medium · Principles of Finance time-value-of-money
An investor views a volatility smile in the S&P 500 index option market where the implied volatility of out-of-the-money (OTM) puts is significantly higher than at-the-money (ATM) calls.
This 'skew' most directly contradicts which assumption of the Black-Scholes-Merton model?
- The assumption that the underlying asset price follows a geometric Brownian motion with constant volatility.
- The assumption that all options here are European-style and cannot be exercised before expiration.
- The assumption that there are no transaction costs, bid-ask spreads, or taxes affecting secondary market trading.
- The assumption that the risk-free interest rate is known in advance and stays constant over the option's entire life.
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