The interest rate on one-year risk-free bonds is 5% in the United Kingdom, and 3.75% in Switzerland. The current exchange rate is £0.5 per Swiss franc. Suppose that you are a British investor and you expect the Swiss franc to appreciate by 2% over the next year.
a. Calculate the foreign currency risk premium.
b. Calculate the domestic currency return on the foreign bond, assuming that your currency appreciation expectations are met.

Question

Quizplus · Accepted Answer

The Answer is a. The interest rate differential (U.K. minus Swiss) = 0.05 - 0.0375 = 0.0125 or 1.25%. This implies that the Swiss franc trades at a forward premium of 1.25%, that is, the forward exchange rate is quoted at a premium of 1.25% over the spot exchange rate of £0.5 per franc. But the expected appreciation of the franc is higher and equal to 2%. Hence, there is a currency risk premium on the Swiss franc:
Foreign currency risk premium = 0.0200 - 0.0125 = 0.0075 = 0.75%.
b. The domestic currency (U.K. pounds) return on the foreign bond is 5.75%. This can be calculated in one of the following two ways:
Domestic risk-free rate + Foreign currency risk premium =5% + 0.75% = 5.75%.
Foreign risk-free rate+ Expected exchange rate movement= 3.75% +2% =5.75%.

The Interest Rate on One-Year Risk-Free Bonds Is 5% in the United