Reading 70: LOS h ～ Q11- 15

11．Song Lee, CFA, is a money manager for a small firm in Seoul. All of Lee’s clients are local. He is considering adding the stock of a U.S. firm, Stockco, to some of his client’s portfolios. Stockco sensitivity to the world index is 0.8 and the risk premium on the index is 6 percent. The risk-free rate is 3 percent in the U.S. and 5 percent in Korea. Stockco is only sensitive to changes in the value of the U.S. dollar. Lee has measured the sensitivity of Stockco to changes in the value of the U.S. dollar to be 1.2. The foreign currency risk premium on the U.S. dollar is 2 percent. Assuming that Lee uses the international capital asset pricing model (ICAPM), what is the required return on Stockco?

A)   10.2%.

B)   14.2%.

C)   9.2%.

D)   12.2%.

The correct answer was D)

In a single foreign currency world, the ICAPM simplifies to: E(R_i) = R₀ + B_iw × RP_w + γ_i1 x FCRP₁. Substituting in the numbers from the problem, we get: E(R_i) = 5% + 0.8 × (6%) + 1.2 × (2%) = 12.2%. Remember to use the domestic risk-free rate.

12．Assume there is a German investor who is restricted to investing only in two currencies—the euro and the U.S. dollar.  The U.S. risk-free rate is 3 percent and the German risk-free rate is 4 percent.  The expected appreciation of the U.S. dollar is 2 percent.  The world portfolio risk premium is 8 percent.  The currency exposures based on euro returns and world betas for three portfolios are as follows:   

What is the foreign currency risk premium?

A)   2.0%.

B)   1.0%.

C)   -1.0%.

D)   -2.0%.

The correct answer was B)

The domestic currency is the German euro. The interest rate differential between the two countries is 1 percent (Domestic – Foreign). The expected appreciation of the U.S. dollar is 2 percent. The SRP is +1 percent (expected appreciation minus the interest rate differential).

13．What is the expected return of each security to a German investor?

A)          E(R_A) = 12.1%; E(R_B) = 14.4%; E(R_C) = 8.4%.

B)          E(R_A) = 14.1%; E(R_B) = 15.0%; E(R_C) = 11.4%.

C)          E(R_A) = 15.1%; E(R_B) = 16.0%; E(R_C) = 12.4%.

D)          E(R_A) = 9.6%; E(R_B) = 11.2%; E(R_C) = 6.4%.

The correct answer was C)     

A German investor would use the German risk free rate of 4 percent. The world beta for each security is multiplied by the world risk premium. The currency exposure is multiplied by the euro risk premium of 1 (expected appreciation of 2% minus the interest rate differential of 1%).

E(R_A) = 0.04 + (1.2 x 0.08) + (1.5 x 0.01) = 0.04 + 0.096 + 0.015 = 0.151
E(R_B) = 0.04 + (1.4 x 0.08) + (0.8 x 0.01) = 0.04 + 0.112 + 0.008 = 0.160
E(R_C) = 0.04 + (0.8 x 0.08) + (2.0 x 0.01) = 0.04 + 0.064 + 0.020 = 0.124

14．Which of the following statements regarding the International Capital Asset Pricing Model (ICAPM) is FALSE? The ICAPM:

A)   is very similar to the domestic CAPM in form, except for an adjustment for currency risk exposure.

B)   can be applied to any financial market.

C)   is very similar to the domestic CAPM in application.

D)   assumes risk is priced similarly in all markets.

The correct answer was B)

The ICAPM applies only in a world with integrated capital markets and therefore cannot be applied to simply any financial market. If markets are segmented, risk may not be priced similarly in all markets and the ICAPM will not be applicable. The ICAPM is very similar to the domestic CAPM in form and application. The only difference is an adjustment for currency risk exposure.

15．A Japanese investor is valuing a Korean security. The risk-free rate is 2 percent in Japan and 3 percent in Korea. The world market risk premium is 6 percent and the securities sensitivity to the world market is 1.2. The security is sensitive to changes in the value of two foreign currencies: the Korean won and U.S. dollar. The foreign currency risk premium (SRP) for the won is 2 percent and the SRP for the U.S. dollar is 1 percent. The sensitivity to the won is estimated at 1 and the sensitivity to the dollar is estimated at 2. According to the international capital asset pricing model (ICAPM), what is the required return on the security?

A)   13.2%.

B)   3.2%.

C)   12.0%.

D)   10.2%.

The correct answer was A)

In a two foreign currency world, the ICAPM becomes to: E(R_i) = R₀ + B_iw × RP_w + γ_i1 × SRP₁ + γ_i2 × SRP₂. Substituting in the numbers from the problem, we get: E(R_i) = 2% + 1.2(6%) + (1)(2%) + 2(1%) = 13.2%. Remember to use the domestic risk-free rate.