Data Management

Crash Risk In Currency Markets

Date Added: Jun 2009
Format: PDF

How much of carry trade excess returns can be explained by the presence of disaster risk? To answer this question, the authors 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. They 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. They find that disaster risk premia account for about 25% of carry trade excess returns in advanced countries.