Crash Risk in Currency Markets

83 Pages Posted: 15 Jul 2009

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: June 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 that 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 based on their forward discounts. We find that disaster risk premia account for about 25% of expected carry trade excess returns in advanced countries.

Keywords: carry trade, currency crisis, currency options, disaster risk, exchange rate, financial crisis

JEL Classification: F3, F31, G01, G14

Suggested Citation

Farhi, Emmanuel and Fraiberger, Samuel P. and Gabaix, Xavier and Rancière, Romain G. and Verdelhan, Adrien, Crash Risk in Currency Markets (June 2009). CEPR Discussion Paper No. DP7322. Available at SSRN: https://ssrn.com/abstract=1433918

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
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Xavier Gabaix (Contact Author)

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

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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