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Larry Lynch has been working for a year as an analyst for an investment company that specializes in serving very wealthy sis of the new
Larry Lynch has been working for a year as an analyst for an investment company that specializes in serving very wealthy sis of the new clients. These clients often purchase shares in closely held in- Specifically, he has asked that Larry address each of t vestment funds with very limited numbers of stockholders. In ing issues 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 col lapse as an opportunity to put together a fund that purchases some of these mortgage-backed securities, which investors have hunned, at bargain prices and holding them until the underlying mortgages are repaid or the market for these securities recovers. . What is The investment company has begun putting together sales nformation concerning the new fund and has made the follow- d. In addition to the information pro ing predictions regarding its possible performance over the com- ing year as a function of how well the economy does Larry's boss has asked him to perform a preliminary analy- fund's performance potential for the coming year a. What is the expected rate of return and standard deviation for the fund, given the estimates of fund performance in dif- ferent states of the economy? b. What is the reward-to-risk ratio for the fund based on the fund's standard deviation as a measure of risk? CAPM? , Larry has observ vided that the risk-free rate of interest for the coming year is 4.5 percent, the market risk premium is 5.5 percent, and the beta for the new investment is 3.55. Based on your analy sis, do you think that the proposed fund offers a fair return given its risk? Explain State of the Economy Probability Fund Return Rapid expansion 10% 50% Modest growth 50% 35% No growth 40% 5% Recession 5% -1 00%
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