The following question and answer… 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 percent and the security has a local currency sensitivity of 0.5. The risk-free rate in Poland is 8 percent and the risk-free rate in Germany is 4 percent. The world market risk premium is 7 percent and the securities sensitivity to the world market is 2. What is the required return of the security? A) 18.5%. B) 12.5%. C) 26.0%. D) 23.5%. Your answer: A was incorrect. The correct answer was D) 23.5%. In a single foreign currency world, the ICAPM simplifies to: E(Ri) = R0 + Biw × RPw + γi1 × 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. Where the hell do they get that 1 they add to the .5???
wow nvm someone just asked the same question underneath me my bad
See post ICAPM about 3 down
p. 273 of book 3 (PM). domestic security sensitivity to itself…benefit from the stock return correlation as well as the changes in the currency value. I think its easier to think about a negative correlation scenario first…say -.5…if the local currency goes up 1%, the stock price will go down -.5%, BUT you don’t forget the 1% up in the currency, so it nets to +.5 (-.5 + 1) Same deal for positive correlation…you get the underlying move in the currency (the +1) and whatever stock movement as a result of the Fx move (the +.5.), for a grand total of +1.5 (1 + .5)…it’s amplified when the local sensitivity is on itself. That make sense?
**** security has a local currency sensitivity of 0.5 *** Read this carefully… S we need 1 right? Hence we use 0.5 + 1 = 1.5 Ans gotta be 23.5%
Exactly right squirrel. Just like all diversification effects, the negative correlation is a natural hedge.