LOS h: Calculate a foreign currency risk premium, and explain a foreign currency risk premium in terms of interest rate differentials and forward rates.

Q1. Steven Retting lives in Canada and is considering investing in a Canadian bond yielding 6% or a U.S. bond yielding 5%. Retting expects the Canadian dollar to appreciate by 3% over the next year.

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

A)   ?4%.

B)   2%.

C)   ?1%.

Q2. What will be the Canadian currency returns on the U.S. bond?

A)   8%.

B)   2%.

C)   6%.

Q3. 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)   more competitive, and there will be an economic expansion in Canada.

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

Q4. Which of the following is the formula for the foreign currency risk premium (FCRP)? The FCRP equals:

A)   E[(S₁ ? S₀) / S₀] ? (r_FC ? r_DC).

B)   E[(S₀ ? S₁) / S₀] ? (r_DC ? r_FC).

C)   [E(S₁) ? F] / S₀.

Q5. Estimation of the foreign currency risk premium (FCRP) is required in which model?

A)   International capital asset pricing model.

B)   Extended capital asset pricing model.

C)   Domestic capital asset pricing model.

Q6. Which of the following describes the foreign currency risk premium (FCRP)? FCRP equals:

A)   expected exchange rate movement minus the interest rate differential.

B)   expected exchange rate movement minus the ratio of the spot to the forward rate.

C)   forward rate minus the spot rate.

Q7. A Canadian investor has a domestic currency risk-free rate of 4%. The risk free rate in the U.S. is 5%. The investor expects the Canadian currency (Can$) to appreciate by 1% against the U.S. dollar ($). What is the foreign currency risk premium (FCRP)?

A)   1%.

B)   0%.

C)   -1%.

Q8. 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)   2%.

C)   3%.

Q9. 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)   -2%.

B)   4%.

C)   2%.

LOS h: Calculate a foreign currency risk premium, and explain a foreign currency risk premium in terms of interest rate differentials and forward rates. fficeffice" />

Q1. Steven Retting lives in ffice:smarttags" />Canada and is considering investing in a Canadian bond yielding 6% or a U.S. bond yielding 5%. Retting expects the Canadian dollar to appreciate by 3% over the next year.

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

A)   ?4%.

B)   2%.

C)   ?1%.

Correct answer is A)

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%.

Q2. What will be the Canadian currency returns on the U.S. bond?

A)   8%.

B)   2%.

C)   6%.

Correct answer is B)

Since Retting lives in Canada, the Canadian rate is the domestic rate. The interest rate differential is 1% (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%

Q3. 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)   more competitive, and there will be an economic expansion in Canada.

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

Correct answer is 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.

Q4. Which of the following is the formula for the foreign currency risk premium (FCRP)? The FCRP equals:

A)   E[(S₁ ? S₀) / S₀] ? (r_FC ? r_DC).

B)   E[(S₀ ? S₁) / S₀] ? (r_DC ? r_FC).

C)   [E(S₁) ? F] / S₀.

Correct answer is C)

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

Q5. Estimation of the foreign currency risk premium (FCRP) is required in which model?

A)   International capital asset pricing model.

B)   Extended capital asset pricing model.

C)   Domestic capital asset pricing model.

Correct answer is A)

The estimation of an FCRP between all paired currencies is required as part of the international capital asset pricing model.

Q6. Which of the following describes the foreign currency risk premium (FCRP)? FCRP equals:

A)   expected exchange rate movement minus the interest rate differential.

B)   expected exchange rate movement minus the ratio of the spot to the forward rate.

C)   forward rate minus the spot rate.

Correct answer is A)

The FCRP is defined as the expected exchange rate movement minus the interest rate differential. The FCRP will be zero if the expected exchange rate change is purely a function of the relative interest rates.

Q7. A Canadian investor has a domestic currency risk-free rate of 4%. The risk free rate in the U.S. is 5%. The investor expects the Canadian currency (Can$) to appreciate by 1% against the U.S. dollar ($). What is the foreign currency risk premium (FCRP)?

A)   1%.

B)   0%.

C)   -1%.

Correct answer is B)

The FCRP is the expected appreciation of the foreign currency minus the interest rate differential (domestic ? foreign). Hence, the FCRP is 0% (= –1% appreciation of U.S. dollar minus –1% interest rate differential (i.e., r_DC – r_FC = 4% – 5% = –1%).

Q8. 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)   2%.

C)   3%.

Correct answer is C)        

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: r_DC – r_FC = 3% – 2% = 1%.

Q9. 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)   -2%.

B)   4%.

C)   2%.

Correct answer is A)

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: r_DC – r_FC = 9% – 2% = 7%).