Rare Disasters and Exchange Rates

70 Pages Posted: 13 Dec 2007 Last revised: 15 Oct 2014

See all articles by Emmanuel Farhi

Emmanuel Farhi

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 4 versions of this paper

Date Written: October 2, 2014

Abstract

We propose a new model of exchange rates, based on the hypothesis that the possibility of rare but extreme disasters is an important determinant of risk premia in asset markets. The probability of world disasters as well as each country's exposure to these events is time-varying. This creates joint fluctuations in exchange rates, interest rates, options, and stock markets. The model accounts for a series of major puzzles in exchange rates: excess volatility and exchange rate disconnect, forward premium puzzle and large excess returns of the carry trade, and comovements between stocks and exchange rates. It also makes empirically successful signature predictions regarding the link between exchange rates and telltale signs of disaster risk in currency options.

Keywords: Disaster risk, forward premium puzzle, uncovered interest rate parity, risk-reversals, international macro-finance puzzles

JEL Classification: E43, E44, F31, G12, G15

Suggested Citation

Farhi, Emmanuel and Gabaix, Xavier, Rare Disasters and Exchange Rates (October 2, 2014). Paris December 2007 Finance International Meeting AFFI-EUROFIDAI Paper. Available at SSRN: https://ssrn.com/abstract=1071607 or http://dx.doi.org/10.2139/ssrn.1071607

Emmanuel Farhi (Contact Author)

Harvard University - Department of Economics ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Xavier Gabaix

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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