Valuation of Contingent Claims

Correct Answer: The expected dividend yield of the underlying asset

The expected dividend yield of the underlying asset is not a required input for the Black-Scholes-Merton model when pricing European call options. The Black-Scholes-Merton model requires the following inputs: - Current price of the underlying asset - Strike price of the option - Time to expiration - Risk-free interest rate - Volatility of the underlying asset's returns While dividends can impact option pricing, the basic Black-Scholes-Merton model assumes no dividends are paid on the underlying asset during the option's life. More advanced variants of the model can incorporate known dividend payments, but the dividend yield itself is not a direct input. The other two answers are incorrect because they list required inputs to the Black-Scholes-Merton model: the current underlying asset price and the risk-free interest rate.

Correct Answer: A convertible bond that allows the holder to convert the bond into a fixed number of shares of the issuing company's common stock

A convertible bond is an example of a contingent claim because the bondholder has the right, but not the obligation, to convert the bond into a fixed number of shares of the issuing company's common stock. This conversion feature is contingent on the bondholder's decision to exercise the option. A regular bond that pays a fixed coupon and returns the principal at maturity does not have any contingent claims attached to it. A futures contract is not a contingent claim because both parties are obligated to fulfill the contract at the specified price on the settlement date. There is no optionality involved.

Correct Answer: The expected future dividends paid out by the underlying stock.

The Black-Scholes-Merton model takes into account the current stock price, strike price, time to expiration, risk-free interest rate, and the volatility of the underlying stock when pricing European options. However, it does not directly incorporate expected future dividends paid out by the underlying stock. The model assumes that the stock does not pay dividends. The current market price of the underlying asset and the strike price at which the option can be exercised are both key inputs into the Black-Scholes model, so those other two answers are incorrect.