Song Lee, CFA, is a money manager for a small firm in Seoul. All of Lee’s clients are local. He is considering adding the stock of a U.S. firm, Stockco, to some of his client’s portfolios. Stockco sensitivity to the world index is 0.8 and the risk premium on the index is 6%. The risk-free rate is 3% in the U.S. and 5% 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%. Assuming that Lee uses the international capital asset pricing model (ICAPM), what is the required return on Stockco? A) 12.2%. B) 14.2%. C) 10.2%. Is it local exposure or domestic exposure? US is local (FC) currency, my guese, so domestic exposure should be 1.2+1. May be I am making a big fat mistake!
no… she has US dollar exposure and sensitivity is already 1.2 to the US Dollar. So you do not need to add 1 to it again. 5 + 1.2 (2) + 0.8*6 = 5 + 2.4 + 4.8 = 12.2
cpk123 Wrote: ------------------------------------------------------- > no… she has US dollar exposure and sensitivity > is already 1.2 to the US Dollar. So you do not > need to add 1 to it again. > > 5 + 1.2 (2) + 0.8*6 = 5 + 2.4 + 4.8 = 12.2 Thank you. I must agree with you. But look at this… Q ID 88961 A French investor holds a U.K. security. The investor has estimated the currency exposure in local currency terms to be 1.3. What is the currency exposure in domestic currency terms? A) 1.3. B) 0.3. C) 2.3. Here local of foreign currency is UK Answer is C. What am I missing…?
You are confusing LC and DC. In the second example, they tell you the exposure to local is 1.3, so Y(DC) = Y(LC) + 1 = 1 + 1.3 = 2.3. In the first example, you are a Korean investor, so your local currency is Korean. However, they tell you in the question that the only sensitivity that applies is that of the USD, so they are already telling you that it is the domestic one. If they said that the sensitivity was to the Korean Won, then that is your local currency exposure, so you would need to add 1 to it to get domestic sensitivity.
Thank you. I was realy bogged down with LC DC confusion.
bluebird Wrote: ------------------------------------------------------- > Song Lee, CFA, is a money manager for a small firm > in Seoul. All of Lee’s clients are local. He is > considering adding the stock of a U.S. firm, > Stockco, to some of his client’s portfolios. > Stockco sensitivity to the world index is 0.8 and > the risk premium on the index is 6%. The risk-free > rate is 3% in the U.S. and 5% 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%. Assuming that Lee uses the > international capital asset pricing model (ICAPM), > what is the required return on Stockco? > > A) 12.2%. > > B) 14.2%. > > C) 10.2%. > > Is it local exposure or domestic exposure? US is > local (FC) currency, my guese, so domestic > exposure should be 1.2+1. May be I am making a big > fat mistake! I think you need to add 1. She is caluclating return in Korean currency and sensitivity is for US. Can somebody correct my fragile concept?
you are a korean investor. So DC=WON and LC=USD. They are directly giving you gamma(LC) = 1.2. So you need to do nothing.
‘Stockco is *ONLY* sensitive to changes in the value of the U.S. dollar’ So no +1
well, look at the explaination given by “mp2438” above. He is correct. “In the first example, you are a Korean investor, so your local currency is Korean. However, they tell you in the question that the only sensitivity that applies is that of the USD, so they are already telling you that it is the domestic one”. Good luck.
bluebird Wrote: ------------------------------------------------------- > well, look at the explaination given by “mp2438” > above. He is correct. > > “In the first example, you are a Korean investor, > so your local currency is Korean. However, they > tell you in the question that the only sensitivity > that applies is that of the USD, so they are > already telling you that it is the domestic one”. > > Good luck. I thought by saying stocko is only sensitive to USD, we are eliminating the possibility of gamm2*FCRp2 etc in ICAPM. I checked secret sauce and this is what appears to me. Can you explain ICAP in plain english then. Seems I am utterly confused between DC and LC. Can somenody help me out with this please? Thanks
Are there two DC we are talking- one for investor (korean here) and one DC for assets (stockco)? Thanks
no LC is the where you assets are localized Domestic is where YOU ARE LOCALIZED! +1 becuase you need to take into efffect you own currency movement
cpk123 Wrote: ------------------------------------------------------- > you are a korean investor. So DC=WON and LC=USD. > They are directly giving you gamma(LC) = 1.2. So > you need to do nothing. Isn;t the DC = USD and LC = WON Hence, Y(DC) = Y(LC) + 1 and since they give you Y(DC), you do not add one. CP could you please clarify?
LC = FC DC = home/domestic country
domestic or foreign in term of whom? e.g. a US investor in France. domestic is USD, local is EUR or the other way around?
It depends where you are physically sitting. If you are in France, then Euro is your local currency. Since you are a US investor (domestic), you want to know the sensitivity of the Euro to the dollar. Therefore, if you’re told that the sensitivity the investor has is to the Euro, you need to use Y(DC) = Y(LC) + 1 to get your domestic currency. If you are told that the investor is only sensitive to the USD, then you do not need to add anything since they have given you Y(DC). In summary: LC - this is the currency of where you are physically located. (Euro, in your example) DC - this is the currency of how the investor thinks, for lack of better terminology. (He is a US investor, so he thinks in US Dollars).
thanks mp…that’s a very good explanation!
solarpower03 Wrote: ------------------------------------------------------- > bluebird Wrote: > -------------------------------------------------- > ----- > > well, look at the explaination given by > “mp2438” > > above. He is correct. > > > > “In the first example, you are a Korean > investor, > > so your local currency is Korean. However, they > > tell you in the question that the only > sensitivity > > that applies is that of the USD, so they are > > already telling you that it is the domestic > one”. > > > > Good luck. > > I thought by saying stocko is only sensitive to > USD, we are eliminating the possibility of > gamm2*FCRp2 etc in ICAPM. I checked secret sauce > and this is what appears to me. Can you explain > ICAP in plain english then. > Seems I am utterly confused between DC and LC. Can > somenody help me out with this please? > Thanks With the G(DC)=G(LC)+1, the +1 has nothing to do with “only” currency you, as an investor, are exposed to. As an investor you are concerned with your domestic currency return. Therefore, sensivity of FC return (basicaly correlation between FC return and FC movement) + change of FC currency to the change of FC currency which is +1 are relevant. You may recall that R(dc)=R(fc)+Change in FC. Devide both side with “change in FC” you will get G(dc)=G(fc)+1. I think it sounds intuitive.