Rare Disasters and Exchange Rates


Farhi, Emmanuel, and Xavier Gabaix. 2016. “Rare Disasters and Exchange Rates.” Quarterly Journal of Economics 131 (1): 1-52.
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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.


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Last updated on 02/24/2017