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.