Mini-Case

Solace has been working for a year as an analyst for aninvestment company that specializes in serving very wealthyclients. These clients often purchase shares in closely held investment funds with very limited numbers of stockholders. Inthe fall of 2008, the market for certain types of securities basedon real estate loans simply collapsed as the subprime mortgagescandal unfolded. Solace's firm, however, sees this market collapse as an opportunity to put together a fund that purchasessome of these mortgage-backed securities, which investors haveshunned, at bargain prices and holding them until the underlyingmortgages are repaid or the market for these securities recovers.The investment company has begun putting together salesinformation concerning the new fund and has made the following predictions regarding its possible performance 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	35%	5%
Recession	5%	100%

Solace's boss has asked her to perform a preliminary analysis of the new fund's performance potential for the coming year.Specifically, he has asked that Solace address each of the following

issues:

a. What is the expected rate of return and standard deviation for the fund, given the estimates of fund performance in differentstates of the economy?

b. What is the reward-to-risk ratio for the fund based on thefund's standard deviation as a measure of risk?

c. In addition to the information provided, Solace has observedthat the risk-free rate of interest for the coming year is 4.5percent, the market risk premium is 5.5 percent, and the beta for the new investment is 3.55. What is the expected rate of return for the fund based on the CAPM?

d. Based on your analysis, do you think that the proposed fund offers a fair return, given its risk? Explain.