Q3 Dec 2007

You will have to tell me the name of the question. I file past questions by name and topic - not by date (and, of course, the ACCA website does not list exams prior to 2010). I am guessing from what you have written, that it might refer to a delta hedge (with options). If it does, then all the variables in the Black Scholes formula change over time and therefore the hedge needs continually adjusting (and I do explain this in the lectures on delta hedges).

Hi sir... It's the question on Black Scholes model, Digunder. 'The Black and Scholes model makes a number of assumptions about the underlying nature of the pricing and return distributions which may not be valid with this type of project. More problematically it assumes that continuous adjustment of the hedged position is possible.' A bit unclear on this still. How come the assumptions in dis model is not valid with this type of project...? Thanks...

The examiners answer is very badly worded (BPP have answered it much better!!). What he is really trying to say is that the BS formula was derived to apply to traded share options. Using it for real options is a problem because it is difficult to identify the variables needed for the formula - especially the volatility of the flows.