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: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP7322.asp.asp

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.