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ICAPM question

My question is, why is “1” added to the 0.5 currency sensitivity?:

Jaro Sumzinski, who lives in Poland, is applying the international capital asset pricing model (ICAPM) to determine the value of a German security. The German currency (Euro) has a risk premium of 1 percent and the security has a local currency sensitivity of 0.5. The risk-free rate in Poland is 8 percent and the risk-free rate in Germany is 4 percent. The world market risk premium is 7 percent and the securities sensitivity to the world market is 2. What is the required return of the security?

The correct answer was D) 23.5%.

Substituting in the numbers from the problem, we get: E(Ri) = 8% + 2(7%) + (1+0.5)(1%) = 23.5%

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“the German currency (Euro) has a risk premium of 1 percent and the security has a local currency sensitivity of 0.5.”

local i the key word- if you get local sensitivity, add 1 to get the sensitivity for the polish guy.

I was struggling with this a few days ago. Hopefully others will chime in and tell me if I am right or wrong.

In this instance, it says the German security has a sensitivity to the local currency (euro). So if the euro appreciates, the company’s value appreciates. The polish currency has a direct relationship with the euro (1 to 1) which is a separate issue. You add those two together to get total exposure.

because 0,5 is the sensitivity of German security to EURO (i.e. the currency of its Country) and 1 is the sensitivity of your investment return (in ZLOTY) to the EURO/ZLOTY exchange rate. Your return in ZLOTY changes in a 1:1 ratio to the exchange rate (is 100% directly affected)…

I finally got it!!! because ICAPM uses sensitivity of security returns in DOMESTIC currency to foreign currencies -> to convert from sensitivity of security returns in local currency to sensitivity of returns in domestic currency you have to add 1. Does that help?

What the heck!! Is this question still around?

Please someone would like to clarify us all, as to when we need to ADD 1 and when we can take the sensitivity as is, given in the problem statement?

Am I close to the correct logic?

Not quite. If Euro goes up relative to Polish Zloty by 2%, returns in Euros of the company will go up by say 1% or returns in Polish Zloty by approximately 1%+2% = 3%

I understand what you’re saying with the sensitivity since its .5 for the company, and 1 to 1 for the currency. But the point overall is if they give you the sensitivity to the local company, you must add a 1. If the company has no sensitivity to whatever currency, then its just the exposure to the actual currency your investment is denominated in?

Everytime I think I understand this… I find get a question wrong. Perhaps someone who completely understands it should write out the explanation in bullet format.

ICAPM pricing model groups risks into 3 categories
Domestic Risk Free Rate
Performance based on Global Market Portfolio
and the Exchange rate.
so for first part u choose Poland’s risk free rate.
second u choose - the Global Market Portfolio Premium.
For the third you are looking
U are looking for R(Domesitc) against Exchange Rate (Direct)
which is defined as R/S = Y

now for Polad return can be broken into R = R (Stock, Currency-FC- German) + S
=> Y = R(FC) + S /S = Y(FC) + 1
which means the sensitivity to the foreign currency + 1
so for the above case it will be 0.5 + 1

maratikus Wrote:
——————————————————-
> I finally got it!!! because ICAPM uses sensitivity
> of security returns in DOMESTIC currency to
> foreign currencies -> to convert from sensitivity
> of security returns in local currency to
> sensitivity of returns in domestic currency you
> have to add 1. Does that help?

Arrrr. I am still not 100% on this. Pissing me off. Could someone try explaining it more. I think it would help you you could reword the original question to show when you would NOT add +1.

pinkman, whenever it says “local currency sensitivity” = that is your Y(LC)

The ICAPM model: Return = RFR(LC) + B(world MRP) + Y1(FCRP1) + Y2(FCRP2)…

to determine Y1 —> Y1 = Y(LC) + 1

In this example, Y(LC) is 0.5 therefore Y1 = 0.5 + 1

Hope that helps.

pink,

When they give you the sensitivity of the company or whatever to the local currency what they are telling you is that the company’s returns have some type of correlation with the currency in their home country. If when the LC appreciatate the stock of the company appreciates then you have positive LC sensitivity.

But here is the catch….the company also HAS to have a 100% exposure to their HOME currency. So when they give you the LC sensitivity you have to add 1 to it to get the proper perspective of the FOREIGN INVESTOR.

For example, If I am from the US and I am investing in Pinkman securites, which is a based in London. I am told that Pinkman securities has positive sensitivy to it’s local currency (pound).

When I go to plug this into the ICAPM formula I have to add the 1 because MY exposure to the pound is Pinkman securities local sensitivity, plus the MY overall sensitivity to the pound.

So you will only add one when you are given the LC sensitivity.

Hope this helps.

mwvt9 said it better.

Thats a great explanation mwvt9. I actually studied this section in depth tonight and feel a lot better about it. Basically as you said, you have to figure out how the company reacts in response to a change in its local currency. Another good way to think about it is; if a company is perfectly correlated with its LC (+1) then, if the LC appreciates 1% the company’s NI also appreciates 1%. Therefore, as an investor abroad, that is double good for me because not only did the LC appreciate (which is good for me) but that also caused the companies stock price to increase by 1%, for a total gain of 2(1+1)%

Right. That is a better example than mine. More intuitive.

Well now that you all think you have understood this concept… Let’s do a question on this.

Song Lee, CFA, is a money manager for a small firm in Seoul. All of Lees clients are local. He is considering adding the stock of a U.S. firm, Stockco, to some of his clients portfolios. Stockco sensitivity to the world index is 0.8 and the risk premium on the index is 6 percent. The risk-free rate is 3 percent in the U.S. and 5 percent 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 percent. Assuming that Lee uses the international capital asset pricing model (ICAPM), what is the required return on Stockco?

A) 12.2%.

B) 10.2%.

C) 14.2%.

D) 9.2%.

a

C

oops, forgot to add the 1. C.

(i guess that oops won’t work on CFA test)

Either one of you are correct. It’s either 12.2% or 14.2%

I say C

whats the answer?

C: korean risk free + (global beta x global mrp) + (FCRP x (local sensitivity +1)) = 14.2

Scorecard: nobody for A but 4 AF’ers for C.

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) local currency γ is greater than one.
C) security provides a natural hedge against currency movements.
D) domestic currency γ is greater than one.

C

LanceTX Wrote:
——————————————————-
> 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) local currency γ is greater than one.
> C) security provides a natural hedge against
> currency movements.
> D) domestic currency γ is greater than one.

I am C for this question..

FOR MY QUESTION: ALL OF YOU ARE WRONG! CORRECT ANS IS A

C.