Larry Lynch has been working for a year as an analyst for an investment company that specializes in serving very wealthy clients. These clients often purchase shares in closely held investment funds with very limited numbers of stockholders. In the fall of 2008, the market for certain types of securities based on real estate loans simply collapsed as the subprime mortgage scandal unfolded. Larry’s firm, however, sees this market collapse as an opportunity to put together a fund that purchases some of these mortgage-backed securities that investors have shunned by acquiring them at bargain prices and holding them until the underlying mortgages are repaid or the market for these securities recovers. The investment company began putting together sales information concerning the possible performance of the new fund and has made the following predictions regarding the possible performance of the new fund over the coming year as a function of how well the economy does: State of the Economy Probability Fund Return Rapid expansion 10% 50% Modest growth 50% 35% No growth 40% 5% Recession 5% ?100% Larry’s boss has asked him to perform a preliminary analysis of the new fund’s performance potential for the coming year. Specifically, he has asked that Larry address each of the following issues: 1. What are the expected rate of return and standard deviation? 2. What is the reward-to-risk ratio for the fund based on the fund’s standard deviation as a measure of risk? 3. What is the expected rate of return for the fund based on the Capital Asset Pricing Model? In addition to the information provided above, Larry has observed that the risk-free rate of interest for the coming year is 4.5%, the market risk premium is 5.5%, and the beta for the new investment is 3.55. Based on your analysis, do you think that the proposed fund offers a fair return given its risk? Explain.
