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Crash Risk in Currency Markets

Author

Listed:
  • Emmanuel Farhi
  • Samuel Fraiberger
  • Xavier Gabaix
  • Romain Ranciere
  • Adrien Verdelhan

Abstract

Since the Fall of 2008, out-of-the money puts on high interest rate currencies have become significantly more expensive than out-of-the-money calls, suggesting a large crash risk of those currencies. To evaluate crash risk precisely, we propose a parsimonious structural model that includes both Gaussian and disaster risks and can be estimated even in samples that do not contain disasters. Estimating the model for the 1996 to 2014 sample period using monthly exchange rate spot, forward, and option data, we obtain a real-time index of the compensation for global disaster risk exposure. We find that disaster risk accounts for more than a third of the carry trade riskpremium in advanced countries over the period examined. The measure of disaster risk that we uncover in currencies proves to be an important factor in the cross-sectional and time-series variation of exchange rates, interest rates, and equity tail risk.

Suggested Citation

  • Emmanuel Farhi & Samuel Fraiberger & Xavier Gabaix & Romain Ranciere & Adrien Verdelhan, 2015. "Crash Risk in Currency Markets," Working Paper 20948, Harvard University OpenScholar.
  • Handle: RePEc:qsh:wpaper:20948
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    File URL: http://scholar.harvard.edu/farhi/node/20948
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • F3 - International Economics - - International Finance
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G01 - Financial Economics - - General - - - Financial Crises
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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