TY - JOUR AU - Farhi,Emmanuel AU - Gabaix,Xavier TI - Rare Disasters and Exchange Rates JF - National Bureau of Economic Research Working Paper Series VL - No. 13805 PY - 2008 Y2 - February 2008 UR - http://www.nber.org/papers/w13805 L1 - http://www.nber.org/papers/w13805.pdf N1 - Author contact info: Emmanuel Farhi Harvard University Department of Economics Littauer Center Cambridge, MA 02138 Tel: 617/496-1835 Fax: 617/495-8570 E-Mail: efarhi@harvard.edu Xavier Gabaix New York University Finance Department Stern School of Business 44 West 4th Street, 9th floor New York, NY 10012 Tel: 212-998-0257 Fax: 212-995-4233 E-Mail: xgabaix@stern.nyu.edu AB - 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. ER -