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Crash-o-phobia in Currency Carry Trade Returns


Hammerschmid, Regina; Janssen, Alexandra (2018). Crash-o-phobia in Currency Carry Trade Returns. Swiss Finance Institute Research Paper 18-64, SSRN.

Abstract

Currency carry trade returns are on average large and non-normally distributed. While the literature has found different explanations for the existence of carry trade returns, the higher order moments of their return distribution still pose a puzzle. We propose a new model to explain these non-normal properties of currency carry trade returns, by assuming that agents are loss averse and overweight states with low probabilities. This combination of loss aversion and probability weighting is called crash-o-phobia. Using non-linear least squares and risk-neutral state prices implied by currency options, we estimate this crash-o-phobia model to price developed and emerging market currencies. The parameter estimates reveal crash-o-phobic beliefs and preferences with significant differences across currencies. Compared to a model with rational beliefs and CRRA utility, our crash-o-phobia model performs significantly better at explaining the whole distribution of currency carry trade returns.

Abstract

Currency carry trade returns are on average large and non-normally distributed. While the literature has found different explanations for the existence of carry trade returns, the higher order moments of their return distribution still pose a puzzle. We propose a new model to explain these non-normal properties of currency carry trade returns, by assuming that agents are loss averse and overweight states with low probabilities. This combination of loss aversion and probability weighting is called crash-o-phobia. Using non-linear least squares and risk-neutral state prices implied by currency options, we estimate this crash-o-phobia model to price developed and emerging market currencies. The parameter estimates reveal crash-o-phobic beliefs and preferences with significant differences across currencies. Compared to a model with rational beliefs and CRRA utility, our crash-o-phobia model performs significantly better at explaining the whole distribution of currency carry trade returns.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:2018
Deposited On:07 Mar 2019 16:02
Last Modified:30 Jan 2020 14:25
Series Name:Swiss Finance Institute Research Paper
Number of Pages:53
OA Status:Green
Free access at:Official URL. An embargo period may apply.
Publisher DOI:https://doi.org/10.2139/ssrn.3251835
Other Identification Number:merlin-id:17563

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