Rare Disasters and Exchange Rates

Emmanuel Farhi, Xavier Gabaix

NBER Working Paper No. 13805
Issued in February 2008
NBER Program(s):Asset Pricing, Economic Fluctuations and Growth, International Finance and Macroeconomics

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.

download in pdf format
   (499 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w13805

Published: Emmanuel Farhi & Xavier Gabaix, 2016. "Rare Disasters and Exchange Rates," The Quarterly Journal of Economics, vol 131(1), pages 1-52.

Users who downloaded this paper also downloaded* these:
Brunnermeier, Nagel, and Pedersen w14473 Carry Trades and Currency Crashes
Gabaix w13724 Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance
Farhi, Fraiberger, Gabaix, Rancière, and Verdelhan w15062 Crash Risk in Currency Markets
Brunnermeier, Nagel, and Pedersen Carry Trades and Currency Crashes
Burnside, Eichenbaum, and Rebelo w16942 Carry Trade and Momentum in Currency Markets
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us