Rare Disasters and Exchange Rates

49 Pages Posted: 17 Mar 2009

See all articles by Emmanuel Farhi

Emmanuel Farhi

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

Multiple version iconThere are 4 versions of this paper

Date Written: March 10, 2008

Abstract

We propose a new model of exchange rates, which yields a theory of the forward premium puzzle. Our explanation combines two ingredients: the possibility of rare economic disasters, and an asset view of the exchange rate. Our model is frictionless, has complete markets, and works for an arbitrary number of countries. In the model, rare worldwide disasters can occur and affect each country's productivity. Each country's exposure to disaster risk varies over time according to a mean-reverting process. Risky countries command high risk premia: they feature a depreciated exchange rate and a high interest rate. As their risk premium mean reverts, their exchange rate appreciates. Therefore, currencies of high interest rate countries appreciate on average.

To make the notion of disaster risk more implementable, we show how options prices might in principle uncover latent disaster risk, and help forecast exchange rate movements. We then extend the framework to incorporate two factors: a disaster risk factor, and a business cycle factor. We calibrate the model and obtain quantitatively realistic values for the volatility of the exchange rate, the forward premium puzzle regression coefficients, and near-random walk exchange rate dynamics. Finally, we solve a model of stock markets across countries, which yields a series of predictions about the joint behavior of exchange rates, bonds, options and stocks across countries. The evidence from the options market appears to be supportive of the model.

Keywords: Forward premium puzzle, return predictability, value, rare disasters, equilibrium asset pricing

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

Suggested Citation

Farhi, Emmanuel, Rare Disasters and Exchange Rates (March 10, 2008). Available at SSRN: https://ssrn.com/abstract=1361252 or http://dx.doi.org/10.2139/ssrn.1361252

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

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