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)
March 12, 2015
NYU Working Paper No. FIN-09-007
Since the Fall of 2008, out-of-the money puts on high interest rate currencies have become significantly more expensive than out-of-the-money calls, suggesting a large crash risk of those currencies. To evaluate crash risk precisely, 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 2014 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 more than a third of the carry trade risk premium in advanced countries over the period examined. The measure of disaster risk that we uncover in currencies proves to be an important factor in the cross-sectional and time-series variation of exchange rates, interest rates, and equity tail risk.
Number of Pages in PDF File: 68
Keywords: Exchange Rates, Disaster Risk, Currency Options
JEL Classification: E44, F31, G12
Date posted: May 7, 2009 ; Last revised: March 13, 2015
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