6. Assume there is one factor that influences the payoff from owning only General Electric or
Texaco stock: oil prices. If oil prices rise (which may occur with 50% probability), then the payoffs
from owning $100 of General Electric or Texaco stock are $100 and $120, respectively. If oil
prices fall (which may occur with 50% probability), then the payoffs from owning $100 of General
Electric or Texaco stock are $120 and $100, respectively.
Instead of investing in only General Electric or Texaco stock, however, an investor decides to split
a $100 investment in both General Electric and Texaco stock; that is $50 will be invested in General
Electric stock and $50 will be invested in Texaco stock. If oil prices rise (which may again occur
with 50% probability), then the payoffs are $50 from owning General Electric stock and $60 from
owning Texaco stock. If oil prices fall (which may again occur with 50% probability), then the
payoffs are $60 from owning General Electric stock and $50 from owning Texaco stock.
Is the investor's strategy (of splitting a $100 investment between General Electric and Texaco
stock) an example of hedging or spreading risk? Why? Please be specific. Then, computationally
demonstrate that the investor's strategy will work to reduce risk.