This paper adds to evidence that the forward-discount puzzle is at least in part explained as a compensation for taking crash risk. A number of Central and Eastern European exchange rates are compared. A hidden Markov model is used to identify two regimes for most of the exchange rates. These two regimes can be characterised as being either periods of calm or periods of crisis The level of international risk aversion and changes in US interest rates affect the probability of switching from one regime to the other. This model is then used to assess the way that these two factors affect the probability of a currency crisis. While the Czech Republic, Hungary and Bulgaria are very sensitive to international financial conditions, Poland and Romania are relatively immune.
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Since the global financial crisis, there is increased evidence that this is not the case as credit and regulatory frictions have become more prominent.
In this case, the parameters are drawn randomly. However, it would be possible to make initial estimates of the response model from Hayward (2013) using the estimates of the carry-trade returns that are identified.
The other two components (remaining in the calm regime and switching from a period of crisis to one of calm) can be calculated from these transition probabilities.
The VIX is an index of implied volatility on options from the S&P 500 index. It is commonly used as a measure of international risk aversion as it signals increased demand by fund managers for option protection of their equity portfolio. See Chicago Board of Trade (2009), Demeterfi (1999) and Diamond (2012) for fuller details.
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Hayward, R., Hölscher, J. The Forward-Discount Puzzle in Central and Eastern Europe. Comp Econ Stud 59, 472–497 (2017). https://doi.org/10.1057/s41294-017-0033-5
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DOI: https://doi.org/10.1057/s41294-017-0033-5