jacksparrow

bpdulog: why isnt there enough information? you have beginning spot rate in USD, the UK inflation rate, the US inflaation rate, and the time.

S1 = ($1.50) (1.05)/1.10) = $1.43.

This does not equal the $1.60 they provide. Take a look at another problem in which they ask for FCRP and to derive the exchange rate in one year, they use Relative PPP. I'm still simply trying to make the point that Relative PPP should get you to the same S1.





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) 7.85%.
B) 7.55%.
C) 9.55%.

The correct answer was A.


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

E(R) = Rf + BgMRPg + y$(FCRP$).

Rf is the domestic risk free rate, in this example Japan. Bg is the World beta. MRPg is the world market risk premium. Y$ 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