bapswarrior

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

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

B) forward rate minus the spot rate.

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

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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.

bapswarrior

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) -1%.

C) 0%.

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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., rDC – rFC = 4% – 5% = –1%).

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%.

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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%.

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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).

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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).

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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.

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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%.

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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%.

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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).

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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%

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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

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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.

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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%.

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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.