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%.
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%).
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%).
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:
CAD rate = 6%
US rate = 5%
interest parity states that since CAD is higher rate, it should depreciate
from derivatives, hypothetically, if exchange rate was par, I could lock in a forward rate of
1.00*(1.05/1.06) = .9905, hence I “expect” cad to depreciate by ~ 1%, and inversely, US to appreciate by 1%
the FCRP is the difference between the forward rate appreciation implied by the 1 year forward rate I could lock in and expected spot rate, in this case 1% and 3% respectively
Therefore from a US dollar perspective, interest rate parity states the US will appreicate by 1%, but I expect the cad dollar to appreciate by 3%. this is obviously a double negative from a US dollar perspective, so the FCRP is - 4%