Reading 70: LOS h ～ Q 6- 10

6．Using the international CAPM (ICAPM), what is the approximate expected return on this security?

A)   14.0%.

B)   10.0%.

C)   22.7%.

D)   12.2%.

The correct answer was C)

The ICAPM in this case would be:

E(R_i) = R_f + (β_g x MRP_g) + (γ_iECD x FCRP_iECD)

The ECD risk premium is:

Substituting in values, we get:

7．Jaro Sumzinski, who lives in Poland, is applying the international capital asset pricing model (ICAPM) to determine the value of a German security. The German currency (Euro) has a risk premium of 1 percent and the security has a local currency sensitivity of 0.5. The risk-free rate in Poland is 8 percent and the risk-free rate in Germany is 4 percent. The world market risk premium is 7 percent and the securities sensitivity to the world market is 2. What is the required return of the security?

A)   23.5%.

B)   18.5%.

C)   12.5%.

D)   26.0%.

The correct answer was A)

In a single foreign currency world, the ICAPM simplifies to: E(R_i) = R₀ + B_iw × RP_w + γ_i1 × SRP₁. Substituting in the numbers from the problem, we get: E(R_i) = 8% + 2(7%) + (1+0.5)(1%) = 23.5%. Remember to use the domestic risk-free rate.

8．Lee Okazaki is a Japanese investor who is considering investing in the United States equity and bond market. The world risk premium is 5 percent. The risk-free rate is 2 percent in Japan and 3.5 percent in the U.S. The current exchange rate is 120 yen/$ and the ratio of the price levels of Japan to U.S. consumption baskets is expected to be 120 to 1 in one year. The 1-year interest rate in Japan is 2.5 percent and the one-year rate is 4 percent in the U.S. The expected inflation rate in the U.S. is 2 percent and in Japan the expected inflation rate is 1 percent.

Okazaki is considering buying common stock in a U.S. firm that has a world beta of 1.1 and an estimated sensitivity of yen-denominated returns to changes in the U.S. dollar of 0.7. What is the required return for this investment?

A)   9.55%.

B)   10.55%.

C)   7.55%.

D)   7.85%.

The correct answer was D)

The ICAPM for a two world currency is E(R) = R_f + β_gMRP_g + γ_$(FCRP_$).

R_f is the domestic risk free rate, in this example Japan. β_g is the World beta. MRP_g is the world market risk premium. γ_$ is the domestic currency sensitivity. FCRP is the foreign currency risk premium calculated by taking the expected appreciation minus the interest rate differential. Note the first part of this is the expected appreciation of the exchange rate. Using relative PPP the expected spot rate is 120 × [(1.01/1.02)] = 118.8. The exchange rate is currently 120yen/$, and a year from now it will be 118.8 yen/$.

FCRP = [E(S₁)- S₀] / S₀ – (r_DC - r_FC) = [(118.8 – 120)/120] – (0.02 - 0.035) = 0.005

E(R) = 0.02 + 1.1(0.05) + 0.7(0.005) = 0.02 + 0.055 + 0.0035 = 0.0785

9．Okazaki is also considering the purchase of a United States corporate bond. If the real exchange rate remains constant over the next period, what is Okazaki’s expected return over the next year on the U.S. bond?

A)   3%.

B)   2%.

C)   1%.

D)   4%.

The correct answer was A)

As long as the real rate remains constant, the expected return on the bond is equal to the U.S. (foreign) interest rate of 4 percent plus the inflation differential of –1 percent (inflation in domestic – inflation in U.S.). The expected return to Okazaki is 3 percent (4% –1%).

10．What will the return be for Okazaki on the 1-year bond if the end-of-period exchange rate is 110/1 instead of the beginning-of-period exchange rate of 120/1?

A)   -1.33%.

B)   8.33%.

C)   -4.33%.

D)   12.33%.

The correct answer was C)

This indicates that the yen has appreciated over the time period and the real rate has changed. The dollar has depreciated compared to the yen over the time period. The depreciation is (110/1)/(120/1) – 1 = 0.9167 – 1 = –8.33%. The return to Okazaki is foreign interest rate plus the currency appreciation (in this example, depreciation) = 4% – 8.33% = –4.33%.