It's a hot housing market and you are offered for purchase an option from a real estate developer to buy a house that in 5 years (use 5 times 365 as the number of days) could be worth anywhere between $2.0 million or $400,000 depending on regulations the government might impose. His option would cost you upfront $300,000, which sounds like a lot, but you are not sure what to do. This private option would allow you to buy the house for $900,000. Mortgage rates have risen and are now 6%. Today that house price is $1.0 million. a) Use the binomial method to estimate the fair value of the call option on the house b) Break apart your answer into both the fundamental value of the option and its speculative/time value. c) Should you buy the real estate developer's option or not? Show whether you would make a loss or a profit.

Answer rating: 100% (QA)

a Using the binomial method we can calculate the fair value of the call option on the house Assuming ... View the full answer