Crash Risk in Currency Markets

68 Pages Posted: 7 May 2009 Last revised: 13 Mar 2015

See all articles by Emmanuel Farhi

Emmanuel Farhi

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Samuel P. Fraiberger

Computer Science; Harvard University - Institute for Quantitative Social Sciences; Northeastern University - Network Science Institute

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Romain G. Rancière

University of Southern California

Adrien Verdelhan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: March 12, 2015

Abstract

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

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

Emmanuel Farhi

Harvard University - Department of Economics ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Samuel P. Fraiberger

Computer Science ( email )

60 5th Avenue
New York, NY 10012
United States

Harvard University - Institute for Quantitative Social Sciences ( email )

1737 Cambridge St
Cambridge, MA 02115
United States

Northeastern University - Network Science Institute ( email )

177 Huntington Avenue
Boston, MA 02115
United States

Xavier Gabaix

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Romain G. Rancière

University of Southern California ( email )

2250 Alcazar Street
Los Angeles, CA 90089
United States

Adrien Verdelhan (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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