Question

All the inputs in the Black-Scholes option pricing model are directly observable except.

Select one:
a. the price of the underlying security.
b. the risk-free rate of interest.
c. the time to expiration.
d. the variance of returns of the underlying asset return.

Answer 1

In the Black-Scholes option pricing model, the variance of returns of the underlying asset return is the input that is not directly observable, in contrast to the observable inputs like the price of the underlying security, risk-free rate, and expiration time.

Step-by-step explanation:

The Black-Scholes option pricing model is an essential framework in financial mathematics for valuing options contracts. The question at hand relates to the inputs used in this model. The input that is not directly observable is d. the variance of returns of the underlying asset return. While the model requires the variance as a measure of the volatility of the underlying asset, this is typically estimated from historical data and involves significant uncertainty, unlike the other inputs such as the price of the underlying security, the risk-free rate, and the time to expiration, which can be observed in the market.