Cost of Capital Comparison:
The International Security Market Line of the International Capital asset pricing model (CAPM) without proper currency hedging is E = R + [E1 - R] * B + sigma (CRP * alpha).
Where:
- E = Required return for portfolio
- R = Risk-free rate
- [E1 - R] = Expected market premium above the domestic risk-free rate
- B = World beta for portfolio
- Sigma (CRP * alpha) = Sum of the currency risk premiums multiplied by currency exposure.
Assume you are a U.S. investor considering in British and French stocks.
Risk free rate = 3%
Market risk premium = 5%
Currency risk premium for the Pound = 1.5%
Currency risk premium for the Euro = 2.0%
What is the required return for the U.K. stock if the beta is 0.80, alpha of the Pound is 1.20, and alpha of the Euro is 0.20?
The required return for the U.K. stock is: