Foreign Currency Risk Premium (FCRP)

[jdane416]

First, just a slight vent - why does CFAI have to call it SRP while Schweser FCRP?
Anyways, I’m having some trouble with the logic behind how to calculate this simple term. I know that the formula to compute it is:
FCRP = {[E(S1) - S0 / S0]} - (rDC - rFC)
Now according to Schweser this translates as “The expected exchange rate movement minus the interest rate differential between the domestic currency and foreign currency”. Makes sense.
However, in the answer to Reading 68, Concept Check #3, Schweser writes “Also note that the expected foreign currency depreciation is the same as negative appreciation”. Ok, makes sense still I guess.
Schweser, Study Session 18, Reading 68, p. 277 “Example: Calculating a foreign currency risk premium”:
An investor’s home country has a risk-free rate of 7%. A foreign country has a risk-free interest rate of 3%. The currency exchange rate between the two countries is 2.00 (DC/FC), and the expected spot rate in one year is 2.10. Calculate the FCRP and the unhedged and hedged expected domestic currency return on the foreign bond. Use the linear approximation.
So, wouldn’t it make sense then, that based on the explanation from the concept checker, that since the spot rate is increasing from 2.0 to 2.1, that represents a DEPRECIATION of the foreign with respect to the domestic? Or, an appreciation of the domestic with respect to foreign? I believe so. Now, this is where I get confused:
Schweser, Study Session 18, Reading 68, Concept Checker #9:
A Canadian investor expects the Swiss franc to depreciate by 1.5% over the next year. The interest rate on a 1-year risk-free bond are 2.25% in Canada and 1.755 in Switzerland. The current exchange rate is C$0.75 per Sf. The foreign currency risk premium on the franc is closet to:
A. -2.0%
B. -1.5%
C. -0.5%
Once again I computed this as an APPRECIATION of the domestic (C$) currency. However, in the answer to this question it states “The foreign currency risk premium is equal to the depreciation of the Swiss franc minus the interest rate differential:
-0.15 - .005
How is the first part -0.15? Doesn’t that go against what Schweser shows in their example from above?
I hope this makes sense. I’m going nuts over here trying to understand this. Thanks.

 

[chedges]

“So, wouldn’t it make sense then, that based on the explanation from the concept checker, that since the spot rate is increasing from 2.0 to 2.1, that represents a DEPRECIATION of the foreign with respect to the domestic? Or, an appreciation of the domestic with respect to foreign? I believe so. Now, this is where I get confused: ”
No, its appreicating.
I look at it this way:
For every 1 of the FC, you get 2 of the domestic currency.
This changes to for every 1 of the foriegn currency, you get 2.1 of the domestic CCY.
This means that as time goes on, you get more of the DC than you did before - hence the FC is strengthening and appreciating.
Perhaps you getting confused in that the rate is usually converted as FC/DC…?

 

[chedges]

just to add to that.
as you get more of the DC for 1 of your FC, this means that the FC is more valuable - you can buy more with it. hence strengthening

 

[jdane416]

Ok, that makes sense… I guess I was just looking at it the wrong way.
One more question though: the first part of the FCRP formula, {[E(S1) - S0 / S0]} — who’s perspective is this spot rate taken from? Is it from the FC perspective, or the DC perspective?
As I understand it now, this is from the perspective of FC so if a direct quote was given I would need to convert it to indirect?

 

[swaptiongamma]

>So, wouldn’t it make sense then, that based on the explanation from the concept >checker, that since the spot rate is increasing from 2.0 to 2.1, that represents a >DEPRECIATION of the foreign with respect to the domestic?
Example on page 277
S0 = 2.00 DC/FC
Interpretation of S0 = 1 unit of FC can buy 2 units of DC today
E(S1) = 2.1 DC/FC
Interpretation of E(S1) = 1 unit of FC will buy 2.1(more) units of DC in the future
Conclusion
FC appreciated or DC depreciated – whatever you like.
>Concept Checker #9
>How is the first part -0.15? Doesn’t that go against what Schweser shows in their >example from above?
Given: Swiss franc to depreciate by 1.5%
Therefore
S0= 0.75 (DC-CAD)/1 (FC-SF)
E(S1) = 0.73875 (DC-CAD)/1 (FC-SF)
Expected appreciation in foreign currency: (0.73875 - 0.75)/(0.75) = -0.015
“Negative Expected appreciation in foreign currency” – English meaning – “foreign currency is going to depreciate in future”
IR(DC-CAD) = 0.0225
IR(FC-SF) = 0.0175
IRD = 0.005
FCRP = -0.015 - 0.005 = -0.02 = -2% = Ans A
>who’s perspective is this spot rate taken from?
S0 & E(S1) are always DC/FC
> so if a direct quote was given I would need to convert it to indirect?
Basically, Whatever it takes to get to (FC : DC) base: counter or DC/FC

 

[jdane416]

chedges and swaptiongamma:
Thanks for the help guys; tt makes sense to me now. My biggest problem is that I’m still confusing the currency quotations in regards to what is the foreign currency and what is the direct. Guess it’s back to Reading 18 to review it yet again…