Rare Disasters and Exchange Rates

72 Pages Posted: 23 Jan 2015

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: January 2015

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, international macro-finance puzzles, risk-reversals, uncovered interest rate parity

JEL Classification: G12, G15

Suggested Citation

Farhi, Emmanuel and Gabaix, Xavier, Rare Disasters and Exchange Rates (January 2015). CEPR Discussion Paper No. DP10334. Available at SSRN: https://ssrn.com/abstract=2554408

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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