Working Paper: CEPR ID: DP10334
Authors: Emmanuel Farhi; Xavier Gabaix
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 macrofinance puzzles; risk reversals; uncovered interest rate parity
JEL Codes: G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| disaster risk (H84) | risk premia (G22) |
| risk premia (G22) | exchange rates (F31) |
| disaster risk (H84) | exchange rates (F31) |
| riskiness (D81) | exchange rates (F31) |
| high-risk countries (F35) | interest rates (E43) |
| interest rates (E43) | exchange rates (F31) |
| risk reversal (D81) | exchange rates (F31) |