Working Paper: NBER ID: w13805
Authors: Emmanuel Farhi; Xavier Gabaix
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: exchange rates; forward premium puzzle; rare disasters; international finance; risk premia
JEL Codes: E43; E44; F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Risky countries (F34) | High risk premia (G19) |
| High risk premia (G19) | Depreciated exchange rate (F31) |
| High risk premia (G19) | High interest rate (E43) |
| Risk premium mean reverts (G19) | Exchange rate appreciates (F31) |
| High interest rate countries (F34) | Appreciate on average (G19) |
| Risk premium (G19) | Interest rates (E43) |
| Risk premium and interest rates (E43) | Forward premium puzzle (C69) |
| Rare worldwide disasters (H84) | Each country’s productivity (O57) |
| Each country’s productivity (O57) | Exchange rates (F31) |
| Each country’s productivity (O57) | Interest rates (E43) |