When calculating expected returns based on ICAPM model when is +1 added to the local currency exposure? CFAI example, EOC #13 from reading 68 does not add 1, but a very similar Schweser example added 1 to each company’s respective local currency exposure, #16 from 2010 notes. Did not see other indications in text of question that would have eluded to the +1 for LC exposure. Thanks, John
I dont have the books in front of me, but heres the way i understand it: Lets say we invest in Japan. If we want to see our total return in Yen, we use the local currency exposure. If we are interested in seeing what our actual dollar denominated return is, then we use the domestic exposure, which is 1+LC exposure. This concept is still a bit hazy to me and still trying to get a grasp on it.
Your Exposure (in terms of your LC) to a position in Foreign Asset = 1 + Exposure of Foreign Asset to the LC where it lives. The first term 1 implies, a x% drop in Asset LC will cause x% drop in your returns and an x% rise in Asset LC will cause x% rise in your returns independent of Asset. A one-one relation, representing a simple monetary currency exposure if you try to liquidate your Foreign Asset. The second term represent correlation of the Foreign assets value to changes in the LC where it lives. Example, value of japanese firm selling products in US will rise when yen falls because for every $ firms gets back more yen ==> -ve corellation ==> yen falls, firm value rises in yen.
Good question… My best guess is that they (CFAI #13) have already factored in the local currency exposure to itself in determining the sensitivities provided in the table. Otherwise you would have to add 1 to them to determine the US investors domestic exposure to the local currency. … The schweser dudes (#18) explicitly stated that the currency exposure was the exposure to the LC which was a hint that it was an exposure to itself hence adding the 1…hope that makes sense…gives me a bad taste just thinkin bout this crap
Yeah, i agree. Maybe assume they’ll reference ‘LC’ in the data when +1 should be added to sensitivity…Good example of straight forward question with a bulky formula where time can be wasted if the data is not clear. There must be some standard way these questions are worded to know if +1 should be added to LC. thanks.