The interest rate on one-year risk-free bonds is 5% in the U.K., and 2.75% in Switzerland. The current exchange rate is £0.5 per SF. Suppose that you are a British investor and you expect the Swiss franc to appreciate by 2% over the next year. Suppose you own an asset in Switzerland whose return is 7%.
1. Calculate the risk premium on the Swiss asset from your viewpoint, assuming that you hedge currency risk.
2. Then show it is the same as the risk premium on the Swiss asset from a Swiss investor’s viewpoint.
The interest rate diffrantial (UK minus Swiss)
=0.05 -0.0275
=0.0225
or we could say 2.25%
This implies that swiss france trades at the forward premium of 2.25% that is forward exchange rate is quoted at the premum of 2.25% over the spot exhange rate of £0.5 per france but the expected appreciation of the france is lower and equal to 2% Hence currancy risk discount at the
=0.0225 -0.02
=0.0025 or 0.25%
B
The domestic currancy UK poud return on the foregn bond is 4.75 can be calculated as follow
Domestic risk free rate – risk free rate discount
= 5 -0.25
=4.75%
or
= 2.75 +2
=4.75
