Risk and Return

Risk and ReturnMr.
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 million that he wishes to
invest for the next 3 years. Beingcompletely 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. Yourboss
has asked you to help Mr. Clayton in making a good investment decision.
Tokeep things simple (not for your sake, but for Mr. Clayton’s) your
advice should stickto investing in either a money market fund, a fixed
income fund, or an equity fund. Asyou 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 fundby
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 andequity fund will depend on the economic situation.
You expect the fixed income fundto 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 and30% p.a. if the economy booms.a) Could you advice
Mr. Clayton on the different investment options he has andtell him
something about the expected return and risk involved in the
variousinvestment options?b) As Mr. Clayton likes to talk in terms of
dollars, could you please tell him howmuch 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 returnon
investment and a confidence level of 95%, could you also tell him what
thevalue of risk and the maximum value of yearly return are for each of
the threeinvestment options?

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