Abstract

This paper adds to evidence that the forward-discount puzzle is at least partly 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 stability or periods of instability. 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. JEL classifications: C24, F31, F32; Key words: Exchange rates, uncovered interest parity, foreign exchange risk discount, hidden-Markov model, carry-trade