Sep_06 question 3 (ii) asks us to modify the Black Model to price a one year Option on a five-year ZCB. The examiner's mention that they were looking for us to show the effect of correlation between the 1 year and 5 year rates as a modification of the Black Scholes model. However the question makes no hint that the rates are correlated. Otherwise this is a normal modification of the Black Scholes Model to give the Black - Model. Does anyone else think though right, the examiner's could have hinted what exactly they wanted?
It's actually funny because A2007 Q8 UK deals with valuing a 1 year option with a 5 year bond, but correlation is not incorporated in the solution. This 2006 question is probably one where they want you to lose marks so they can say "ha-ha-ha-ha-haaa-ha na-na-na-na-naaa-nah - you've lost marks!".
