General equilibrium pricing of currency and currency options

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review

16 Scopus Citations
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Detail(s)

Original languageEnglish
Pages (from-to)730-751
Journal / PublicationJournal of Financial Economics
Volume110
Issue number3
Online published21 Aug 2013
Publication statusPublished - Dec 2013

Abstract

This paper presents a consumption-based general equilibrium model for valuing foreign exchange contingent claims. The model identifies a novel economic mechanism by exploiting highly but imperfectly shared consumption disaster with variable intensities which are the concerns to the representative investor under recursive utility. When applied to the data, the model simultaneously replicates (i) the moderate option-implied volatilities; (ii) substantial variations in the risk-neutral skewness of currency returns; (iii) the uncovered interest rate parity puzzle; and (iv) the first two moments of carry trade returns. Furthermore, the model rationalizes salient features of the aggregate stock, government bonds, and equity index options. © 2013 Elsevier B.V.

Research Area(s)

  • Carry trade, Recursive preference, Stochastic skewness, Uncovered interest parity anomaly, Variable disaster