James Fromholtz is considering whether to invest in a newly formed investment fu

Question

James Fromholtz is considering whether to invest in a newly formed investment fund. The fund’s investment objective is to acquire home mortgage securities at what it hopes will be bargain prices. The fund sponsor has suggested to James that the fund’s performance will hinge on how the national economy performs in the coming year. Specifically, he suggested the possible outcomes. State of Economy Probability Fund Returns Rapid Expansion recovery 10% 100% Modest growth 50% 30% Continued recession 30% 20% Falls into depression 10% -100%(this is negative 100) A.) Based on these potential outcomes, what is your estimate of the expected rate of return from this investment opportunity? B.) Calculate the standard deviation in the anticipated returns found in part a. C.) Would you be interested in making such an investment? Note that you lose all your money in one year if the economy collapses into the worste state or you double your money if the economy enters into a rapid expansion.

Explanation / Answer

SOLUTION :

A] EXPECTED RATE OF RETURN = 21%

B] STANDARD DEVIATION = 46.14%

C] YES I WOULD LIKE TO INVESTMENT SOME PORTION OF MONEY IN THIS INVESTMENT OPPORTUNITY AS THERE IS ONLY 10% POSSIBILITY FOR FALLS IN TO DEPRESSION AND 90% CHANCES OF GETTING POSITIVE RETURN.

a

b

c

d

e

f

state of economy

Probability (p)

return (r)

P xr (i.e mean)

(c-0.21)^2

b x e

Rapid Expansion recovery

0.1

1

0.1

0.6241

0.06241

Modest growth

0.5

0.3

0.15

0.0081

0.00405

Continued recession

0.3

0.2

0.06

1E-04

3E-05

Falls into depression

0.1

-1

-0.1

1.4641

0.14641

0.21

2.0964

0.2129

Variance = p [(r - mean)^2]

expected rate of return = 21%

46.14%

Standard deviation = square root of variance = 46.14%

Variance = p [(r - mean)^2]

Standard deviation = square root of variance

A] EXPECTED RATE OF RETURN = 21%

B] STANDARD DEVIATION = 46.14%

C] YES I WOULD LIKE TO INVESTMENT SOME PORTION OF MONEY IN THIS INVESTMENT OPPORTUNITY AS THERE IS ONLY 10% POSSIBILITY FOR FALLS IN TO DEPRESSION AND 90% CHANCES OF GETTING POSITIVE RETURN.

a

b

c

d

e

f

state of economy

Probability (p)

return (r)

P xr (i.e mean)

(c-0.21)^2

b x e

Rapid Expansion recovery

0.1

1

0.1

0.6241

0.06241

Modest growth

0.5

0.3

0.15

0.0081

0.00405

Continued recession

0.3

0.2

0.06

1E-04

3E-05

Falls into depression

0.1

-1

-0.1

1.4641

0.14641

0.21

2.0964

0.2129

Variance = p [(r - mean)^2]

expected rate of return = 21%

46.14%

Standard deviation = square root of variance = 46.14%

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