Black-Scholes formula, interest rates are assumed to be constant. This is not appropriate for pricing options on bonds primarily because
A) The value of a bond is constant if interest rates are constant.
B) Constant rates would mean no volatility in bond prices and no option value.
C) Payoffs would be discounted at a constant rate.
D) None of the above.

Question

Quizplus · Accepted Answer

Constant interest rates imply no volatility in bond prices, which is unrealistic because bond prices are sensitive to changes in interest rates. This lack of volatility would incorrectly suggest that there is no value in holding an option on a bond, as options derive value from the underlying asset's volatility.

In the Black-Scholes Formula, Interest Rates Are Assumed to Be