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Crash Risk in Currency MarketsEmmanuel FarhiHarvard University - Department of Economics; National Bureau of Economic Research (NBER) Samuel P. FraibergerNew York University (NYU) - Department of Economics Xavier GabaixNew York University - Stern School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI) Romain RanciereInternational Monetary Fund (IMF) Adrien VerdelhanMassachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER) June 1, 2009 Abstract: 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, G12 working papers seriesDate posted: May 7, 2009 ; Last revised: June 3, 2009Suggested CitationContact Information
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