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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)

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 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
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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