Option on land

Discussion in 'Options' started by 9999, May 13, 2007.

  1. 9999


    Hey guys,
    I need to calculate the value of an option on a piece of land.
    Any books, links, ideas, suggestions?
    Thank you in advance!
  2. IMO Black-Scholes will do just fine here, but you'll need to input some volatility.

    Or, here's a text I copied a while ago:

    You would like to buy a 1-year call option on a piece of land. Unfortunately, the landowner is unwilling to sell you a call option but is willing to sell the land for $1,000,000. Assume that the 1-year risk-free rate of interest is 10%, that you could borrow as much as $900,000 to purchase the land if you also buy an insurance policy which will pay off the loan if you do not pay the loan’s par value. The cost of the insurance is $5,000.

    Even though the landowner will not sell you a call option directly, you can replicate the outcomes of a call on the land by taking the following steps. First, buy the insurance policy for $5,000 and arrange a 1-year loan with a par value of $900,000. Based on a 10% interest rate and a 1-year repayment, you will be able to borrow $818,182 ($900,000 ÷ 1.1). Thus, your personal down payment on the land will have to be $181,818. Adding in the insurance cost, the total cost to you will be $186,818.

    When the loan is to be repaid in 1-year, you will repay it if the land is worth more than the required $900,000 loan payment. If the land is worth less than $900,000, you will default on the loan and let the insurance policy pay the lender any difference between the land’s value and the required loan payment. The outcome is identical to owning a 1-year call option on the land with an exercise price of $900,000! And the cost of this replicated call option is $186,812:

    Replicated Call = Buy Spot Asset - Debt Financing + Insurance Cost

    +C = +S - [X ÷ (1+RF)^T] + P

    $186,812 = $1,000,000 - [$900,000 ÷ 1.11] + $5,000
  3. This has nothing to do with Black-Scholes, and volatility input is not required.

    What you're refering to is known as a "real option". google it, buy books on it or take an MBA (they all cover it these days). it's one of the newest growing areas in finance & management.

    the copied text above from nonprophet is also an example of a real option.
  4. there are many variables, assuming this is not a hypothetical case. What are the terms, ie date, price, concessions, etc. you are in the wrong area maybe. May want to be on a real estate forum.
  5. 9999


    Thank you guys.
    Any good real estate forum?