General Equilibrium Pricing of Currency and Currency Options with Variable Disasters and Recursive Utility

56 Pages Posted: 12 Jan 2010  

Du Du

Hong Kong University of Science & Technology (HKUST)

Multiple version iconThere are 2 versions of this paper

Date Written: January 10, 2010

Abstract

This paper proposes a preference-based general equilibrium model that explains various pricing features of currency and currency options. The central ingredients are i) a variable disaster component that is highly but imperfectly shared across countries; and ii) the separation of EIS from risk aversion facilitated by the Epstein-Zin preference which enables the direct pricing of disaster risks. The predominant global disaster component reconcile the discrepancy between poorly shared consumption shocks and high risk sharing implied from the smooth exchange rate series. When investors prefer intertemporal risk to resolve sooner than later, shocks on home disaster intensity produce the negative correlation between the home interest rate and the premia demanded for holding foreign bonds, which explains why high interest paying currencies tend to appreciate. Country-specific disasters move independently, and they induce skewness in exchange rate changes with opposite signs, which generates the substantial variations in option risk reversal as a measure of the skewness. The model also accounts for the aggregate stock and option market behaviors.

Keywords: economic disaster, disaster intensity, risk sharing, forward premium

JEL Classification: F31, G01, G11

Suggested Citation

Du, Du, General Equilibrium Pricing of Currency and Currency Options with Variable Disasters and Recursive Utility (January 10, 2010). Available at SSRN: https://ssrn.com/abstract=1534365 or http://dx.doi.org/10.2139/ssrn.1534365

Du Du (Contact Author)

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon
Hong Kong

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