Question 2

In the middle of 2010, Charlotte Lynch had 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 shareholders. In late 2008, the market for certain types of securities based on real-estate

loans simply collapsed as the sub-prime mortgage scandal unfolded. Charlotte's firm, however, saw 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 made the following predictions regarding the possible performance of the new fund over the ensuing

year as a function of the performance of the economy:

State of the economy Probability Fund return

Rapid expansion 10% 50%

Modest growth 50% 35%

No growth 35% 5%

Recession 5% -100%

Charlotte's boss asked her to perform a preliminary analysis of the new fund's performance potential for the

coming year. Specifically, he asked that Charlotte address each of the following issues:

Questions

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, Charlotte observed that the risk-free rate of interest for the following

year was 4.5%, the market risk premium was 5.5% and the beta for the new investment was 3.55. Based on your

analysis, do you think the proposed fund offered a fair return given its risk? Explain.