DP7322 Crash Risk in Currency Markets

Author(s): Emmanuel Farhi, Samuel P. Fraiberger, Xavier Gabaix, Romain Rancière, Adrien Verdelhan
Publication Date: June 2009
Keyword(s): carry trade, currency crisis, currency options, disaster risk, exchange rate, financial crisis
JEL(s): F3, F31, G01, G14
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7322

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.