Crash Risk in Currency Markets

Emmanuel Farhi (), Samuel Paul Fraiberger, Xavier Gabaix (), Romain Rancière () and Adrien Verdelhan ()

No 15062, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E44 F31 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ifn, nep-mac, nep-rmg and nep-upt
Date: 2009-06
Note: AP EFG IFM
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Working Paper: Crash Risk in Currency Markets (2009)
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