Mortgage-backed securities - Investment Fund creation

You have 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 fall of 2008, the market for certain types of
securities based on real estate loans simply collapsed as the subprime mortgage scandal

Your 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 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%

Your boss has asked you to perform a preliminary analysis of the new fundís performance
potential for the coming year. Specifically, he has asked you to address the following issues:

  1. 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?
  2. What is the reward-to-risk ratio for the fund based on the fundís 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
  4. In addition to the information provided, you have 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.

Mortgage-backed securities - Investment Fund creation

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