Questions A-D
Mini-Case 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, which investors have shunned, at bargain prices and holding them until the underlying mortgages are repaid or the market for these securities recovers. The investment company has begun putting together sales information 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 40 3 Recession - 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: a. What is the expected rate of return and standard deviation for the fund, given the estimates of fund performance in different 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? c. What is the expected rate of return for the fund based on the CAPM? d. In addition to the information provided, Larry has observed 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 analysis, do you think that the proposed fund offers a fair return, given its risk? Explain Mini-Case 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, which investors have shunned, at bargain prices and holding them until the underlying mortgages are repaid or the market for these securities recovers. The investment company has begun putting together sales information 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 40 3 Recession - 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: a. What is the expected rate of return and standard deviation for the fund, given the estimates of fund performance in different 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? c. What is the expected rate of return for the fund based on the CAPM? d. In addition to the information provided, Larry has observed 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 analysis, do you think that the proposed fund offers a fair return, given its risk? Explain
