Working Paper: CEPR ID: DP7322
Authors: Emmanuel Farhi; Samuel P. Fraiberger; Xavier Gabaix; Romain Rancière; Adrien Verdelhan
Abstract: 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.
Keywords: carry trade; currency crisis; currency options; disaster risk; exchange rate; financial crisis
JEL Codes: F3; F31; G01; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| disaster risk (H84) | carry trade excess returns (G15) |
| Gaussian risk + disaster risk (H84) | expected currency excess returns (F31) |
| disaster risk (H84) | hedged carry trade returns (G15) |
| disaster risk premia (H84) | carry trade excess returns (G15) |