bapswarrior

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

A) −3%.

B) 3%.

C) 2%.

---

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

bapswarrior

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

A) 4%.

B) -2%.

C) 2%.

---

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: rDC – rFC = 9% – 2% = 7%).

bapswarrior

The international capital asset pricing model (ICAPM) expresses expected returns as:

A) E(R) = RF + (b × MRP) + (γ1 × FCRP1) + (γ2 × FCRP2) + … + (γk × FCRPk).

B) E(R) = (b × MRP) + (γ1 × FCRP1) + (γ2 × FCRP2) + … + (γk × FCRPk).

C) E(R) = RF + (γ1 × FCRP1) + (γ2 × FCRP2) + … + (γk × FCRPk).

---

Where:

E(R) = asset’s expected return

RF = domestic currency risk-free rate

bG = sensitivity of the asset i domestic currency returns to changes in the global market portfolio

MRPG = world market risk premium [E(RM) – RF]

E(RM) = expected return on world market portfolio

γ1 to γk = sensitivities of asset’s domestic currency returns to changes in the value of currencies 1 through k

FCRP1 to FCRPk = foreign currency risk premiums on currencies 1 through k

E(R) = RF + (b × MRP) + (γ1 × FCRP1) + (γ2 × FCRP2) + … + (γk × FCRPk).

The ICAPM tells us that the expected return on any asset i is equal to the investor’s domestic risk-free rate, plus a world market risk premium (which is scaled by the asset’s world market beta), plus a foreign currency risk premium for each foreign currency.

bapswarrior

In a two-currency world, the international capital asset pricing model expresses expected returns as:

A) E(R) = RF + (b × MRP) + (γLC × FCRPLC) + (γFC × FCRPFC).

B) E(R) = RF + (b × MRP) + (γFC × FCRPFC).

C) E(R) = RF + (γLC × FCRPLC) + (γFC × FCRPFC).

---

E(R) = RF + (b × MRP) + (γFC × FCRPFC).

The relevant risk is world market risk. An additional risk premium is added for the asset’s sensitivity to changes in the foreign currency.

bapswarrior

Which of the following statements related to the International Capital Asset Pricing Model (ICAPM) is least accurate?

A) Expected return for any asset is a function of the U.S. Treasury rate, the world market risk premium, and the sensitivity of the asset to changes in all other foreign currencies.

B) Investors are concerned with nominal returns in their home currency.

C) All investors should hold some combination of their domestic risk-free asset and the world portfolio.

---

Expected return for any asset is a function of the investor’s domestic risk-free rate, the world market risk premium, and the sensitivity of the asset to changes in all other foreign currencies. Only if the investor is from the U.S. would he use the U.S. Treasury security.

bapswarrior

A Japanese investor is valuing a Korean security. The risk-free rate is 2% in Japan and 3% in Korea. The world market risk premium is 6% 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% and the SRP for the U.S. dollar is 1%. 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) 10.2%.

B) 13.2%.

C) 3.2%.

---

In a two foreign currency world, the ICAPM becomes to: E(Ri) = R0 + Biw × RPw + γi1 × SRP1 + γi2 × SRP2. Substituting in the numbers from the problem, we get: E(Ri) = 2% + 1.2(6%) + (1)(2%) + 2(1%) = 13.2%. Remember to use the domestic risk-free rate

bapswarrior

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% and the German risk-free rate is 4%.
The expected appreciation of the U.S. dollar is 2%.
The world portfolio risk premium is 8%.
The currency exposures based on euro returns and world betas for three portfolios are as follows:

	A	B	C
World Beta	1.2	1.4	0.8
Currency Exposure	1.5	0.8	2.0

What is the foreign currency risk premium?

A) 1.0%.

B) 2.0%.

C) −1.0%.

---

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

---

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

E(RA)

E(RB)

E(RC)

A) 9.6% 11.2% 6.4%

B) 15.1% 16.0% 12.4%

C) 14.1% 15.0% 11.4%

---

A German investor would use the German risk free rate of 4%. 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% − the interest rate differential of 1%).E(RA) = 0.04 + (1.2 × 0.08) + (1.5 × 0.01) = 0.04 + 0.096 + 0.015 = 0.151
E(RB) = 0.04 + (1.4 × 0.08) + (0.8 × 0.01) = 0.04 + 0.112 + 0.008 = 0.160
E(RC) = 0.04 + (0.8 × 0.08) + (2.0 × 0.01) = 0.04 + 0.064 + 0.020 = 0.124

---

Which of the following statements regarding the International Capital Asset Pricing Model (ICAPM) is least accurate? The ICAPM:

A) can be applied to any financial market.

B) assumes risk is priced similarly in all markets.

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

---

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.

bapswarrior

ong 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%. The risk-free rate is 3% in the U.S. and 5% 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%. Assuming that Lee uses the international capital asset pricing model (ICAPM), what is the required return on Stockco?

A) 14.2%.

B) 12.2%.

C) 10.2%.

---

In a single foreign currency world, the ICAPM simplifies to: E(Ri) = R0 + Biw × RPw + γi1 × FCRP1. Substituting in the numbers from the problem, we get: E(Ri) = 5% + 0.8 × (6%) + 1.2 × (2%) = 12.2%. Remember to use the domestic risk-free rate.

bapswarrior

Lee Okazaki is a Japanese investor who is considering investing in the United States equity and bond market. The world risk premium is 5%. The risk-free rate is 2% in Japan and 3.5% 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% and the one-year rate is 4% in the U.S. The expected inflation rate in the U.S. is 2% and in Japan the expected inflation rate is 1%.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) 7.55%.

B) 9.55%.

C) 7.85%.

---

The International Capital Asset Pricing Model (ICAPM) for a two world currency is:

E(R) = Rf + βgMRPg + γ$(FCRP$).

Rf is the domestic risk free rate, in this example Japan. βg is the World beta. MRPg is the world market risk premium. γ$ is the domestic currency sensitivity. Foreign currency risk premium (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 purchasing power parity (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 – (rDC − rFC) = [(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

---

Okazaki is also considering the purchase of a United States one-year 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. one-year bond?

A) 4%.

B) 2%.

C) 3%.

---

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% plus the inflation differential of –1% (inflation in domestic − inflation in U.S.). The expected return to Okazaki is 3% (= 4% −1%).

---

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%.

---

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%

bapswarrior

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% and the security has a local currency sensitivity of 0.5. The risk-free rate in Poland is 8% and the risk-free rate in Germany is 4%. The world market risk premium is 7% and the securities sensitivity to the world market is 2. What is the required return of the security?

A) 18.5%.

B) 12.5%.

C) 23.5%.

---

In a single foreign currency world, the ICAPM simplifies to: E(Ri) = R0 + Biw × RPw + γi1 × SRP1. Substituting in the numbers from the problem, we get: E(Ri) = 8% + 2(7%) + (1 + 0.5)(1%) = 23.5%. Remember to use the domestic risk-free rate.