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Post by Sapphire Capital on Oct 4, 2008 1:10:19 GMT 4
Crash-Neutral Currency Carry Trades Jakub W. Jurek Princeton University - Bendheim Center for Finance October 29, 2007 Abstract: Currency carry trades implemented within G10 currencies have historically delivered significant excess returns with annualized Sharpe ratios in excess of one. This paper investigates whether these excess returns reflect compensation for exposure to crash risk by analyzing the time-series dynamics of the moments of the risk-neutral distribution extracted from currency options, and by examining returns to crash-neutral currency carry trades in which exposure to crashes has been hedged by combining positions in currencies and currency options. Risk-neutral and realized skewness are shown to move in opposite directions in response to realized currency returns such that insurance against currency crashes is cheapest precisely when it is needed most. Although excess returns to crash-neutral strategies decline relative to their unhedged counterparts, they remain positive and highly statistically significant. The results indicate that crash risk premia can explain 30-40% of the total excess return to currency carry trades. Rationalizing the entirety of the excess return via a crash risk premium would require implied volatilities of out-of-the-money currency options to be roughly four times greater than those observed in the data. papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1262934_code449598.pdf?abstractid=1262934&mirid=1
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