Working Paper: NBER ID: w15062
Authors: Emmanuel Farhi; Samuel Paul Fraiberger; Xavier Gabaix; Romain Rancière; Adrien Verdelhan
Abstract: Since the fall of 2008, option smiles have been clearly asymmetric: out-of-the-money currency options point to large expected exchange rate depreciations (appreciations) for high (low) interest rate currencies, suggesting that disaster risk is priced in currency markets. To study the price of disaster risk, we propose a simple structural model that includes both Gaussian and disaster risk and can be estimated even in samples that do not contain disasters. Estimating the model over the 1996 to 2011 period using exchange rate spot, forward, and option data, we obtain a real-time index of world disaster risk premia. We find that disaster risk accounts for more than a third of currency risk premia in advanced countries over the period.
Keywords: Currency Markets; Disaster Risk; Carry Trades; Option Pricing
JEL Codes: E44; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| disaster risk (H84) | currency risk premia (F31) |
| disaster risk (H84) | currency risk premium on carry trades (F31) |
| changes in currency option prices post-2008 (F31) | increased disaster risk (H84) |
| market events (G14) | pricing of disaster risk in currency options (G13) |
| disaster risk exposure (H84) | exchange rate movements (F31) |