Reading 70: LOS f ～ Q1- 5

1．A Swiss investor’s domestic risk-free rate is 9 percent. Japanese risk-free rates are 2 percent. The investor expects the Swiss Franc (SF) to depreciate by 5 percent. What is the foreign currency risk premium (FCRP)?

A)   2%.

B)   -2%.

C)   -4%.

D)   4%.

The correct answer was B)

The FCRP is the expected appreciation of the foreign currency minus the interest rate differential (domestic – foreign). Hence, the FCRP is –2% (= 5% appreciation of the yen minus 7% interest rate differential). The interest rate differential is calculated as: r_DC – r_FC = 9% – 2% = 7%).

2．A Korean investor’s domestic risk-free rate is 3 percent. The Japanese risk-free rate is 2 percent. The investor expects that the Korean currency (won) will depreciate by 4 percent over the next year. What is the foreign currency risk premium (FCRP)?

A)   2%.

B)   3%.

C)   -2%.

D)   -3%.

The correct answer was B)

The FCRP is the expected appreciation of the foreign currency minus the interest rate differential (domestic – foreign). Hence, the FCRP is 3 percent (= 4% appreciation of the yen minus 1% interest rate differential). The interest rate differential is calculated as: r_DC – r_FC = 3% – 2% = 1%).

3．A Canadian investor has a domestic currency risk-free rate of 4 percent. The risk free rate in the U.S. is 5 percent. The investor expects the Canadian currency (Can$) to appreciate by 1 percent against the U.S. dollar ($). What is the foreign currency risk premium (FCRP)?

A)   1%.

B)   0%.

C)   -1%.

D)   3%.

The correct answer was B)

The FCRP is the expected appreciation of the foreign currency minus the interest rate differential (domestic-foreign). Hence, the FCRP is 0% (= –1% appreciation of U.S. dollar minus –1% interest rate differential (i.e., r_DC – r_FC = 4% – 5% = –1%).

4．Which of the following describes the foreign currency risk premium (FCRP)? FCRP equals:

A)   forward rate minus the spot rate.

B)   forward rate divided by the spot rate minus one.

C)   expected exchange rate movement minus the interest rate differential.

D)   expected exchange rate movement minus the ratio of the spot to the forward rate.

The correct answer was C)     

The FCRP is defined as the expected exchange rate movement minus the interest rate differential. The FCRP will be zero if the expected exchange rate change is purely a function of the relative interest rates.

5．Estimation of the foreign currency risk premium (FCRP) is required in which model?

A)   Domestic capital asset pricing model.

B)   Extended capital asset pricing model.

C)   Risk premia arbitrage pricing theory.

D)   International capital asset pricing model.

The correct answer was D)

The estimation of an FCRP between all paired currencies is required as part of the international capital asset pricing model.