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Crash Risk in Currency Market

  • Xavier Gabaix

    (NYU Stern)

  • Samuel Fraiberg

    (NYU)

  • Romain Ranciere

    (IMF and PSE)

  • Adrien Verdehlha

    (MIT Sloan)

  • Emmanuel Farhi

    (Harvard)

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 Society for Economic Dynamics in its series 2010 Meeting Papers with number 640.

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Date of creation: 2010
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Handle: RePEc:red:sed010:640
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Fax: 1-314-444-8731
Web page: http://www.EconomicDynamics.org/society.htm
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