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Crash Risk in Currency Markets

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  • Emmanuel Farhi
  • Samuel Paul Fraiberger
  • Xavier Gabaix
  • Romain Ranciere
  • Adrien Verdelhan

Abstract

Since the fall of 2008, option smiles have been clearly asymmetric: out-of-the-money currency options point to large expected exchange rate depreciations (appreciations) for high (low) interest rate currencies, suggesting that disaster risk is priced in currency markets. To study the price of disaster risk, we propose a simple structural model that includes both Gaussian and disaster risk and can be estimated even in samples that do not contain disasters. Estimating the model over the 1996 to 2011 period using exchange rate spot, forward, and option data, we obtain a real-time index of world disaster risk premia. We find that disaster risk accounts for more than a third of currency risk premia in advanced countries over the period.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15062.

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Date of creation: Jun 2009
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Handle: RePEc:nbr:nberwo:15062

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