Crash Risk in Currency Markets
Harvard University - Department of Economics; National Bureau of Economic Research (NBER)
Samuel P. Fraiberger
New York University (NYU) - Department of Economics
New York University - Stern School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)
International Monetary Fund (IMF)
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)
June 1, 2009
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 which 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 on their forward discounts. We find that disaster risk premia account for about 25% of carry trade excess returns in advanced countries.
Number of Pages in PDF File: 57
Keywords: Exchange Rates, Disaster Risk, Currency Options
JEL Classification: E44, F31, G12working papers series
Date posted: May 7, 2009 ; Last revised: June 3, 2009
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