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Crash Risk in Currency Markets

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

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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  1. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," 2006 Meeting Papers 872, Society for Economic Dynamics.
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  12. Adrien Verdelhan & Hanno Lustig, 2005. "The Cross-Section Of Foreign Currency Risk Premia And Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2005-019, Boston University - Department of Economics.
  13. Emmanuel Farhi & Xavier Gabaix, 2014. "Rare Disasters and Exchange Rates," Working Paper 71001, Harvard University OpenScholar.
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  15. Stephen Gilmore & Fumio Hayashi, 2011. "Emerging Market Currency Excess Returns," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(4), pages 85-111, October.
  16. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
  17. Peter Carr & Liuren Wu, 2004. "Stochastic Skew in Currency Options," Finance 0409014, EconWPA.
  18. Tim Bollerslev & Viktor Todorov, 2011. "Tails, Fears, and Risk Premia," Journal of Finance, American Finance Association, vol. 66(6), pages 2165-2211, December.
  19. David Backus & Silverio Foresi & Chris Telmer, 1996. "Affine Models of Currency Pricing," NBER Working Papers 5623, National Bureau of Economic Research, Inc.
  20. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
  21. Francois Gourio, 2008. "Disasters and Recoveries," American Economic Review, American Economic Association, vol. 98(2), pages 68-73, May.
  22. Jarque, Carlos M. & Bera, Anil K., 1980. "Efficient tests for normality, homoscedasticity and serial independence of regression residuals," Economics Letters, Elsevier, vol. 6(3), pages 255-259.
  23. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 231-237, December.
  24. Bates, David S., 1996. "Dollar jump fears, 1984-1992: distributional abnormalities implicit in currency futures options," Journal of International Money and Finance, Elsevier, vol. 15(1), pages 65-93, February.
  25. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  26. Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
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