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 8, 2014
NYU Working Paper No. FIN-09-007
Out-of-the-money currency options point to large expected exchange rate depreciations for high interest rate currencies, suggesting that disaster risk is priced in currency markets. To study the price of disaster risk, 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 2013 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 a third of average currency carry trade excess returns in advanced countries over the period examined. We document that after the Fall of 2008, options prices exhibit a sharp increase in tail risk, similar to the emergence of the smirk in equity options after the 1987 crash.
Number of Pages in PDF File: 62
Keywords: Exchange Rates, Disaster Risk, Currency Options
JEL Classification: E44, F31, G12working papers series
Date posted: May 7, 2009 ; Last revised: June 9, 2014
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