Question

You were recently appointed financial manager for Speedgro Limited and are now requested by the board of directors to invest an amount of R5million taking the risk associated with the investment alternatives into account

The chairman of the board feels that the funds should be invested in government bonds. The interest earned on government bonds are directly related to the state of the economy. If a recession sets in the interest rate is estimated at 20% per year for a boom economy at 10% per year and for a normal economy at 15% per year.

One of the external directors feels that the funds should rather be invested in a unit trust fund. The rates of return on the trust funds are also dependent upon the state of the economy and should have a negative rate of return of 8% if a recession sets in or positive rates of return of 24% and 16% respectively for a boom and normal economy.

Economists estimate the probability of a recession at 10% and a boom economy at 30%

Calculate for each of the two investment alternatives all measures of risk known to you

Make a motivated recommendation on which investment should be chosen.

Answer 1

In the given situation, two possible alternatives have been identified. On comparison of the two alternatives, we observe as below:

Economy situation	Probability (p)	Interest rate in Govt bonds (x)	Interest rate in unit trust fund (y)	p*x	p*y
Recession	0.1	20%	-8%	2%	-1%
Boom	0.3	10%	24%	3%	7%
Normal	0.6	15%	16%	9%	10%
Expected return	14%	16%

On analysis of the above, it is observed that 2% excess return can be obtained through 2nd alternative.

Thus, management can choose Alternative 2 (investment in unit trust fund).