Two State Option Pricing European puts and calls when dividends are paid continuously at a constant rate. This model is used in Table 3 as a benchmark for determining the accuracy of the two-state model for pricing European puts and calls In Table 3 the prices of European and american puts and calls are shown under the assumption that the underlying stock is expected to pay a quarterly dividend at an annual rate of 4%. The assumptions underlying Tables 1 and 2 are maintained The two-state prices of European puts and calls are all within $.03 of the corresponding dividend-adjusted Black-Scholes-Merton prices when the life of the options are partitioned into 100 time intervals. Therefore, with dividends, the two-state model appears to provide an accurate approximation to the lognormal model As one would expect, the ability to exercise an American call option on a dividend paying stock prior to maturity can carry a sigmificant premium. For example, for X- 75 and T=100, the difference between the prices of American and European calls is $1.03. This premium declines as the option s exercise price In contrast to the call option, the payment of a 4% dividend significantly lowers the value associated with the ability to exercise the put option prematurely. For xample, for T= 100 and X= 100, the premature exercise premium is $.54 for a non-dividend paying stock but only $ 16 if the stock pays a quarterly dividend at an annual rate of 4% V. Conclusions This paper develops a simple two-state option pricing model and demonstrates the application of the model to several complex option pricing problems. Although the mathematics of the model are quite simple, especially when compared to the more conventional continuous time approach, the economics of both approaches to option pricing are essentially the same. Thus, the two-state approach opens he door to the understanding of modern option pricing theory without the added complications associated with the solutions to stochastic differential equations In addition to its pedagogic features, the two state approach can be used as a numerical procedure for solving continuous time option pricing problems for which closed form solutions are unattainable. Moreover, the Black-Scholes equa tion can be derived from the two-state model as a special case. Admittedly, the mathematics of this derivation are as difficult as stochastic calculus itself, yet one need not carry the two-state model to its continuous limit to derive many interesting insights into both theoretical and practical applications of modern option pricing theory Derivation of the Continuous Time version of the TSOPm in this appendix we determine the value of a European call option, wo, using the TSoPM, assuming that the interval of time over which price changes in the underlying stock are recognized is infinitesimally small. This is equivalent to