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hw2 - Derivative Securities Fall 2007 Homework 2...

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Derivative Securities, Fall 2007 – Homework 2. Distributed 9/19/07, due 10/3/07. Note: A solution sheet to HW1 will be posted 9/26; a solution sheet to HW2 will be posted 10/10; no late HW’s will be accepted once the corresponding solution sheet has been posted. Problems 1 and 2 reinforce our discussion of one-period markets (the Section 2 notes). 1. You suspect that Delta airlines will merge with Northwest Airlines in the coming month. Delta stock is trading at $0.85. We assume that the forward price equals the stock price. There is a 60% chance that the merger will occur, in which case the stock will be worth $1.20. There is a 40% chance that the merger will not occur, in which case the stock will continue its downward plunge to $0.30. If r = 0 . 02 per annum, what is the value of a call with strike price K = $1 . 00 and maturity one month (i.e. T = 1 / 12)? If you were to sell one thousand of these calls, explain precisely now much of the forward you would buy or sell in order to hedge.
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