Can someone explain why we calc the Foreign currency risk premium? I understand how to, but why are we and what is the idea behind it? I dont get it.
My understanding is the foreign currency risk premium is to account for the differences in risks associated with investing in foreign currency. That is, there will be different default rates (higher default rates) relative to investing in the “risk-free rate” in your domestic (US) currency. I think, among others, we assume the US Treasury to be free of default, and every other country in the world to have varying degrees of default, all of which are higher. That plays a factor in the FCRP. I recall other factors like political risk and economic instability playing a role in the FCRP.
good call lin! go over the factors that make the world market segmented i.e. not free flow of capital, bc of this investors demand a premium that is correlated to the currency of the investment
FCRP is used in the ICAPM, which is the international version of the CAPM. In the ICAPM, the particular asset has a certain exposure to each local currency in the ‘universe’. Typically, the question assumes only two or three currencies exist in the ‘universe’, say Domestic currency, local currency a, and local currency b. Remember that the asset’s sensitivity to each local currency is its own sensitivity to its domestic currency plus 1. This is basically the asset’s “beta”, although it’s actually denoted as a gamma.