# ICAPM Question

1. 2 currency world (USD and SF) 2. Investor is US Citizen 3. US RF IR = 3% 4. SF RF IR = 2% 5. Expected Appreciation of SF = 2% 6. World Portfolio Risk Premium = 7% 7. World Beta = 1.0 8. Currency Gamma = 2.0 Find E® for US using ICAPM? A. 12.0% B. 16.0% C. 10.0% D. 3.0%

I get A.

you are correct (as always) slouiscar!! I just made this question up to understand a concept here and I delibrately added 12% and 16% as the answer choices. So to clarify, when we calculate Foreign Currency Risk Premium (FCRP) as the expected foreign currency appreciation minus the Interest differentials (ID) The ID = Rdc - Rfc (ALWAYS???) Because I did the other way round, FCRP = 2% - [2% - 3%] = 2% - [-1%] = 3% E® = 3% + (1)*(7%) + (2)*(3) = 16%

3 + (1 x 7) + (2 x 1) = 12%… get A also.

This was one of the formula’s on “the list”. I’m not sure on this but you would raise your required return if the foreign rfr is higher. So if you - (Rd - Rf) then you increase the premium if foreign is higher and decrease if foreign is lower. thanks for the kind words. I would be very happy to be always correct 70% of the time.

I’m only posting this one because I just studied this a few days ago and want to publicly humiliate myself if I can’t recall the formula correctly, so here goes: the basic formula for the ICAPM will be E®= Domestic RF rate + Global Beta x (Global Mkt Risk Prem) + FCRP X ( Expected Currency Move) for each foreign currency, is that right? And the FCRP = the Expected currency appreciation - Dom I rate - Foreign I-rate?

I hate to ask, but what section was this covered in? I’m going to have to review unless its in port mgt.

it’s in port mgmt

ilvino Wrote: ------------------------------------------------------- > I’m only posting this one because I just studied > this a few days ago and want to publicly humiliate > myself if I can’t recall the formula correctly, so > here goes: > > the basic formula for the ICAPM will be E®= > Domestic RF rate + Global Beta x (Global Mkt Risk > Prem) + FCRP X ( Expected Currency Move) for each > foreign currency, is that right? > > And the FCRP = the Expected currency appreciation > - Dom I rate - Foreign I-rate? Only this forluma looks a little dicey… FCRP = the Expected currency appreciation - Dom I rate - Foreign I-rate

i haven’t seen schweser use the term “currency gamma”. do they use it in the cfa text?

no, I used it as a shortcut to get the point across let’s keep the greek in the derivatives section, man. : ) i thought i needed to reread port. mgmt in the text! but i suppose the institute could do that if they wanted…

I am not sure whether I am correct but this is how I tried to understand currency risk premium. If a investor, goes ahead and invests in a foreign counrty and also buys a forward then the return due to currency movement for the investor is fixed as the forward is already known. But if the investor doesn’t hedge the transaction by going into a forward then he will be getting some premium for remaining unhedged in the market, that is the expected change in spot might be different from the forward. This difference is defined as the currency risk premium. Currency risk premium = (E(S0) - F)/S0. Another formula for the same currency risk premium: Expected change in currency - (Rdc - Rfc). Now the formula is always rdc - rfc because the return has to be calculated in domestic currency. Similarly for forward hedged transaction it will be specified in DC/FC and this would lead to Rdc - Rfc.

Good, good, haven’t covered that yet, had me worried.