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

55 Pages Posted: 16 Mar 2010

See all articles by Du Du

Du Du

Hong Kong University of Science & Technology (HKUST)

Multiple version iconThere are 2 versions of this paper

Date Written: March 1, 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 strongly prefer earlier resolutions of intertemporal risks, positive shocks on home disaster intensity produce foreign currency premium large enough to offset the associated decreases of home interest rate. As the result, the foreign currency which pays higher interest rate tends 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 puzzle, stochastic skewness

JEL Classification: F31, G01, G11

Suggested Citation

Du, Du, General Equilibrium Pricing of Currency and Currency Options with Variable Disasters and Recursive Utility (March 1, 2010). Available at SSRN: https://ssrn.com/abstract=1570502 or http://dx.doi.org/10.2139/ssrn.1570502

Du Du (Contact Author)

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

Clearwater Bay
Kowloon, 999999
Hong Kong

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