"Rare Disasters and Exchange Rates",Xavier Gabaix with Emmanuel Farhi, Quarterly Journal of Economics, forthcoming.
A rare disasters model accounts for many puzzling features of the joint fluctuations in exchange rates, interest rates, options, and stock markets.
RARE DISASTERS AND EXCHANGE RATES
Emmanuel Farhi
Harvard, CEPR and NBER
Xavier Gabaix
NYU, CEPR and NBER
August 27, 2015
Forthcoming in the Quarterly Journal of Economics
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.
JEL codes: G12, G15.