Crash-o-phobia in Currency Carry Trade Returns

53 Pages Posted: 10 Oct 2018 Last revised: 13 Oct 2018

See all articles by Regina Hammerschmid

Regina Hammerschmid

University of Zurich; Swiss Finance Institute

Alexandra Janssen

University of Zurich - Department of Banking and Finance

Date Written: September 19, 2018


Currency carry trade returns are on average large and non-normally distributed. While the literature has found different explanations for the existence of carry trade returns, the higher order moments of their return distribution still pose a puzzle. We propose a new model to explain these non-normal properties of currency carry trade returns, by assuming that agents are loss averse and overweight states with low probabilities. This combination of loss aversion and probability weighting is called crash-o-phobia. Using non-linear least squares and risk-neutral state prices implied by currency options, we estimate this crash-o-phobia model to price developed and emerging market currencies. The parameter estimates reveal crash-o-phobic beliefs and preferences with significant differences across currencies. Compared to a model with rational beliefs and CRRA utility, our crash-o-phobia model performs significantly better at explaining the whole distribution of currency carry trade returns.

Keywords: currency carry trade returns, loss aversion, belief estimation, probability distortion, crash-o-phobia

JEL Classification: G11, G12, G40

Suggested Citation

Hammerschmid, Regina and Janssen, Alexandra, Crash-o-phobia in Currency Carry Trade Returns (September 19, 2018). Swiss Finance Institute Research Paper No. 18-64, Available at SSRN: or

Regina Hammerschmid (Contact Author)

University of Zurich ( email )

Schönberggasse 1
Zürich, 8001

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4

Alexandra Janssen

University of Zurich - Department of Banking and Finance ( email )


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