“Explaining Regularities in Currency and Currency Option Markets” by Du DU
Hong Kong University of Science & Technology
This paper proposes a preference-based general equilibrium model that replicates various pricing features for currency and currency options. The central ingredients are the highly but imperfectly shared economic disasters with variable intensity, and the recursive prefence which enables the direct pricing of disaster risks. The predominant global disaster generates the high risk sharing suggested by the smooth exchange rate series. In response to the positive shock on home disaster intensity, domestic investors save more and demand higher premiums which predict the appreciation of foreign currency paying the higher interest rate. The potential home and foreign- specific disasters generate, respectively, the negative and the positive skewness in the exchange rate process, and the observed stochastic skewness emerges due to their independent evolutions. The framework also explains salient features for the aggregate equity and equity index options.