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Question - You are in discussions to purchase an option on an office building with a strike price of $91 million. The building is currently valued at $84 million. The option will allow you to purchase the building either six months from today or one year from today. Six months from today, accrued rent payment from the building in the amount of $1,030,000 will be made to the owners. If you exercise the option in six months, you will receive the accrued rent payment; otherwise, the payment will be made to the current owners. A second accrued rent payment of $1,030,000 will be paid one year from today with the same payment terms. The standard deviation of the value of the building is 35 percent and the risk-free rate is an annual percentage rate of 4.4 percent.
Required - What is the price of the option today using a two-state model with six-month steps? (Hint: The value of the building in six months will be reduced by the accrued rent payment if you do not exercise the option at that time.)
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