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Crash risk and risk neutral densities

Ren-Raw Chen, Pei-lin Hsieh and Jeffrey Huang

Journal of Empirical Finance, 2018, vol. 47, issue C, 162-189

Abstract: “Crash risk” has been one of the major focuses in the recent asset pricing literature. Motivated by the recent literature that suggests an increase in crash risk since Fall 2008 and the recent troubles in the Euro zone, we use EUR/USD FX options for January 2, 2008 to March 18, 2015 to study option-implied risk-neutral densities (RND). We find that RND, especially higher moments, has superior explanatory power in predicting and explaining crash risk and its risk premiums. Furthermore, the higher moments of RND co-move closely with macroeconomic variables. Consistently, we find RND moments outperform the implied volatility from the Black–Scholes model.

Keywords: European crisis; Subprime crisis; Tail risk; Risk neutral density; FX option (search for similar items in EconPapers)
JEL-codes: G12 G14 (search for similar items in EconPapers)
Date: 2018
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Journal of Empirical Finance is currently edited by R. T. Baillie, F. C. Palm, Th. J. Vermaelen and C. C. P. Wolff

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Handle: RePEc:eee:empfin:v:47:y:2018:i:c:p:162-189