Let say, /CAD , if appreciate by 3% then CAD will depreciates exactly 3%? Please comment
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%.
Your answer: A was incorrect. The correct answer was B) −4%.
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%.