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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number
15062.
Length: Date of creation: Jun 2009 Date of revision: Handle: RePEc:nbr:nberwo:15062
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Paper
Farhi, Emmanuel & Fraiberger, Samuel P. & Gabaix, Xavier & Rancière, Romain & Verdelhan, Adrien, 2009.
"Crash Risk in Currency Markets,"
CEPR Discussion Papers
7322, C.E.P.R. Discussion Papers.
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Find related papers by JEL classification: E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy F31 - International Economics - - International Finance - - - Foreign Exchange
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