Fabozzi Frank, Peterson Pamela. Financial Management and Analysis Workbook
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90 QUESTIONS AND PROBLEMS
______________ risky investments. Risk ______________
indicates indifference towards risk. Risk ______________
persons do not need ______________ for bearing
______________. Risk ______________ indicates a(n)
______________ for risk—someone who is even willing to
pay to take on risk.
9. ______________ is the combination of assets whose
returns do not ______________ with one another in the
______________ direction at the ______________ time. If
the ______________ on investments move together, they
are ______________ with one another. Correlation is the
______________ for two or more sets of data to vary
together. The ______________ on two investments are
______________ correlated if one tends to vary in the
______________ direction at the same time as the other,
and ______________ correlated if one tends to vary in the
______________ direction with respect to the other. They
are ______________ if there is ______________ relation
between the changes in one to changes in the other.
10.______________ that goes away as we ______________
assets is diversifiable risk; this is also referred to as
______________ risk or ______________-specific risk.
______________ that cannot be reduced by adding more
______________ is nondiversifiable risk, also referred to as
______________ risk or ______________ risk.
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Risk and Expected Return 91
11.______________ took the idea that portfolio ______________
and ______________ are the only elements to consider and
developed a model that deals with how ______________
are priced. This model is referred to as the ______________
asset ______________ model (______________). The
______________ specifies that the ______________ on any
______________ is a function of the ______________ on a(n)
______________ asset plus a(n) ______________ premium.
The ______________ on the risk-free asset is
______________ for the time ______________ of money. The
risk ______________ is the ______________ for bearing
______________. Therefore CAPM says: The market port-
folio represents the most well ______________ portfolio
with the only ______________ in a portfolio comprising
all ______________ being ______________ risk, also
called ______________ risk or ______________ risk.
12. An alternative to ______________ in relating
______________ and ______________ is the ______________
pricing ______________ (______________), which was devel-
oped by ______________. The ______________ is a(n)
______________ pricing model that is based on the idea
that ______________ assets in ______________ markets
should be priced ______________. APM states that an
asset’s ______________ should ______________ the inves-
tor for the ______________ of the asset, where the
______________ is due to a number of ______________
influences, or ______________ factors. The APM provides
______________ support for an asset ______________
model where there is more than one risk ______________.
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92 QUESTIONS AND PROBLEMS
SHORT ANSWER QUESTIONS
Refer to Chapter 10, pages 257–302 in Financial Manage-
ment and Analysis.
1. What are the degree of operating leverage, the degree of
financial leverage, and the degree of total leverage? How
do they interact?
2. What may cause default and why should financial manag-
ers be concerned with default?
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Risk and Expected Return 93
3. What two risks are closely associated with reinvestment
risk? How do these risks contribute to reinvestment risk
for the investor?
4. How does interest rate risk affect the valuation of bonds?
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94 QUESTIONS AND PROBLEMS
5. Explain the relationships among expected return, vari-
ance, and standard deviation.
PROBLEMS
Refer to Chapter 10, pages 257–302 in Financial Manage-
ment and Analysis.
1. Home Decor Incorporated sells faux fur wallpaper for
$1,500 per roll. The rolls cost the firm $30 to produce.
The firm has fixed operating costs of $175,000 and pays
an annual interest expense on its debt of $65,000.
a. Calculate Home Decor’s degree of operating leverage at
10,000 units sold.
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Risk and Expected Return 95
b. Calculate Home Decor’s degree of financial leverage at
10,000 units sold.
c. Calculate Home Decor’s degree of total leverage at
10,000 units sold.
d. Calculate Home Decor’s break-even number of units
produced and sold.
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96 QUESTIONS AND PROBLEMS
e. If the sales volume were increased from 10,000 units to
15,000 units, by what percentage would the cash flow to
shareholders increase?
6. Consider two investments with the following cash flows:
a. Calculate the expected value of each investment.
Economic
Scenario
Probability of
Economic Scenario
Possible Outcome
for Investment 1
Possible Outcome
for Investment 2
Boom 25% $2,000 $1,500
Normal 40% $1,000 $1,000
Bust 35% $500 $857
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Risk and Expected Return 97
b. Calculate the standard deviation for each investment’s
possible outcomes.
c. Which investment is riskier?
4. Suppose the expected risk-free asset is 6% and the return
on the market is 10%. Further suppose you have a portfo-
lio comprised of the following securities with equal invest-
ments in each:
Security Security Beta
A 0.85
B 1.00
C 1.25
D 1.50
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98 QUESTIONS AND PROBLEMS
a. What is the expected return for each security in the port-
folio?
b. What is the portfolio’s beta?
c. What is the expected return on the portfolio?
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Risk and Expected Return 99
4. Given the following investments:
a. Calculate the covariance between the two investments.
b. Calculate the correlation coefficient between the two
investments.
Economic
Scenario
Probability of
Economic Scenario
Possible Outcome
for Investment 1
Possible Outcome
for Investment 2
Boom 15% 18% 25%
Normal 30% 50% 45%
Bust 55% 40% 30%
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