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Crash Risk in Currency Markets

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  • Farhi, Emmanuel
  • Fraiberger, Samuel P.
  • Gabaix, Xavier
  • Rancière, Romain
  • Verdelhan, Adrien

Abstract

How much of carry trade excess returns can be explained by the presence of disaster risk? To answer this question, we propose a simple structural model that includes both Gaussian and disaster risk premia and can be estimated even in samples that do not contain disasters. The model points to a novel estimation procedure based on currency options with potentially different strikes. We implement this procedure on a large set of countries over the 1996-2008 period, forming portfolios of hedged and unhedged carry trade excess returns by sorting currencies based on their forward discounts. We find that disaster risk premia account for about 25% of expected carry trade excess returns in advanced countries.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7322.

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Date of creation: Jun 2009
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Handle: RePEc:cpr:ceprdp:7322

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Keywords: carry trade; currency crisis; currency options; disaster risk; exchange rate; financial crisis;

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