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 following possible​ outcomes: James has estimated the expected rate of return from this investment is 18.00 percent. James wants to apply his recently acquired understanding of the security market line concept to his analysis. a. If the​ risk-free rate of interest is currently 2.5 percent and the beta for the investment is 2.0​, what is the slope of the security market line for the real estate mortgage security​ investment? b. James is also considering the investment of his money in a market index fund that has an expected rate of return of 10 percent. What is the slope of the security market line​ (i.e., the​ reward-to-risk ratio) for this investment​ opportunity? c. Based on your analysis of parts a and b​ above, which investment should James​ take? ​ Why?

State of Economy	Probability		Fund Returns
Rapid expansion and recovery	5​%		100​%
Modest growth	45​%		35​%
Continued recession	45​%		5​%
Falls into depression	5​%		−100​%

Answer 1

a)	Slope of the SML for the real estate investment = (18-2.5)/2 =	7.75
b)	Slope of the SML for the MM investment = (10-2.5)/(7.5/7.75)=	7.75
	CALCULATION OF BETA OF MM:
	Return on the real estate = 18 = 2.5+2*(Rm-2.5)
	Rm = (18-2.5)/2+2.5 = 10.25%
	Return on the MM = 10 = 2.5+beta (MM)*(10.25-2.5)
	Beta (MM) = (10-2.5)/7.75 = 0.96774
c)	Both the investments give the same reward to risk ratio.
	However, James' preference would depend on whether he is
	risk taker or risk avoider. If he is a risk taker he can go for the
	real estate investment fund; if not he can prefer the MM
	investment.