Reading 70: LOS f ～ Q7-9

6．Which of the following is the formula for the foreign currency risk premium (FCRP)? The FCRP equals:

A)   [F - E(S₁)]/ S₁.

B)   E[(S₁ - S₀)/S₀] - (r_FC - r_DC).

C)   E[(S₀ - S₁)/S₀] - (r_DC - r_FC).

D)   [E(S₁) - F]/ S₀.

The correct answer was D)

The formula for the foreign currency risk premium is: FCRP = [E(S₁) – F]/ S₀. All other formulas are incorrect in the algebra or the subscripts.

7．Steven Retting lives in Canada and is considering investing in a Canadian bond yielding 6 percent or a U.S. bond yielding 5 percent. Retting expects the Canadian dollar to appreciate by 3 percent over the next year.

What is the foreign currency risk premium on the U.S. dollar?

A)   -1%.

B)   -4%.

C)   3%.

D)   2%.

The correct answer was B)

The interest rate differential is 1% (Canada – U.S.). We expect the Canadian dollar to appreciate by 3% relative to the U.S. dollar therefore the U.S. dollar will depreciate by 3%. The foreign currency risk premium (FCRP) is the expected exchange rate movement minus the interest rate differential between the domestic currency and the foreign currency. FCRP = -3% -1% = -4%.

8．What will be the Canadian currency returns on the U.S. bond?

A)   6%.

B)   2%.

C)   4%.

D)   8%.

The correct answer was B)

Since Retting lives in Canada, the Canadian rate is the domestic rate. The interest rate differential is 1 percent (Canada – U.S.). The foreign currency risk premium (FCRP) is -3% – 1% = -4%. The domestic currency return on the foreign U.S. bond can be calculated as the domestic Canadian interest rate plus the FCRP: 6 - 4 = 2%. Alternatively, the domestic currency return can be calculated as the U.S. interest rate plus the expected currency depreciation: 5 -3 = 2%

9．According to the traditional model, if the Canadian currency appreciates, then Canadian industries in the long run should become:

A)   more competitive, and there will be an economic slowdown in Canada.

B)   less competitive, and there will be an economic expansion in Canada.

C)   less competitive, and there will be an economic slowdown in Canada.

D)   more competitive, and there will be an economic expansion in Canada.

The correct answer was C)

In the long run, an increase in the value of a country’s currency decreases national competitiveness. Likewise, a decrease in the value of a country’s currency increases national competitiveness in the long run. However, in the short run a decrease in the national currency causes a widening gap in the trade balance and an increase in domestic inflation. Therefore, short-run and long-run reactions to changes in currency differ.