Choosing Hedge Funds An investor is considering investing a sum of money in one

Question

Choosing Hedge Funds

An investor is considering investing a sum of money in one of three hedge funds as shown in the table below. The funds are constructed with different risk profiles, and any one of them could be the best choice depending on how the markets behave. Assuming that the market conditions will be rising, stable or declining, the expected payoffs from this investment are given in the table. Based on publicly available reports, the investor considers the likelihood of those conditions to be .2, .7 and .1 respectively.

a) On an expected value basis, which fund should the investor choose? What is the expected value?

b) What is the value of perfect information? That is to say, what is the maximum amount the investor should consider spending to obtain better market projections?

Still undecided, the investor is considering buying a personalized market report from a well-known guru. Said guru will only predict rising or declining markets, and of course the prediction will not be perfect. Based on history, the probability that the guru will predict rising or declining markets under any of the three actual conditions is as follows:

You will notice that this information cannot be used directly, but can be converted to useful numbers!

c) If the investor were to buy the report, what strategy should be followed to maximize expected value? What is that expected value?

d) What is the maximum that this report could be worth (the difference between a and c)?

For all questions, show your work in a clear way – how you choose to do this is up to you.

Payoff table Marketing Conditions Rising Stable Declining Fund #1 $120,000 $35,0000 $-30,000 Fund #2 $60,000 $40,000 $20,000 Fund #3 $35,000 $30,000 $30,000

Explanation / Answer

A.

Hence Fund 1 is the best with EV of 45500

B.

C.

So Fund 1 is the best option.

D.

As the recommendation is actually gaining less = EV =

And EVwoPI = 45500

But as the worst outcome is 31000 .

So,

can be paid

P P P Payoff table 0.2 0.7 0.1 Rising Stable Declining EV (P*Outcome) Fund #1 120000 35000 -30000 45500 Best Fund #2 60000 40000 20000 42000 Fund #3 35000 30000 30000 31000

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