International Asset Pricing

interest rate. Domestic bond price declines would accompany domestic

currency appreciation.
■ The two models of how real exchange rate changes affect domestic economic
activity give opposite conclusions. The traditional approach can be sketched as
follows: A decline in a currency’s real exchange rate tends to improve competi-
tiveness, whereas the concomitant deterioration in terms of trade increases the
cost of imports, which creates additional domestic inflation and reduces real
income and, hence, domestic demand and production. The initial reduction
in real GNP caused by a deterioration in the terms of trade should eventually
be offset by improved international competitiveness and export demand until
purchasing power parity is restored. In the money-demand model, on the
other hand, real growth in the domestic economy leads to increased demand
for the domestic currency through a traditional money-demand equation. This
increase in currency demand induces a rise in the relative value of the domes-
tic currency. Because domestic stock prices are strongly influenced by real
growth, this model justifies a positive association between real stock returns
and domestic currency appreciation.

Problems
1. Consider an asset that has a beta of 1.25. If the risk-free rate is 3.25 percent and the
market risk premium is 5.5 percent, calculate the expected return on the asset.

2. An asset has a beta of 0.9. The variance of returns on a market index, s2m , is 90. If the
variance of returns for the asset is 120, what proportion of the asset’s total risk is system-
atic, and what proportion is residual risk?

3. A portfolio consists of three assets. Asset 1 has a beta of 0.85, Asset 2 has a beta of 1.3,
and Asset 3 has a beta of 0.9. Asset 1 has an allocation of 50 percent, while Assets 2 and
3 each have an allocation of 25 percent. The variance of returns on a market index, s2m,
is 120. Calculate the variance of portfolio returns, assuming that the specific risk of the
portfolio is negligible.
4. A Canadian investor is considering the purchase of U.K. securities. The current
exchange rate is Can$1.46 per pound. Assume that the price level of a typical consump-
tion basket in Canada is 1.46 times the price level of a typical consumption basket in the
United Kingdom.
a. Calculate the real exchange rate.
b. One year later, price levels in Canada have risen 2 percent, while price levels in the
United Kingdom have risen 4 percent. The new exchange rate is Can$1.4308 per
pound. What is the new real exchange rate?
c. Did the Canadian investor experience a change in the real exchange rate?

5. Consider a U.S. investor who wishes to purchase U.K. securities. The current exchange
rate is $1.80 per pound. Assume that the price level of a typical consumption basket in
the United States is three times the price level of a typical consumption basket in the
United Kingdom.

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a. Calculate the real exchange rate.

b. One year later, price levels in the United States have risen 5 percent, while price
levels in the United Kingdom have risen 2 percent. The new exchange rate is $1.854
per pound. What is the new real exchange rate?
c. Did the U.S. investor experience a change in the real exchange rate?

6. An investor based in the United States wishes to invest in Swiss bonds with a maturity of
one year. Suppose that the ratio of the price levels of a typical consumption basket in the
United States versus Switzerland is 1 to 1.5 and the current exchange rate is $0.62 per
Swiss franc. The one-year interest rate is 2 percent in the United States and 4.5 percent in
Switzerland. Assume that inflation rates are fully predictable, and expected inflation over
the next year is 1.5 percent in the United States and 4 percent in Switzerland.
a. Assuming that real exchange rates remain constant, calculate the real exchange rate,
the expected exchange rate in one year, and the expected return over one year on
the Swiss bond in U.S. dollar terms.
b. Now assume that the inflation rate over the one-year period has been 1.5 percent in
the United States and 4 percent in Switzerland. Further, assume that the exchange
rate at the end of one year is $0.63 per Swiss franc. Calculate the real exchange rate
at the end of one year. What is the return on the Swiss bond investment now? Is the
return on the Swiss bond the same as in part (a)? Explain.

7. A portfolio manager based in the United Kingdom is planning to invest in U.S. bonds
with a maturity of one year. Assume that the ratio of the price levels of a typical con-
sumption basket in the United Kingdom versus the United States is 1.2 to 1. The cur-
rent exchange rate is £0.69 per dollar. The one-year interest rate is 1.76 percent in the
United States and 4.13 percent in the United Kingdom. Assume that inflation rates are
fully predictable, and expected inflation over the next year is 1.5 percent in the United
States and 3.75 percent in the United Kingdom.
a. Assuming that real exchange rates remain constant, calculate the real exchange rate,
the expected exchange rate in one year, and the expected return over one year on
the U.S. bonds in pounds.
b. Now assume that the inflation rate over the one-year period has been 1.5 percent in
the United States and 3.75 percent in the United Kingdom. Further, assume that the
exchange rate at the end of one year is £0.67 per dollar. Calculate the real exchange
rate at the end of one year. What is the return on the U.S. bond investment now? Is
the return on the U.S. bond the same as in part (a)? Explain.

8. Assume that the Eurozone risk-free interest rate on bonds with one year to maturity is
4.78 percent and the U.S. risk-free interest rate on one-year bonds is 3.15 percent. The
current exchange rate is $0.90 per euro. Assume that the United States is the domestic
country.
a. Calculate the one-year forward exchange rate.
b. Is the euro trading at forward premium or discount?
c. Is your answer to part (b) consistent with interest rate parity? Explain.

9. Take the case of a U.S. firm that wishes to invest some funds (U.S. dollars) for a period
of one year. The choice is between investing in a U.S. bond with one year to maturity,
paying an interest rate of 2.75 percent, and a U.K. bond with one year to maturity, pay-
ing an interest rate of 4.25 percent. The current exchange rate is $1.46 per pound, and
the one-year forward exchange rate is $1.25 per pound. Should the U.S. firm invest in
U.S. bonds or in U.K. bonds?

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10. Consider a German firm that wishes to invest euro funds for a period of one year. The
firm has a choice of investing in a euro bond with one year to maturity, paying an inter-
est rate of 3.35 percent, and a U.S. dollar bond with one year to maturity, paying an
interest rate of 2.25 percent. The current exchange rate is €1.12 per U.S. dollar, and
the one-year forward exchange rate is €1.25 per U.S dollar. Should the German firm
invest in euro bonds or in U.S. dollar bonds?

11. The interest rate on one-year risk-free bonds is 4.25 percent in the United States and
3.75 percent in Switzerland. The current exchange rate is $0.65 per Swiss franc.
Suppose that you are a U.S. investor and you expect the Swiss franc to appreciate by
2.75 percent over the next year.
a. Calculate the foreign currency risk premium.
b. Calculate the domestic currency return on the foreign bond, assuming that your cur-
rency appreciation expectations are met.
12. Suppose that you are an investor based in Switzerland, and you expect the U.S. dollar to
depreciate by 2.75 percent over the next year. The interest rate on one-year risk-free
bonds is 5.25 percent in the United States and 2.75 percent in Switzerland. The current
exchange rate is SFr1.62 per U.S. dollar.
a. Calculate the foreign currency risk premium from the Swiss investor’s viewpoint.
b. Calculate the return on the U.S bond from the Swiss investor’s viewpoint, assuming
that the Swiss investor’s expectations are met.

13. Assume you are a U.S. investor who is considering investments in the French (Stocks
A and B) and Swiss (Stocks C and D) stock markets. The world market risk premium is
6 percent. The currency risk premium on the Swiss franc is 1.25 percent, and the currency
risk premium on the euro is 2 percent. The interest rate on one-year risk-free bonds
is 3.75 percent in the United States. In addition, you are provided with the following
information:
Stock A B C D
Country France France Switzerland Switzerland
bw 1 0.90 1 1.5
g€ 1 0.80 -0.25 -1.0
gSFr -0.25 0.75 1.0 -0.5

a. Calculate the expected return for each of the stocks. The U.S. dollar is the base
currency.
b. Explain the differences in the expected returns of the four stocks in terms of bw, g€,
and gSFr.

14. a. List reasons that an international extension of the CAPM is problematic.

b. In an international extension of the CAPM, why would the optimal portfolio differ
from the world market portfolio, as suggested by the traditional CAPM, even if the
markets are fully efficient?

15. You are a U.S. investor who is considering investments in the Australian stock market,
but you worry about currency risk. You run a regression of the returns on the Australian
stock index (in A$) on movements in the Australian dollar exchange rate (U.S.$ per
A$) and find a slope of -0.5.
a. What is your currency exposure if you invest in a diversified portfolio of Australian
stocks?

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