Question

(Security market line) 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 suggested the following possible outcomes: . James has estimated the expected rate of retum from this investment is 23.00 percent. James wants to apply his recently acquired understand ing of the security market line concept to his analysis. .the nskle rale of inr ey ortod rto of rature of 11 percent What is the sione of the security market line fie the reward-to-risk ratio) this investment opportunity? c. Based on your analysis of parts a and b above, which investment should James take? Why? a. If the risk-free rate of interest is currently 2.2 percent and the beta for the investment is 2.3, the slope of the security market line 1 r the real estate mortgage security investment is %. (Round to two decimal places.) b. James is also considering the investment of his money (Round to two decimal places.) na market index fund that has an expected rate of return of 11 percent. The slope of the security market line (i..., the reward-to-risk ratio) for this investment opportunity is%. c. Based on your analysis f parts a and b above, which investment should James take? Why? (Select the best choice below. O A. The market index fund O B. Cannot be determined from the information given in this problem. O c. The real estate portfolio. State of Economy Probability Fund Returns Rapid expansion and recovery Modest growth 10% 100% 50% 40% Continued recession 30% 10% Falls into depression 10% 100%

Answer 1

a. Slope of Security Market Line = (Expected Return of Mortgage Security Investment - Risk Free Rate) / Beta

Slope of Security Market Line = (23% - 2.2%) / 2.3

Slope of Security Market Line = 9.04%

b. Slope of Security Market Line = (Expected Return of Market Fund - Risk Free Rate) / Beta

Slope of Security Market Line = (11% - 2.2%) / 1

Slope of Security Market Line = 8.80%

c. Option C The Real Estate Portfolio . Because the SML of the mortgage investment is higher.