68 Pages Posted: 7 May 2009 Last revised: 13 Mar 2015
Date Written: March 12, 2015
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.
Keywords: Exchange Rates, Disaster Risk, Currency Options
JEL Classification: E44, F31, G12
Suggested Citation: Suggested Citation
Farhi, Emmanuel and Fraiberger, Samuel P. and Gabaix, Xavier and Rancière, Romain G. and Verdelhan, Adrien, Crash Risk in Currency Markets (March 12, 2015). NYU Working Paper No. FIN-09-007 . Available at SSRN: https://ssrn.com/abstract=1397668 or http://dx.doi.org/10.2139/ssrn.1397668
By Jakub Jurek