Jaro Sumzinski, who lives in Poland, is applying the international capital asset pricing model (ICAPM) to determine the value of a German security. The German currency (Euro) has a risk premium of 1% and the security has a local currency sensitivity of 0.5. The risk-free rate in Poland is 8% and the risk-free rate in Germany is 4%. The world market risk premium is 7% and the securities sensitivity to the world market is 2. What is the required return of the security? A) 18.5%. B) 23.5%. C) 12.5%. Your answer: B was correct! In a single foreign currency world, the ICAPM simplifies to: E(Ri) = R0 + Biw ~ RPw + ƒÁi1 ~ SRP1. Substituting in the numbers from the problem, we get: E(Ri) = 8% + 2(7%) + (1 + 0.5)(1%) = 23.5%. Remember to use the domestic risk-free rate Question: Why is the sensitivity (1 + 0.5)(1%) and not (.5)(1%)? Where does the 1 + come from? Thanks-
has a local currency sensitivity of 0.5 sensitivity = LC sensitivity + 1 if they give you local, add 1. if they give you the home guy’s, leave it as is.
because gamma(DC) = gamma(LC) + 1 gamma(LC) was given to be 0.5 we need gamma(DC) in the equation. So B is right ans.
Since you are a polish investor, your investment in germany will have .5 + 1 exposure to garman currency, since you must conver it back to your own.
Ah, thanks a lot guys. That clears it up. Best of luck to all-