 # ICAPM - FCRP

Hi, What is the FCRP? I’m not looking for equations but a conceptual answer, what is it actually telling you? Thanks

Couple of Questions, I coudn’t edit my original post. What does FCRP = 0 tell you? What does FCRP<0 tell you? What does FCRP>0 tell you? thanks

Someone needs to double check this but I think it revolves around 1, not 0. If FCRP = 1 and a foreign currency appreciates by lets say 10%, it will have no affect on the stock’s return. The increase in earnings due to the 10% appreciation in the foreign currency will be offset by a decrease in earnings due to the 10% depreciation in the domestic currency. If FCRP > 1, let’s say 1.4, a 10% appreciation in a foreign currency will cause the return to increase by 4.0%. If FCRP < 1, a return will increase when the foreign currency depreciates and the domestic currency appreciates.

I’m pretty sure it’s arround 0 as I’ve seen some questions but am not 100% sure. Also how does hedged and unhedged exposure fit into all this?

I was wrong with some things above, but it does revolve around 1. Check page 501 in Book 6. “The currency exposure of a currency itself is equal to one. So the currency exposure of a foreign asset is equal to its local-currency exposure + 1 Y = Y(FC) + 1 Zero correlation means no systematic reaction to exchange rate adjustments. Y(FC) =0 so Y = 0 + 1 = 1. If a foreign currency depreciates by 1.25%, the rate will decrease by 1.25% Negative correlation would mean the local stock price benefits from a depreciation of the local currency. A perfect currency hedge would be attained if Y(FC) = -1 so Y = -1 + 1 = 0. A 1.25% foreign currency depreciation causes no affect on return. Positive correlation would mean local stock price drops in reaction to depreciation of local currency. With a perfect positive correlation, Y(FC) = 1 so Y = 1 + 1 = 2. A 1.25% depreciation of local currency causes a 2.5% return to the US investor.”

The foreign currency risk premium is the difference between the expected future spot rate and the forward spot rate (from interest rate parity) as a percentage of the current spot rate. basically it is the the premium the market will pay for accepting exposure to a currency risk. If the spot is 100JPN/USD and the expected spot in a year is 105JPN/USD and interest rates are 5% in Japan and 1% in US then the forward price will be about 104JPN/USD therefore the FCRP will be about (105-104)/100 = 1% meaning that the market will pay a 1% premium to a Japanese investor for buying the USD and risking the currency exposure. If the Japanese investor buys the USD and hedges the risk with a forward contract then he will ensure himself a return of 4%, however if he does not use a forward contract and bares the currency risk then he can expect to earn a return of 5%

marty3 Wrote: ------------------------------------------------------- > The foreign currency risk premium is the > difference between the expected future spot rate > and the forward spot rate (from interest rate > parity) as a percentage of the current spot rate. > > basically it is the the premium the market will > pay for accepting exposure to a currency risk. > > If the spot is 100JPN/USD and the expected spot in > a year is 105JPN/USD and interest rates are 5% in > Japan and 1% in US then the forward price will be > about 104JPN/USD therefore the FCRP will be about > (105-104)/100 = 1% meaning that the market will > pay a 1% premium to a Japanese investor for buying > the USD and risking the currency exposure. > > If the Japanese investor buys the USD and hedges > the risk with a forward contract then he will > ensure himself a return of 4%, however if he does > not use a forward contract and bares the currency > risk then he can expect to earn a return of 5% Nice explanation. Thanks.

marty3 Wrote: ------------------------------------------------------- > The foreign currency risk premium is the > difference between the expected future spot rate > and the forward spot rate (from interest rate > parity) as a percentage of the current spot rate. > > basically it is the the premium the market will > pay for accepting exposure to a currency risk. > > If the spot is 100JPN/USD and the expected spot in > a year is 105JPN/USD and interest rates are 5% in > Japan and 1% in US then the forward price will be > about 104JPN/USD therefore the FCRP will be about > (105-104)/100 = 1% meaning that the market will > pay a 1% premium to a Japanese investor for buying > the USD and risking the currency exposure. > > If the Japanese investor buys the USD and hedges > the risk with a forward contract then he will > ensure himself a return of 4%, however if he does > not use a forward contract and bares the currency > risk then he can expect to earn a return of 5% Shouldn’t it be a total return of 2% instead of 4%? I.e. 1% on US fixed income holdings and another 1% arbitrage profit as the forward JPN/USD rate is too high (should be 104JPN/USD)? Any thoughts?

marty3 Wrote: ------------------------------------------------------- > The foreign currency risk premium is the > difference between the expected future spot rate > and the forward spot rate (from interest rate > parity) as a percentage of the current spot rate. > > basically it is the the premium the market will > pay for accepting exposure to a currency risk. > > If the spot is 100JPN/USD and the expected spot in > a year is 105JPN/USD and interest rates are 5% in > Japan and 1% in US then the forward price will be > about 104JPN/USD therefore the FCRP will be about > (105-104)/100 = 1% meaning that the market will > pay a 1% premium to a Japanese investor for buying > the USD and risking the currency exposure. > > If the Japanese investor buys the USD and hedges > the risk with a forward contract then he will > ensure himself a return of 4%, however if he does > not use a forward contract and bares the currency > risk then he can expect to earn a return of 5% Can I also say: Currency % change - (domestic i rate-foreign i rate) ((105-100)/100) = 5% expected currency change 5%-(5% in japan -1% in US)=1% FCRP