# FCRP

Steven Retting lives in Canada and is considering investing in a Canadian bond yielding 6% or a U.S. bond yielding 5%. Retting expects the Canadian dollar to appreciate by 3% over the next year.

What is the foreign currency risk premium on the U.S. dollar?

A) 2%. B) −4%. C) −1%.

The interest rate differential is 1% (Canada – U.S.). We expect the Canadian dollar to appreciate by 3% relative to the U.S. dollar therefore the U.S. dollar will depreciate by 3%. The foreign currency risk premium (FCRP) is the expected exchange rate movement minus the interest rate differential between the domestic currency and the foreign currency. FCRP = −3% − 1% = −4%.

Yes - if \$ appreciate by 3% then CAD will depreciates exactly 3%. It’s just a different way of saying the same thing - think of it like a reciprocal.

No it isn’t.

Simply:

By not investing in US and choosing to invest in Canada, the investor will get 3% appreciation of CAD plus Canadian bond yielding 6% and will mis out on the U.S. bond yielding 5% making net return of (3% + 6% - 5%).

If exchange rate now is \$2/1pound then next year \$4/1pound. Pound will increase (4-2)/2 = 100% but US dollar will decrease only (0.25-0.5)/0.5 = 50%

The quote would actually be given as USD:CAD - FC:DC - The investor has a DC of CAD. FCRP is given in terms of the FC. The CAD will appreciate by 3%, there the dollar will depreciate by 3%.

FCRP USD = Change in spot to a USD investor - (RFDC - RDFC) = (-3) - (6-5) = -4%

If they wanted it in terms of CAD, it would be the opposite.

I found to myself that doing all FX stuff with formulas only creates a lot of confusion and actually kills understanding.

Foreign currency risk premium is the premium that the investor demands for the future uncertainty. Looking into your problem, I may say that FOR SURE by investing into the foreing bond I’ll get 5%. Also, I know that FOR SURE, that my local bond would yields me 6%. Thus, by investing into the foreign bond I’ll get for SURE -1%. The foreign currency will PROBABLY appreciate by -3%. This is unsure. Foreign currency risk premium is - something UNSURE - something SURE. You get -3% - (6% - 5%).

hey all,

FCRP is a tricky subject, and schweser doesn’t really explain it well… this is how I think of it, it really relates (obviously) to the econ and derivatives stuff

from the question: