Chartered Financial Analyst (CFA) Practice Exam Level 2

Which of the following is a key assumption of the Black-Scholes option pricing model?

1. Discount rates vary over time

2. Market conditions are frictionless

3. Underlying asset returns follow a uniform distribution

4. Volatility of returns is inconsistent

The correct answer is: Market conditions are frictionless

The Black-Scholes option pricing model is built on a set of foundational assumptions, one of which is that market conditions are frictionless. This means that there are no transaction costs, taxes, or restrictions on short selling, and that all investors have access to the same information at the same time. In a frictionless market, traders can buy and sell securities freely without the influence of external costs or barriers, leading to more efficient pricing of options. This assumption is crucial because it allows for the establishment of a replicating portfolio using the underlying asset and a risk-free bond to create a risk-neutral pricing structure. If markets had friction, the pricing derived from the Black-Scholes model could be significantly altered, as these costs would affect trading behavior and market efficiency. The assumptions of a frictionless market lay a foundational basis for the derivation of the Black-Scholes formula, enabling analysts and traders to price options accurately under the prescribed conditions. The other options present assumptions that do not accurately reflect the premises of the Black-Scholes model. For instance, the model assumes that the returns of the underlying assets are normally distributed, not uniformly distributed. Additionally, it operates under the assumption of constant volatility, rather than suggesting that volatility is inconsistent or that discount rates vary over