I’m going to cover only the first part of the reading here. Btw, you might want to study from the Official Curriculum the entire Portfolio Management portion. Schweser sucks, at least for this part. I found several rounding and formula errors while studying this reading. So…just a small warning.
1. International markets are integrated and efficient if the securities with the same risk characteristics have the same expected return all over the world.
They are segmented and inefficient if the securities with similar characteristics sell at different exchange rate- adjusted prices in different countries, thus violating the law of one price. This is often the case when we deal with emerging markets.
There are six impediments to international capital mobility- Psychological barriers, legal restrictions, transaction costs, discriminatory taxation against foreign income, political risks and foreign exchange risks.
Intl. integration requires only a sufficient flow of capital to make the world market efficient and to eliminate mispricing among countries.
2. Expected return on an unhedged foreign investment:
E(R)= E(Rfc)+ s, where E(R)= expected return in DC , E(Rfc)= Expected return in FC and s= appreciate/depr, calculated as (S1-S0)/S0
OR
E(R)=R(dc) +FCRP, Rdc= risk free domestic interest rate and FCRP= Foreign currency risk premium. (Take a look at #7 regarding how to calculate FCRP)
Expected return on a hedged foreign investment:
E(R)=E(Rfc)+ (F-s)/s, where F= Locked in forward rate
Both F and S are DC/FC. (F-S)/S is the forward risk premium/discount, which can be found out from the Interest Rate Parity Equation: F=(S*(1+rDC))/(1+rFC) or approx, (F-S)/S= (Rdc-Rfc).
3. Extended CAPM is the domestic CAPM, with the domestic Rf as the Rf rate and the market portfolio is composed of all the risky assets of the world.
4. This extension of CAPM can be justified with addl. two more assumptions:
a. Investors throughout the world have identical consumption baskets
b. PPP holds (the real prices of consumptions goods are identical across countries).
5. Real exchange rate (X)= (S dc/fc)(P fc/dc), where S= nominal exchange rate and P= Price level
6. Also, x (real rate) = s- (Idc-I fc) , where s= change in nominal rate and (I dc- I fc) = inflation differential rate. If PPP holds, then, x=0% and the nominal exchange rate movement (DC/FC) = Inflation rate differential. If this doesn’t happen, then any such real exchange rate movement (means nominal rate movement that is not explained by the inflation % change) would violate the assumptions supporting the domestic CAPM extension, which is the same as real foreign exchange currency risk.
Hence, in the absence of real exchange currrency risk, CAPM extension holds, otherwise not!
Part II (01/25/08)
7. FCRP (Foreign Currency Risk Premium) is calculated as: E(s)- (Rdc-Rfc), where E(s)= (S1-So)/S0 or the currency appreciation/depreciatio; and (Rdc-Rfc) is the approx. forward premium or discount. Alternate method: [E(S1)-F]/S0
8. Since PPP does not always hold in the real world, we need to use the International CAPM Model (ICAPM), which is almost the same as domestic CAPM, except that it also factors in the FCRP and the sensitivity to each FCRP (gamma).
Limitation: Applies only to an integrated world capital market with currency hedging available.
9. Other forms of market imperfections and constraints cannot be easily integrated with the equilibrium asset pricing framework.
10. Local currency exposure measures the sensitivity of the local asset return to the local currency value and is found by time series regression. Can either be zero correlation (no relation between return and value), negative correlation (value of the currency increases, then the stock return decreases), or positive correlation (both currency value and the stock return increase).
11. For an investor, the domestic currency exposure= 1+ local currency exposure. It only depends upon the value of the local currency and not the local asset return.
12. If exchange rate movements only reflect inflation rate differentials , that is PPP holds, then there is no specific influence on the economy. Real exchange rate movements, however, have an impact on the equity prices, depending on currency exposures.
13. Two models for explaining the effect of the exchange rate movement on the domestic economic activity:
The traditional model: A decline in real exchange rate for a country creates problems in the short term, because the trade deficit increases –>GNP decreases because imports become costly, production cost increases etc. –> eventually offset by the improved international competitiveness and export demand until PPP is restored. Thus, the traditional model predicts a negative currency exposure.
The Money Demand Model: Predicts a positive currency exposure. An increase in the real exchange rate of the country will cause in increase in the stock returns because of the increase in the currency demand.
Caution: A drop in the value of an emerging market’s currency is often a signal that the country is running into severe problems.
14. Currency Exposure for Bonds: There are two models again-
a. The Free Market Model– Predicts a negative currency exposure. Increase in real interest rate will cause an increase in the currency value, but the bond price will go down.
b. The Govt. Intervention Method (Leaning against the Wind)– Predicts a positive currency exposure. Increase in the stock price will make the Govt . reduce the real interest rates, thus inflating the bond prices.
15. Currency Exposure of Individual Firms- Can be estimated by regressing the company’s stock’s returns against market returns and currency returns. Can be fine tuned by a detailed analysis of the source of sales, profit margins , costs, geographical origin of the sales, costs etc.