bapswarrior

Paul Wilkes, a U.S. investor, is interested in investing in securities in the Caribbean country of Grenada. He is convinced that current market conditions make the securities of Grenada very attractive relative to those securities of other countries. Wilkes’ current portfolio is composed entirely of domestic securities, with an allocation of 60% equity and 40% fixed income. Wilkes has little experience in global investing, but has decided that the timing is right to invest at least 10% of his portfolio in foreign assets. Wilkes is particularly attracted to the high rate of return attainable in the Grenada market, but first needs to determine if the additional risk outweighs the return.  
After carefully developing his investment criteria and researching the financial markets of Grenada, Wilkes has narrowed his potential investments down to one choice. The secondary markets for equities issued in Grenada are more illiquid than Wilkes had previously thought. This lack of liquidity in the equities market leads Wilkes to determine that equities would be an inappropriate investment for his portfolio. However, bonds issued by the government of Grenada seem to have a history of good liquidity as well as steady returns, both of which are qualities Wilkes is seeking for his portfolio. Wilkes must now use various methods to determine expected returns for these bonds, given a one-year time horizon, expected changes in the U.S./Grenada exchange rates, and inflation rates. Wilkes also must consider the foreign currency risk premium of the issue, and decide if it is appropriate given the additional exposure.
The currency of Grenada is the Eastern Caribbean Dollar (ECD). The current exchange rate is 2.50 USD/ECD. The ratio of the price levels of American goods to Grenadian goods is also 2.50. Inflation in the U.S. is expected to be 2% and 3% in Grenada. The end-of-year expected spot exchange rate is 2.75 USD/ECD. The one-year U.S. (risk free) interest rate is 4%, and in Grenada it is 8%.
Also assume that these two currencies are the only ones that exist. The world portfolio risk premium is 6%. The security Wilkes is interested in is a government issue that has a world beta of 1.25 and currency exposure of 0.80.What is the beginning of period real exchange rate and the end of period real rate, respectively?

A) 2.50; 2.55.

B) 6.25; 6.94.

C) 1.00; 1.11.

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Beginning of period real exchange rate:
X0 = S × PF / PD = (2.5USD/ECD)(1.0PGrenada / 2.50PUS) = 1.0 USD/ECD
End of period real exchange rate:
X1 = (2.75 USD/ECD)(1.03PGrenada / 2.55PUS) = 1.11 USD/ECD
PGrenada = 1 × 1.03 = 1.03
PUS = 2.50 × 1.02 = 2.55
(Study Session 18, LOS 62.g)

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Has there been a change in the real exchange rate?

A) No, inflation remained constant.

B) Yes, purchasing power has changed.

C) No, the inflation differential compensated for the change in the spot rate.

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The real exchange rate was 1.00 at the beginning of the period, and at the end it is 1.11. (Study Session 18, LOS 62.g)

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For this question, assume the real exchange rate is expected to be constant. What is the expected exchange rate?

A) 2.52.

B) 2.40.

C) 2.48.

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If the real rate remains constant, the change in the exchange rate will be the inflation differential. Since the differential is 1%, we would expect to see the ECD depreciate by 1% against the dollar. Hence, the expected exchange rate is = 2.50USD/ECD / (1.01) = 2.475USD/ECD. (Study Session 18, LOS 62.f)

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For this question, assume the real exchange rate is expected to be constant. If the U.S. investor wants to buy a bond in Grenada, what would be the approximate expected return of this bond?

A) 7%.

B) 8%.

C) 9%.

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The return on the bond should be approximately equal to the foreign interest rate minus the depreciation of the foreign currency = 8% + (–1%) = 7%. (Study Session 18, LOS 62.f)

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What is the foreign currency risk premium (SRP)?

A) 10.0%.

B) 14.0%.

C) 6.0%.

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SRP = (E(S1) − S0) / S0 − (rDC − rFC)
The expected foreign currency appreciation is = (2.75 − 2.50) / (2.50) = 0.10.
The SRP is the expected foreign currency appreciation minus the interest rate differential:

SRP	= 10% − (4% − 8%)
	= 10% + 4%
	= 14.0%

(Study Session 18, LOS 62.h)

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

A) 12.2%.

B) 14.0%.

C) 22.7%.

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The ICAPM in this case would be:
E(Ri) = Rf + (βg × MRPg) + (γiECD × FCRPiECD)
The ECD risk premium is:

FCRPECD	= (E (S1) − S0) / S0 − (rDC − rFC)
	= 10% − (4% − 8%)
	= 10% + 4%
	= 14.0%

Substituting in values, we get:

E(Ri)	= 0.04 + (1.25 × 0.06) + (0.80 × 0.14)
	= 0.04 + 0.075 + 0.112
	= 0.2270 or 22.70%

(Study Session 18, LOS 62.j)

bapswarrior

Suppose world markets are fully segmented. What will be the effect of segmentation of the international capital asset pricing model (ICAPM)? Risk will be priced:

A) differently in each national market and the ICAPM will be valid.

B) similarly in each national market and the ICAPM breaks down.

C) differently in each national market and the ICAPM breaks down.

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Segmentation means that risk will be priced differently in each national market, hence the ICAPM, which assumes uniform risk pricing, breaks down.

bapswarrior

For the international capital asset pricing model (ICAPM), which of the following statements regarding the integration of national markets is most accurate? If international markets are:

A) integrated, there is no need for the ICAPM.

B) integrated, the ICAPM breaks down.

C) segmented, the ICAPM breaks down.

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For the ICAPM to be valid, international markets must be integrated. If markets are segmented, risk will be priced differently in different national markets so the world risk premium will not be a robust comparison measure.

bapswarrior

If international markets are integrated, which of the following statements is least accurate?

A) The international risk-free rate will be the appropriate base rate for asset pricing.

B) Risk will be priced similarly in all markets.

C) The international capital asset pricing model will be valid.

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There is no such thing as an “international risk-free rate,” hence it cannot be used in asset pricing. In broad terms, both remaining answers will be correct in the presence of well-integrated world markets.

bapswarrior

Paul McCormack is a U.S. investor interested in valuing a Japanese security. Which of the following regression equations would be useful to McCormack in assessing the currency exposure of the Japanese security to changes in the dollar/yen exchange rate?

A) Local currency return = α + β (world market return).

B) Domestic currency return = α + β (exchange rate movement).

C) Domestic currency return = α + β (world market return).

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To assess currency exposure, regress domestic currency returns against exchange rate movements [Domestic currency return = α + β (exchange rate movement)]. In this formulation, β would be an estimate of the currency exposure and would likely be called γ if used in the international capital asset pricing model.

bapswarrior

A French investor holds a U.K. security. The investor has estimated the currency exposure in local currency terms to be 1.3. What is the currency exposure in domestic currency terms?

A) 2.3.

B) 1.3.

C) 0.3.

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The investor estimated γFC = 1.3. To translate local (or FC) exposure to domestic currency exposure, we use: γ = γFC + 1. Hence, the domestic currency exposure is: γ = γFC + 1 = 1.3 + 1 = 2.3.

bapswarrior

Suppose that a U.K. investor holds a U.S. security. The U.S. security has a negative correlation with changes in the value of the U.S. dollar in local currency terms. What does the negative correlation mean for the U.K. investor? The:

A) security exaggerates the impact of currency movements.

B) domestic currency γ is greater than one.

C) security provides a natural hedge against currency movements.

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A negative correlation means that as the value of the dollar falls (depreciates) the value of the security rises. Hence, the security provides a natural hedge against exchange rate movements to the U.K. investor. If the correlation is negative, the local currency γ will be less than zero.

bapswarrior

Suppose the value of the euro depreciates by 5 percent in real terms. Of the following firms, which will most likely be hurt by the change in the euro? (The euro is used as the official currency in France and the pound is used in the U.K.) A:

A) U.K. firm that imports food from French suppliers.

B) French firm that exports food to U.K. distributors.

C) French firm that imports and resells computers in France.

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The firm that imports and resells goods in France, which

bapswarrior

Suppose an analyst is assessing the currency exposure of a French firm that imports bicycles from the U.K. If the value of the British pound appreciates, will the French firm’s cost structure improve or deteriorate? Why?

A) Deteriorate, because the French cost of imported bicycles will go down.

B) Improve, because the French cost of imported bicycles will go down.

C) Deteriorate, because the French cost of imported bicycles will go up.

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If the pound appreciates, then bicycles imported from the U.K will be more expensive in France. Hence, the cost structure of the French bicycle importer will deteriorate.

bapswarrior

Consider a Canadian firm that exports hockey sticks to the U.S. Prices are set and collected in U.S. dollars. The inflation differential between Canada and the U.S. is 2% (Canadian inflation minus U.S. inflation). What is the valuation impact on the Canadian exporter if the value of the Canadian dollar falls by 2% during the next year?

A) The firm is helped by the falling value of the Canadian dollar.

B) The firm is hurt by the falling value of the Canadian dollar.

C) All currency changes are nominal, so the change has no real impact.

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The change in the valuation of the currency is fully explained by the inflation differential. Hence, there should be no impact on the valuation of the firm in real terms