Discussion paper

DP7322 Crash Risk in Currency Markets

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.


Gabaix, X, A Verdelhan, R Rancière, E Farhi and S Fraiberger (eds) (2009), “DP7322 Crash Risk in Currency Markets”, CEPR Press Discussion Paper No. 7322. https://cepr.org/publications/dp7322