General equilibrium pricing of currency and currency options

Du Du

Journal of Financial Economics, 2013, vol. 110, issue 3, 730-751

Abstract: This paper presents a consumption-based general equilibrium model for valuing foreign exchange contingent claims. The model identifies a novel economic mechanism by exploiting highly but imperfectly shared consumption disaster with variable intensities which are the concerns to the representative investor under recursive utility. When applied to the data, the model simultaneously replicates (i) the moderate option-implied volatilities; (ii) substantial variations in the risk-neutral skewness of currency returns; (iii) the uncovered interest rate parity puzzle; and (iv) the first two moments of carry trade returns. Furthermore, the model rationalizes salient features of the aggregate stock, government bonds, and equity index options.

Keywords: Variable disaster; Recursive preference; Stochastic skewness; Carry trade; Uncovered interest parity anomaly (search for similar items in EconPapers)
JEL-codes: F37 G01 G15 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (10)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:110:y:2013:i:3:p:730-751

DOI: 10.1016/j.jfineco.2013.08.006

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