Sales & Trading Interview Practice Test

Black-Scholes limitations come from its simplifying assumptions about how markets behave. It treats volatility and the risk-free rate as constant, and it models stock prices with a lognormal distribution and continuous, frictionless hedging with no transaction costs. It also assumes no dividends unless you adjust the model, and it effectively ignores more complex features managers care about in reality, like volatility skew, jumps in prices, and liquidity constraints. These gaps mean the model can misprice options in markets where volatility varies by strike and time, rates move, prices jump on events, dividends exist, or trading costs and liquidity affect hedging.

The other statements don’t fit because Black-Scholes does not account for stochastic volatility and jumps exactly, it assumes continuous hedging rather than discrete hedging with costs, and it does not assume a normal distribution with heavy tails (it uses a lognormal process for prices).