A producer of chemical products has been sued for damages...

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Ec1723, Fall 2007: Assignment 1 This assignment is due at the beginning of class on Tuesday, October 2. The assignment will not be accepted after 10.15am on Tuesday, October 2. If you have a question, please email any of the teaching sta ff or post it to the Discussions section of the course website. We will use the Discussions section to answer questions, so this is a good place to look if anything confuses you. 1. A producer of chemical products has been sued for damages over cancer cases in the community where one of its plants is located. Tomorrow the case will be decided. If the decision goes in the company’s favor, its stock price, currently $2.00, will increase to $5.00. If the decision goes against the company, the fi rm will be liquidated and the stock price will drop to zero. The fi rm has also issued bonds, each of which will be worth $1.00 (face value) tomorrow if the decision goes in the company’s favor. If the company is liquidated, each bond will be worth only $0.25. For simplicity, you may assume that the overnight interest rate for money invested safely is zero. That is, $1.00 invested today at the safe interest rate will be worth $1.00 tomorrow for sure. a) Using the stock and the riskfree asset, construct a portfolio that pays $1.00 tomorrow if the company wins the case, and $0.00 if the company loses. (Both long and short positions are permitted.) What is the price of this portfolio today? b) Using the stock and the riskfree asset, construct a portfolio that pays $1.00 tomorrow if the company loses the case, and $0.00 if the company wins. (Both long and short positions

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