Question

You are a US investor considering investing in Swizerland. The world market risk premium is estimated at 5%, the Swiss franc
offers a 1% risk premium, and the current risk-free rates are equal to 4% in dollars and 3% in francs. In other words, you expect
the Swiss franc to appreciate against the dollar by an amount equal to the interest rate differential plus the currency risk
premium, or a total of 2%. You believe that the following equilibrium model (ICAPM) is appropriate for your investment analysis
	E(Ri)=Rf +b1 *RPw +b2 *RPSFr
where all returns are measured in dollars, RPw is the risk premium on the world index, and the RPSFr is the risk premium on the
Swiss france. Your broker provides you with the following estimates and forecasted returns.
	Stock A	Stock B	Stock C	Stock D
Forecased returns (in francs)	0.08	0.09	0.11	0.07
World beta (b1)	1	1	1.2	1.4
Dollar currency exposure (b2)	1	0	0.5	-0.5
A. What should be the expected dollar returns on the four stocks, according to the ICAPM?

Answer 1

ANSWER

ICAPM =Rf + b1*RPw + b2*RPSFr

Rf (domestic risk free rate- dollar) = 4% (given)

• Stock A

b1 = 1

b2 = 1

RPw = 5%

RPSFr = 1%

Now, putting these values in formula, we will arrive at return for Stock A

ICAPM = 4 + 1*5 + 1*1  

= 10%(Expected dollar returns)

• Stock B

b1 = 1

b2 = 0

RPw = 5%

RPSFr = 1%

Now, putting these values in formula, we will arrive at return for Stock A

ICAPM = 4 + 1*5 + 0*1  

= 9%(Expected dollar returns)

• Stock C

b1 = 1.2

b2 = 0.5

RPw = 5%

RPSFr = 1%

Now, putting these values in formula, we will arrive at return for Stock A

ICAPM = 4 + 1.2*5 + 0.5*1  

= 10.5%(Expected dollar returns)

• Stock D

b1 = 1.4

b2 = -0.5

RPw = 5%

RPSFr = 1%

Now, putting these values in formula, we will arrive at return for Stock A

ICAPM = 4 + 1.4*5 + (-0.5)*1  

= 10.5% (Expected dollar returns)