Question

Empirical tests of the Black-Scholes option pricing model
a. show that the model generates values fairly close to the prices at which options trade.

b. All of the options are correct.

c. show that the model generates values fairly close to the prices at which options trade and indicate that the mispricing that does occur is due to the possible early exercise of American options on dividend-paying stocks.

d. show that the model tends to overvalue deep in-the-money calls and undervalue deep out-of-the-money calls.

e. indicate that the mispricing that does occur is due to the possible early exercise of American options on dividend-paying stocks.

Answer 1

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Solution

Empirical studies have shown that the model tends to undervalue deep in the money calls and to overvalue deep out of the money calls.

Hence option D is incorrect

Also the model predicts the value of the option as close to the fair market value of the option trading prices. The reason being for slight mispricing is because of the early call exercise of American option

Hence option C