Chapter 4

International Asset Pricing

1. According to the CAPM, expected return = 3.25 + 1.25(5.5) = 10.125%.
2. The total risk of the asset is 120%. The systematic risk = 0.9 (90) = 72.9. Thus, the portion of total
risk that can be attributed to market risk is 72.9/120 = 60.75%. The balance, 39.25%, can be
attributed to asset-specific risk.
2

3. The portfolio beta, p = 0.5(0.85) + 0.25(1.3) + 0.25(0.90) = 0.975.

2
Total portfolio risk, 2p = 0.975 (120) = 114.1. So, p = 10.7%.
4. a. Current real exchange rate = Can$1.46(1/1.46) = Can$1 per pound.
b. Real exchange rate one year later = Can$1.4308(1.04/1.4892) = Can$1 per pound.
c. The Canadian investor did not experience a change in the real exchange rate. While inflation in
the United Kingdom is greater than inflation in Canada by two percentage points, the pound has
depreciated relative to the Canadian dollar by 2 percent. Thus, the real exchange rate is
unchanged.
5. a. Current real exchange rate = $1.80(1/3) = $0.60 per pound.
b. Real exchange rate one year later = $1.854(1.02/3.15) = $0.60 per pound.
c. The U.S. investor did not experience a change in the real exchange rate. This is because while
inflation in the United Kingdom is less than inflation in the United States by 3 percentage points,
the pound has appreciated relative to the dollar by 3 percent. Thus, the real exchange rate is
unchanged.
6. a.

The current real exchange rate = $0.62(1.5/1) = $0.93 per Swiss franc. The inflation differential
between the United States and Switzerland is 2.5 percent. That is, U.S. inflation minus Swiss
inflation is 2.5 percent. Thus, for real exchange rates to remain the same, the Swiss franc would
have to depreciate by 2.5 percent.
The expected exchange rate = 0.62(1 0.025) = $0.6045 per Swiss franc.
The real exchange rate would then be = $0.6045(1.56/1.015) = $0.93 per Swiss franc.
The expected return on the Swiss bond = (1 + 0.045) (1 0.025) 1 = 0.0189, or 1.9%.

b. If the exchange rate at the end of one year is $0.63 per Swiss franc, the Swiss franc has
appreciated by 1.61 percent.
The real exchange rate is = $0.63(1.56/1.015) = $0.9683 per Swiss franc.
The return on the Swiss bond = (1 + 0.045) (1 + 0.0161) 1 = 0.0618, or 6.18%.
The return on the Swiss bond is higher than in Question 6a because the Swiss franc has
appreciated by 1.61 percent in Question 6b, whereas the Swiss franc depreciated by
2.5 percent in Question 6a.

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7. a. The current real exchange rate = 0.69(1/1.2) = 0.575 per U.S. dollar.
The inflation differential between the United Kingdom and the United States is 2.25 percent.
That is, U.K. inflation minus U.S. inflation is 2.25 percent. Thus, for real exchange rates to
remain the same, the U.S. dollar would have to appreciate by 2.25 percent.
The expected exchange rate = 0.69(1 + 0.0225) = 0.7055 per U.S. dollar.
The real exchange rate would then be = 0.7055(1.015/1.245) = 0.575 per U.S. dollar.
The expected return on the U.S. bond = (1 + 0.0176) (1 + 0.0225) 1 = 0.0405, or 4.05%. This is
close to the U.K. one-year interest rate of 4.13 percent.
b. If the exchange rate at the end of one year is 0.67 per U.S. dollar, the U.S. dollar has depreciated
by approximately 2.9 percent.
The real exchange rate is = 0.67(1.015/1.245) = 0.5462 per dollar.
The return on the U.S. bond is = (1 + 0.0176) (1 0.029) 1 = 0.0119, or 1.19%.
The return on the U.S. bond is lower than in Question 7a because the U.S. dollar has depreciated
by 2.9 percent in Question 7b, whereas the U.S. dollar appreciated by 2.25 percent in Question 7a.
8. a. The forward rate = 0.90(1.0315/1.0478) = $0.886 per euro.
b. The euro is trading at a forward discount = (0.886 0.90)/0.90 = 0.0156, or 1.56%.
c. The interest rate differential between the domestic interest rate and the foreign interest rate
(U.S. minus Eurozone) is 3.15 4.78 = 1.63%. This is in line with the forward discount on
the foreign currency (euro) of 1.56 percent. This result is consistent with interest rate parity.
9. If the U.S. firm invests funds (say, $1) in one-year U.S. bonds, at the end of one year it will have
1(1 + 0.0275) = $1.0275.
Alternatively the U.S. firm could convert $1 into (1/1.46) = 0.6849. This amount would be invested
in one-year U.K. bonds, and at the end of one year it will have 0.6849(1 + 0.0425) = 0.714. This can
be converted back to U.S. dollars at the forward exchange rate = 0.714(1.25) = $0.8925.
The firm is better off investing domestically in U.S. bonds.
10. If the German firm invests funds (say, 1) in one-year euro bonds, at the end of one year it will have
1(1 + 0.0335) = 1.0335.
Alternatively the German firm could convert 1 into $(1/1.12) = $0.8929. This amount would be
invested in one-year U.S. bonds, and at the end of one year it will have 0.8929(1 + 0.0225) = $0.913.
This can be converted back to euros = 0.913(1.25) = 1.1412.
The firm is better off investing in U.S. bonds.
11. a.

The interest rate differential (U.S. minus Swiss) = 0.0425 0.0375 = 0.005, or 0.50%. This
implies that the Swiss franc trades at a forward premium of 0.50 percent. That is, the forward
exchange rate is quoted at a premium of 0.50 percent over the spot exchange rate of $0.65 per
Swiss franc.
The foreign currency risk premium = 0.0275 0.005 = 0.0225, or 2.25%.

b. The domestic currency (U.S.$) return on the foreign bond is 6.5 percent. This can be calculated
in one of two ways:
Domestic risk-free rate + Foreign currency risk premium = 4.25% + 2.25% = 6.5%.
Foreign risk-free rate + Expected exchange rate movement = 3.75% + 2.75% = 6.5%.

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12. a. The interest rate differential (Swiss minus U.S.) = 0.0275 0.0525 = 0.025, or 2.50%. This
implies that the U.S. dollar trades at a forward discount of 2.50 percent. That is, the forward
exchange rate is quoted at a discount of 2.50 percent over the spot exchange rate, SFr 1.62 per dollar.
The foreign currency risk premium = 0.0275 (0.025) = 0.0025 = 0.25%.
b. The domestic currency (Swiss franc) return on the foreign (U.S.) bond is 2.5 percent. This can be
calculated in one of two ways:
Domestic risk-free rate + Foreign currency risk premium = 2.75% + (0.25%) = 2.5%.
Foreign risk-free rate + Expected exchange rate movement = 5.25% + (2.75%) = 2.5%.
13. a.

The expected return for each of the stocks is calculated using the following version of the
ICAPM:
E ( Ri ) = R0 + biw ( RPw ) + i (SRP ) + iSFr (SRPSFr ).

Thus, the expected returns for Stocks A, B, C, and D are

E(RA) = 0.0375 + 1(0.06) + 1(0.02) 0.25(0.0125) = 0.1144, or 11.44%
E(RB) = 0.0375 + 0.90(0.06) + 0.80(0.02) + 0.75(0.0125) = 0.1169, or 11.69%
E(RC) = 0.0375 + 1(0.06) 0.25(0.02) + 1(0.0125) = 0.1050, or 10.50%
E(RD) = 0.0375 + 1.5(0.06) 1(0.02) 0.50(0.0125) = 0.1013, or 10.13%
b. Stock B has the lowest world beta but the highest expected return, whereas Stock D has the
highest world beta and the lowest expected return. The reason lies with differences in currency
exposures of the stocks. The negative currency exposures of Stock D result in a lower expected
return. Stock B, on the other hand, has positive currency exposures, which increase expected
returns in this example.
14. a.

The derivation of the traditional CAPM relies on assumptions about investors expectations and
market perfection.
In the international context, tax differentials, high transaction costs, regulations, capital, and
exchange controls are obvious market imperfections. Their magnitude is greater than in a
domestic context and is more likely to create problems in the model.
Because of deviations from purchasing power parity (real exchange rate movements), investors
from different countries have a different measure of the real return of a given asset. For example,
if the euro depreciates by 20 percent, a U.S. investor may obtain a negative (real dollar) return on
his Club Med investment, while a French investor could obtain a positive (real euro) return on
Club Med.

b. Even if markets were fully efficient and integrated, deviations from purchasing power parity
alone could explain why, in theory, optimal portfolios differ from the world market portfolio.
15. a. From a U.S. dollar viewpoint, the currency exposure of a diversified Australian portfolio (similar
to the index) is equal to +0.5. The regression coefficient A$ measures the sensitivity of the
Australian dollar value of the portfolio to changes in the value of the Australian dollarthis
coefficient is 0.50. Thus, the currency exposure of the Australian portfolio is = = 1 + A$ =
1 0.5 = 0.5.
b. Because the currency exposure is 0.5, if the Australian dollar declined by 10 percent against the
U.S. dollar, you can expect to lose approximately 5 percent of U.S. $10 million, i.e.; $500,000.

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16. a. For Mega: Assume a sudden and unanticipated depreciation of the euro. Production costs are
unaffected in the short run; they stay constant in euros. Product prices stay constant in dollars and
therefore increase by 20 percent in euros. The earnings are vastly increased in the short run.
For Club: The short-run effect is opposite to that of Mega. The import costs rise while the
product prices must stay constant to match French competition.
b. For Mega: In the longer run, this unanticipated depreciation of the euro could have several
effects. Mega could use it to lower the dollar price of its products and increase its sales (and
earnings) as it becomes more competitive. On the other hand, this euro depreciation could
import inflation into Europe. The price of imported goods and inflation rise. Wages
consequently adjust. In the long run, Megas production costs in euros will rise.
For Club: In the long run, the importer will still be in a difficult position. However, French and
European competitors may seize this opportunity to raise the price of their products.
c.

For Mega: Assume now that the euro depreciation is simply an adjustment to the existing
inflation differential (high inflation rate in Europe). This purchasing power parity movement has
no real effect on Mega. It will simply make the euro price of its products rise at the same rate as
the inflated production costs.
For Club: Again, the effect should be neutral as on Mega.

17. Because you want an asset whose price will go up if the Australian dollar depreciates, you would
choose Company I. However, this is only one factor of the investment choice. For example, it may be
more interesting to buy the most attractive assets (even if they exhibit a positive correlation with the
euro per A$ exchange rate) and hedge the currency risk using currency futures.
18. a.

In general, the short-term appreciation of the won versus the euro would make South Korean
goods more expensive to European buyers and would make European goods cheaper for South
Korean citizens.
The likely effect of a short-term appreciation of the won versus the euro on KoreaCos unit sales
in Europe would be a decline in KoreaCos sales resulting from the increased cost of the
imported KoreaCo widgets relative to domestic alternatives (or other imports). European widgets
or other imports would become more attractive, and purchases would shift to them.
A decline in unit sales as a result of the appreciation, and an assumption that variable costs are
not subjected to change, implies a higher cost per unit because of the lower number of units over
which the fixed costs can be spread. Profit margins would contract.
In the short run, KoreaCo could absorb the currency impact by lowering the won price in an
effort to maintain the euro price of widgets and unit sales/market share in Europe. The lower
price would cause a decline in profit margins on European sales unless KoreaCo could stabilize
margins through manipulation of such variable costs as labor and materials.

b. The traditional trade approach suggests that real exchange rate appreciation tends to reduce the
competitiveness of a domestic economy and, therefore, reduce domestic activity over time.
Worsening economic conditions resulting from reduced competitiveness would be expected to
lead to a depreciation of the currency at some point, restoring competitiveness and foreign sales.
In the long run, industries from countries with overvalued currencies will make direct
investments in countries with undervalued currencies. In time, such activity will contribute to
restoration of purchasing power parity.

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If KoreaCo elects to maintain all production facilities in South Korea based on its expectation of
a long-term currency appreciation, such a strategy would be expected to have a negative effect on
its competitive position in the European market, and thus on the long-run profitability of its
European sales. Such a decision would result in downward pressure on unit European sales.
Because all costs are variable in the long run, KoreaCo may be able to adjust capacity utilization
and other factors of production to maintain margins in the face of declining sales.
KoreaCos shift of production facilities to Europe would be expected to have a beneficial or
positive effect on its long-run competitive position in Europe. The proposed strategy would lower
average total costs on KoreaCos European sales as it establishes production facilities in the
cheaper currency. KoreaCos lower cost structure and improved competitiveness would be
expected to have a positive effect on the profitability of KoreaCos European sales.
19. The dollar value of the foreign bonds would rise because the foreign currency appreciates relative to
the dollar. Furthermore, many countries practice a leaning against the wind exchange rate policy.
Foreign bond yields are likely to drop to stabilize the exchange rate against the dollar. The local
currency price of foreign bonds tends to go up when the dollar depreciates relative to the local
currency. Hence, the dollar value of the foreign bonds would rise both because the foreign currency
appreciates relative to the dollar and because the foreign bond prices rise.
20. The following are some arguments in favor of international bond diversification:
A rise in European inflationary anticipations is bad for European bond prices (increasing nominal
yields), but should not affect foreign bond prices. Because foreign economies are lagging the
European economy, inflationary pressures are not yet felt abroad.
Increased European inflation would lead to a depreciation of the euro, which would be good for the
euro return of assets denominated in foreign currencies.
An inflation-induced depreciation of the euro (appreciation of the foreign currency) is good for
investing in foreign bond markets, if foreign governments lower their interest rates to avoid too
strong an appreciation of their domestic currency (leaning against the wind).