1．Which of the following assumptions is needed to justify the international capital asset pricing model (ICAPM)? In the ICAPM, the risk-free rate is:

A)   the investor’s domestic risk-free rate, and the market portfolio is the market capitalization weighted portfolio of all risky assets in the world.

B)   the investor’s domestic risk-free rate, and the market portfolio is the market capitalization weighted portfolio of all risky assets in the domestic market.

C)   LIBOR-based, and the market portfolio is the market capitalization weighted portfolio of all risky assets in the world.

D)   LIBOR-based, and the market portfolio is the market capitalization weighted portfolio of all risky assets in the domestic market.

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

A)   E(R) = R_F + (b × MRP) + (γ_LC × FCRP_LC) + (γ_FC × FCRP_FC).

B)   E(R) = R_F + (b × MRP).

C)   E(R) = R_F + (γ_LC × FCRP_LC) + (γ_FC × FCRP_FC).

D)   E(R) = R_F + (b × MRP) + (γ_FC × FCRP_FC).

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

A)   E(R) = (b × MRP) + (γ₁ × FCRP₁) + (γ₂ × FCRP₂) + … + (γ_k × FCRP_k).

B)   E(R) = R_F + (γ₁ × FCRP₁) + (γ₂ × FCRP₂) + … + (γ_k × FCRP_k).

C)   E(R) = R_F + (b × MRP) + (γ₁ × FCRP₁) + (γ₂ × FCRP₂) + … + (γ_k × FCRP_k).

D)   E(R) = R_F + (b × MRP).

1．Which of the following assumptions is needed to justify the international capital asset pricing model (ICAPM)? In the ICAPM, the risk-free rate is:

A)   the investor’s domestic risk-free rate, and the market portfolio is the market capitalization weighted portfolio of all risky assets in the world.

B)   the investor’s domestic risk-free rate, and the market portfolio is the market capitalization weighted portfolio of all risky assets in the domestic market.

C)   LIBOR-based, and the market portfolio is the market capitalization weighted portfolio of all risky assets in the world.

D)   LIBOR-based, and the market portfolio is the market capitalization weighted portfolio of all risky assets in the domestic market.

The correct answer was A)

In the extended CAPM, the risk-free rate (R_F) is the investor’s domestic risk-free rate and the market portfolio is the market capitalization weighted portfolio of all risky assets in the world.

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

A)   E(R) = R_F + (b × MRP) + (γ_LC × FCRP_LC) + (γ_FC × FCRP_FC).

B)   E(R) = R_F + (b × MRP).

C)   E(R) = R_F + (γ_LC × FCRP_LC) + (γ_FC × FCRP_FC).

D)   E(R) = R_F + (b × MRP) + (γ_FC × FCRP_FC).

The correct answer was D)

E(R) = R_F + (b × MRP) + (γ_FC × FCRP_FC).

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

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

A)   E(R) = (b × MRP) + (γ₁ × FCRP₁) + (γ₂ × FCRP₂) + … + (γ_k × FCRP_k).

B)   E(R) = R_F + (γ₁ × FCRP₁) + (γ₂ × FCRP₂) + … + (γ_k × FCRP_k).

C)   E(R) = R_F + (b × MRP) + (γ₁ × FCRP₁) + (γ₂ × FCRP₂) + … + (γ_k × FCRP_k).

D)   E(R) = R_F + (b × MRP).

The correct answer was C)

Where:

E(R) = asset’s expected return

R_F = domestic currency risk-free rate

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

MRP_G = world market risk premium [E(R_M) – R_F]

E(R_M) = expected return on world market portfolio

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

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

E(R) = R_F + (b × MRP) + (γ₁ × FCRP₁) + (γ₂ × FCRP₂) + … + (γ_k × FCRP_k).

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.