Risk and Return
Mr. Clayton, a client of A.P. Investments, has contacted your boss and is seekinginvestment advice. Mr. Clayton has absolutely no experience with investing, but hasrecently inherited $10 million that he wishes to invest for the next 3 years. Being completely unfamiliar with any investment opportunities, Mr. Clayton is very riskaverse, but at the same time would like to make a nice return on his investment. Your boss has asked you to help Mr. Clayton in making a good investment decision. To keep things simple (not for your sake, but for Mr. Clayton's) your advice should stick to investing in either a money market fund, a fixed income fund, or an equity fund. As you know from your finance classes, the return on the money market fund willobviously mostly be driven by the risk-free rate, the performance of the fixed incomefund by the performance of corporate bonds, and the performance of the equity fund by the performance of the share market. Looking at the economic situation, you consider three possible cases for the next 3years. You expect that the chance of a continuing recession is equal to 40%, thechance of a normal growth situation is 50% and the chance of an economic boom is10%. For the performance of the money market fund you expect its performance to bestable at the risk-free rate of 3%. However, the performance of the fixed income and equity fund will depend on the economic situation. You expect the fixed income fund to give a return of -2% p.a. if the economy will go into recession, 8% p.a. if the economygoes into normal growth and 12% p.a. if the economy will boom. Similarly for the equityfund you expect a return of -8% p.a. in a recession, 15% p.a. in normal situation and 30% p.a. if the economy booms.
a) Could you advice Mr. Clayton on the different investment options he has and tell him something about the expected return and risk involved in the various investment options?
b) As Mr. Clayton likes to talk in terms of dollars, could you please tell him how much money he can expect to have for each of the three investment optionsafter 3 years?
c) Suppose that yearly returns are normally distributed. In terms of yearly return on investment and a confidence level of 95%, could you also tell him what the value of risk and the maximum value of yearly return are for each of the three investment options?