BSM cannot be used to value options on Bond nor options on MBS? from Konvexity practise tests???

CFA Level II
#1

BSM cannot be used to value options on Bond nor options on MBS? from Konvexity practise tests??? Is this correct?

#2

you can, but there is no closed form formula for the pricing. you need to do simulations (monte carlo) or use finite differences of finite elements techniques

#3

I thought that you couldn’t because of the assumptions concerning the risk-free rate and volatility. Both of those are assumed to be constant in the BSM, but isn’t the case with bonds. Correct me if I’m wrong.

#4

^

that’s what I’m thinking too …

Where does it say it can be used for bonds and MBS ?

#5

^ But if that is the case, then BSM shouldn’t be valid for any option since RFR is never constant (irrespective of whether the underlying security is option on bond or stock)?

#6

With bonds, price changes are driven by interest rate changes, whereas with stocks they don’t have to be. The assumption of a constant risk-free rate is (much) less a problem with stocks than with bonds.

You cannot use the BSM model to calculate the value of interest-rate (related) options.

#7

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#8

You’re too kind.

That’d make me a star bigamist.

#9

it’s just not called BSM but of course you can value options on bonds with a short term interest following the exact same process as a stock’s return in BSM