Currency sensitivity

should use local currency sensitivvity of 0.5, why add 1 to it? since Poland investor invest in German .

Please add some comments


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% and the security has a local currency sensitivity of 0.5. The risk-free rate in Poland is 8% and the risk-free rate in Germany is 4%. The world market risk premium is 7% and the securities sensitivity to the world market is 2. What is the required return of the security?

A) 23.5%. B) 18.5%. C) 12.5%.

Your answer: A was correct!

In a single foreign currency world, the ICAPM simplifies to: E(Ri) = R0 + Biw × RPw + γi1 × SRP1. Substituting in the numbers from the problem, we get: E(Ri) = 8% + 2(7%) + (1 + 0.5)(1%) = 23.5%. Remember to use the domestic risk-free rate.

I don’t get the logic behind it either, but I learned that if ou are going to find teh expected return using ICAMP, you have to add 1 (I actually look at the I in ICAMP and remember to add 1 :-)). There is a logic which says that the German security you are buying is sensitive to the Euro in two ways, one is that the stock itself gets affected by the Euro, and then your final investment is also affected by the Euro…but again, I don’t get it completely.

hey guys, more or less it goes like this…

I am an american… and I want to buy a european shoemaker

the european shoemaker sells his shoes in europe and sources his products from the US.

Since it sells its shoes in europe, (revenue) and sources its shoes in the US (cost), if the Euro appreciates against the greenback, the company makes more money and the stock should appreciate as a result

Now as a US investor, who wants to buy the company, I am exposed to the euro on two fronts, by converting my dollars into euros to buy the company and by the companies exposure to the euro

so lets say I convert $1320 into euros at 1.32, so now I have 1000 euros and I buy the company. Also, the lets assume the company’s exposure to the euro is 0.8

if euro appreciations, my 1000 euros I am holding (my investment in euros) is 100% exposed to the movement in euros. also if euro appreciations, my shoe company is 80% exposed to the movement in the euro.

therefore in US dollar terms, my investment in euros earns 100% of any appreciation in the euro and my shoe stock earns 80% of any appreciation in the euro. therefore my exposure to the euro is 100% + 80% = 1 + 0.8 = 1.8

hope that makes sense!

I totally guessed using this logic - let me know how Off I am since I have NOT reviewed this section yet:

CAPM = RF + B (Rp)

So if the Risk Premium is 7% and the sensitivity (reading as “Beta”) is 2 – Then the second half of the equation is 14.

RF rate is a local measure so - Poland Risk Free Rate is 8% so (8% + 14%) Gets me to 22%… Which would only leave A

BUT – just since I’m lost on this problem let’s think about this intuitively

Since I’m unfamiliar w/ the currency sensitivities and their input to the formula I can eyeball the RF rate and show that Poland > Germany — Thinking back to Econ doesn’t this lend itself to you getting a higher real return in German/Euro (i.e. > 22%) because of the interest rate differential.

Give my day I’m assuming I just made a lucky guess and talked myself into the “logic” through delirium… Waiting for someone smarter than me to make fun of this post…

I think this explains it very well. But I want to try it out with other problems to see that this always holds, and whether the FCRP already factors that in.