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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