Reconsider the determination of the hedge ratio in the two-state model where we showed that one-third share of stock would hedge one option. The possible end-of-year stock prices, uS₀ = $85 (up state) and dS₀ = $42 (down state).

a. What would be the call option hedge ratio for each of the following exercise prices: $85, $70, $52, $42, given the possible end-of-year stock prices, uS₀ = $85 (up state) and dS₀ = $42 (down state)? (Round your answers to 3 decimal places.)

Exercise price Hedge Ratio

85 ?

70 ?

52 ?

42 ?

b. What do you conclude about the hedge ratio as the option becomes progressively more in the money?

• Increases to a maximum of 1.0

• Decreases to a minimum of 0