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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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  21. David K. Backus & Gregor W. Smith, 1993. "Consumption and Real Exchange Rates in Dynamic Economies with Non-Traded Goods," Working Papers 1252, Queen's University, Department of Economics.
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  23. Francois Gourio, 2008. "Disasters and Recoveries," American Economic Review, American Economic Association, vol. 98(2), pages 68-73, May.
  24. 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.
  25. Christian Julliard & Anisha Ghosh, 2008. "Can rare events explain the equity premium puzzle?," LSE Research Online Documents on Economics 4808, London School of Economics and Political Science, LSE Library.
  26. Ian W. Martin, 2013. "Consumption-Based Asset Pricing with Higher Cumulants," Review of Economic Studies, Oxford University Press, vol. 80(2), pages 745-773.
  27. Kaminsky, Graciela, 1993. "Is There a Peso Problem? Evidence from the Dollar/Pound Exchange Rate, 1976-1987," American Economic Review, American Economic Association, vol. 83(3), pages 450-72, June.
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