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## Rare Disasters and Exchange Rates (2014)

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1974 | A theory of the term structure of interest rates - Cox, Ingersoll, et al. - 1985 |

1446 | By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior
- Cochrane
(Show Context)
Citation Context ...gent rational expectations models to explain both the level and the volatility of risk premia (something that the plain consumption CAPM with low risk aversion fails to generate):2 habits (Abel 1990, =-=Campbell and Cochrane 1999-=-), long run risks (Epstein and Zin 1989, Bansal and Yaron 2Pavlova and Rigobon (2007, 2008) provide an elegant and tractable framework for analyzing the joint behavior of bonds, stocks, and exchange r... |

1413 | Substitution Risk Aversion and the Temporal Behaviour of Consumption and Asset Returns: An Empirical Analysis - Epstein, Zin - 1991 |

852 | Empirical Exchange Rate Models of the Seventies: Do They Fit out of Sample?”
- Meese, Rogoff
- 1983
(Show Context)
Citation Context ...Ht is quite volatile, the exchange rate is hard to forecast (the same way stocks are hard to forecast). At short horizons, the exchange rates behaves like a random walk (qualitatively consistent with =-=Meese and Rogoff 1983-=-). In the remainder of this section, we focus on our preferred calibration (Calibration 1) and dig deeper into its implications. We turn to the model’s implications for the correlation between changes... |

814 |
The Purchasing Power Parity Puzzle
- Rogoff
- 1996
(Show Context)
Citation Context ... interpretations here. The speed of mean-reversion is φ H =0.2, which gives a half-life of ln 2/φ H =3.5 years, and is in line with typical estimates from the exchange rate predictability literature (=-=Rogoff 1996-=-). This translates into a range for bHt = p (B−γ h i Ft − 1), bHmin, bHmax . We parametrize the volatility according to Appendix C, with σ 2 ´ bH =2vφH ¯ b Hmin¯ b Hmax 1 − b H/ b ´ 2 Hmin 1 − b... |

806 | Asset Prices under Habit Formation and Catching Up with the Joneses
- Abel
- 1990
(Show Context)
Citation Context ...vity in the country. The above formulation could be used for many other models of the exchange rate. For instance, the stochastic discount factor M ∗ t+s could come from a model with habit formation (=-=Abel 1990-=-, Bekaert 1996, Campbell Cochrane 1999), long run risk (Bansal and Yaron 2004), or first order risk aversion (Bekaert, Hodrick and Marshall 1997). We choose to study disasters, in part because they ha... |

758 | Risks for the long run: A potential resolution of asset pricing puzzles
- Bansal, Yaron
- 2004
(Show Context)
Citation Context ...ecently, Verdelhan (2007) generates counter-cyclical risk premia via the varying habit formation models pioneered by Abel (1990) and Campbell and Cochrane (1999). In his model, the domestic investor expects to receive a positive foreign currency excess return in bad times when he is more risk-averse than his foreign counterpart. Times of high risk-aversion correspond to low interest rates at home. Thus domestic investors expect positive currency excess returns when domestic interest rates are low and foreign interest rates are high. Finally, Colacito (2006) and Colacito and Croce (2006) apply Bansal and Yaron (2004)’s model with Epstein-Zin-Weil preferences to international economics. Bansal and Shaliastovich (2007) have two-country setting, rely on a perfect cross-country correlation among shocks to the long run components of consumption growth rates to reproduce the UIP puzzle. Turning to explanations based on behavioral biases, Bacchetta and van Wincoop (2006) develop a model where information is costly to acquire and to process. Because of these costs, many investors optimally choose to assess available information and revise their portfolios infrequently. This rational inattention mechanism produces... |

749 | Exchange Rate Dynamics Redux
- Obstfeld, Rogoff
- 2000
(Show Context)
Citation Context ...s a result, changes in beliefs about disasters translate into meaningful volatility. This is why the model yields a sizable volatility which is difficult to obtain with more traditional models (e.g., =-=Obstfeld and Rogoff 1995-=-). The model is very tractable, and expressions for the exchange rate, interest rate, risk premia, and forward premium puzzle coefficients are obtained in closed form. 2 To achieve this, we build on t... |

626 | Asset prices in an exchange economy - Lucas, J - 1978 |

462 | Economic growth and business cycles - Cooley, Prescott - 1995 |

458 |
Forward exchange rates as optimal predictors of future spot rates: an econometric analysis
- Hansen, Hodrick
- 1980
(Show Context)
Citation Context ...dy Atkeson, David Backus, Robert Barro, Daniel Cohen, Alex Edmans, Christian Julliard, Pat and Tim Kehoe, Raj Mehra, Emi Nakamura, Eric van Wincoop, and seminar participants at Boston University, Dartmouth, LBS, LSE, Minneapolis Fed, NBER, New York Fed, NYU, UBC, and the University of Virginia. Gabaix thanks the NSF for support. 1 depreciation of a currency should be equal to the interest rate differential between that country and the reference region. A regression of exchange rate changes on interest rate differentials should yield a coefficient of 1. However, empirical studies starting with Hansen and Hodrick (1980) and Fama (1984), and recently surveyed by Froot and Thaler (1990), Lewis (1995) and Engel (1996), consistently produce a regression coefficient that is less than 1, and often negative. This invalidation of UIP has been termed the forward premium puzzle: currencies with high interest rates tend to appreciate. In other words, currencies with high interest rates feature positive predictable excess returns. There are four possible explanations: time-varying risk premia, Peso problems, expectations errors, and illiquid markets1. Our paper provides a theory of international time-varying risk premia... |

443 | Forward and spot exchange rates’,
- Fama
- 1984
(Show Context)
Citation Context ...appreciate — consistent with the “forward exchange rate premium puzzle” or “uncovered interest rate parity puzzle.” Fama regressions. We analyze the predictions of our model for Fama regressions (see =-=Fama 1984-=-) in two different types of samples: with and without disasters. We consider countries with identical constant parameters but possibly different b���, ���, and���. Consider the Fama regression of the ... |

422 | Asset returns and inflation, - Schwert - 1977 |

400 | The forward discount anomaly and the risk premium: a survey of recent evidence,
- ENGEL
- 1996
(Show Context)
Citation Context ...hange rate premium puzzle” or “uncovered interest rate parity puzzle” highlighted by Hansen and Hodrick (1980) and Fama (1984), and replicated for various countries and time periods many times since (=-=Engel 1996-=-, Lewis 1995 provide surveys). Et 11 The derivation is standard. In the international currency, the payoff of the bond is et+1, so its price is h M ∗ t+1et+1 M ∗ t i , and its domestic price is (13). ... |

388 | The Market Microstructure Approach to Exchange Rates, - LYONS - 2001 |

338 | Rare disasters and asset markets in the twentieth century,”
- Barro
- 2006
(Show Context)
Citation Context ...rward premium puzzle coefficients are obtained in closed form. 2 To achieve this, we build on the closed-economy model with stochastic intensity of disasters proposed in Gabaix (2010) (Rietz 1988 and =-=Barro 2006-=- assume a constant intensity of disasters), and use the “linearitygenerating” processes developed in Gabaix (2007). Our framework is also very flexible. We show that it is remarkably easy to extend th... |

299 |
Recovering probability distributions from option prices
- Jackwerth, Rubinstein
- 1996
(Show Context)
Citation Context ... three times as large as before the crisis. Figure 2 shows a similar pattern for the British Pound. This phenomenon is reminiscent of what happened with stock options before and after the 1987 crash (=-=Jackwerth and Rubinstein 1996-=-). Before the 1987 crash, there was no significant put premium (i.e., no skew). After the 1987 crash, a skew appeared and remained ever since. One interpretation is that options market participants be... |

267 | Foreign Exchange”,
- Froot, Thaler
- 1990
(Show Context)
Citation Context ...hristian Julliard, Pat and Tim Kehoe, Raj Mehra, Emi Nakamura, Eric van Wincoop, and seminar participants at Boston University, Dartmouth, LBS, LSE, Minneapolis Fed, NBER, New York Fed, NYU, UBC, and the University of Virginia. Gabaix thanks the NSF for support. 1 depreciation of a currency should be equal to the interest rate differential between that country and the reference region. A regression of exchange rate changes on interest rate differentials should yield a coefficient of 1. However, empirical studies starting with Hansen and Hodrick (1980) and Fama (1984), and recently surveyed by Froot and Thaler (1990), Lewis (1995) and Engel (1996), consistently produce a regression coefficient that is less than 1, and often negative. This invalidation of UIP has been termed the forward premium puzzle: currencies with high interest rates tend to appreciate. In other words, currencies with high interest rates feature positive predictable excess returns. There are four possible explanations: time-varying risk premia, Peso problems, expectations errors, and illiquid markets1. Our paper provides a theory of international time-varying risk premia in a complete markets, frictionless and rational framework. In ou... |

263 |
The equity risk premium a solution
- Rietz
- 1988
(Show Context)
Citation Context ... premia, and forward premium puzzle coefficients are obtained in closed form. 2 To achieve this, we build on the closed-economy model with stochastic intensity of disasters proposed in Gabaix (2010) (=-=Rietz 1988-=- and Barro 2006 assume a constant intensity of disasters), and use the “linearitygenerating” processes developed in Gabaix (2007). Our framework is also very flexible. We show that it is remarkably ea... |

256 | Exchange Rates and Fundamentals,
- Engel, West
- 2006
(Show Context)
Citation Context ...Stock view of the exchange rate) In terms of the “international currency,” the exchange rate eit of country i is the discounted present value of its future export productivity: eit = Et " ∞X s=0 M∗t+s exp(−λs)ωi,t+s # /M∗t (3) with the convention that an increase in eit means an appreciation of country i’s currency. In Eq. 3, ωi,t+s is the productivity of country i’s export sector at time t + s. M∗t+s is the international pricing kernel, and is independent of country i. To our knowledge, the above formulation is novel, complete-market microfoundation for the “asset view” of the exchange rate (Engel and West 2005 survey earlier “asset view” models, that feature incomplete markets). The exchange rate is the relative price of two goods, the traded and the non-traded good.5 At the same time, Eq. 3 gives us a stock view of the exchange rate: the exchange is a present value of future levels of productivity in the country. The above formulation 5In our model, the real exchange rate is the relative price of non-tradables in terms of tradables. The merit of this identity has been investigated in the literature. The debate has focused on whether the relative price of non-tradables is as volatile as the real ex... |

222 |
Consumption and real exchange rates in dynamic economies with non-traded goods.
- Backus, Smith
- 1993
(Show Context)
Citation Context ...y change our results, but would make the analysis more complex. Last but not least, the utility function (1) could be changed to: E0 " ∞X t=0 exp (−δt) ¡ CTt ¢1−γ 1− γ # + V ({CNTit }t≥0) (4) where V is any utility function over non-traded goods consumption processes {CNTit }t≥0. With this formulation, our formulas for the exchange rate (e.g., Eq. 10-11) would still hold. The only thing that matters here is the marginal utility from one unit of tradable. Were we to follow this route, our model would generate a very imperfect correlation between total consumption and real exchange rates, which Backus and Smith (1993) have demonstrated holds in the data. For instance, V could incorporate habit formation or adjustment costs. 2.2 Macroeconomic environment: Disaster risk World consumption of the traded good. We will study equilibria where the world consumption of the traded good CT∗ follows the following stochastic process. As Rietz (1988) and Barro (2006), we assume that in each period t + 1, a disaster may happen, with a probability pt. If a disaster does not happen, CT∗t+1/C T∗ t = exp(g), where g is the normal-times growth rate of the economy. If a disaster happens, then CT∗t+1/C T∗ t = exp(g)Bt+1, with B... |

215 | From world banker to world venture capitalist: the U.S. external adjustment and the exorbitant privilege. NBER working paper No.
- Gourinchas, Rey
- 2005
(Show Context)
Citation Context ...is h M ∗ t+1et+1 M ∗ t i , and its domestic price is (13). 12 Safe countries can borrow at a lower interest rate, which may explain why historically the dollar or Swiss Franc interest rates were low (=-=Gourinchas and Rey 2007-=-). 11We analyze the predictions of our model for Fama regressions in two different types of samples: with disaster and with no disaster. We consider countries with identical constant parameters, but ... |

163 | Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in
- Gabaix
- 2012
(Show Context)
Citation Context ... with interest rate. In other words, our theory does not rely on mismeasurement of expectations. We calibrate a version of 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. The model is very tractable, and expressions for the exchange rate, interest rate, risk premia, and forward premium puzzle coefficients are obtained in closed forms2. For this, it uses the modelling of environments with stochastic intensity of disasters proposed in a closed economy in Gabaix (2007b) (Rietz (1988) and Barro (2006) have constant intensity of disasters), and the "linearitygenerating" processes developed in Gabaix (2007a). Our framework is also very flexible. We show 1Maynard and Phillips (2001) argue that the forward premium puzzle is the result of misspecification issues. The Fama (1984) regression assumes short-memory stationarity of the data, but evidence contradicts this. Misspecification arises from long memory in the forward premium (the independent variable), and this may induce a bias away from 1. 2Pavlova and Rigobon (2007) also provide an elegant and tractable f... |

162 |
Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets,
- Bekaert, Hodrick
- 1992
(Show Context)
Citation Context ... time-varying risk premia must generate large and volatile risk premia. However, it has proven difficult for traditional structural asset pricing models to generate sufficiently volatile risk premia (=-=Bekaert and Hodrick 1992-=-, Bekaert 1996, and Backus, Foresi, and Telmer 2001). Time-varying rare disasters provide a natural foundation for such risk premia. Accordingly, we explore theoretically and quantitatively the disast... |

146 | Foreign currency option values - Garman, Kohlhagen - 1983 |

109 | Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle? - Bacchetta, Wincoop - 2006 |

104 |
Affine Term Structure Models and the Forward Premium Anomaly,
- Backus, Foresi, et al.
- 2001
(Show Context)
Citation Context ...root (1989) for an empirical investigation of the irrrationality of investors’ expectations, and more recently Frankel (2007) for an insightful discussion. 4 Here we concentrate on some of the most successful studies. We start by reviewing arguments that rely on counter-cyclical risk premia. We then discuss the literature that departs from rational expectations and introduces behavioral biases. Frachot (1996) shows that a two-country Cox, Ingersoll, and Ross (1985) framework can account for the UIP puzzle but it does not provide an economic interpretation of the currency risk premium. Backus, Foresi and Telmer (2001) pursue a similar line of research and show that affine models of the term structure can only rationalize the forward premium puzzle if either the state variables have asymmetric effects on state prices in different currencies or nominal interest rates take on negative value with positive probability. Our model is outside of the scope of their criticism: it is entirely real and does not belong to the affine class. Alvarez, Atkeson, and Kehoe (2002) rely on a model with endogenously segmented markets to generate qualitatively the forward premium anomaly. In their model, higher money growth lead... |

92 | Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?,” - Wachter - 2012 |

86 | Do Peso Problems explain the returns to the carry trade? - Burnside, Eichenbaum, et al. - 2011 |

86 | A habit-based explanation of the exchange rate risk premium,
- Verdelhan
- 2010
(Show Context)
Citation Context ...e not correlated with traditional risk factors. This disagreement spurred a debate on whether or not consumption growth risk explains excess returns on currency speculation (Burnside 2007, Lustig and =-=Verdelhan 2007-=-b). Our paper also contributes to the large literature on Peso problems in international finance. See Lewis (2008) for a recent survey. Of most interest to us is Kaminsky (1993) and Evans and Lewis (1... |

85 | International Risk sharing is Better Than You Think, or Exchange Rates are Too Smooth,” GSB, University of Chicago, working paper (available on John Cochrane’s website). - Brandt, Cochrane, et al. - 2004 |

81 | Exchange rates, equity prices, and capital flows
- Hau, Rey
- 2005
(Show Context)
Citation Context .... Controlling for this resilience, if the currency is strong (because the country as a whole is safe), then the stock price in domestic currency is low.13 As et is expected to depreciate, the expected return of the stock in local currency is high. In this sense, currency risk premia and local currency equity premia 13Of course, if the resilience of the stocks has a strong covariance with the currency’s resilience, the relationship is inverted: good news about resilience increases both et and bHD,t, and increases (49). 28 are negatively correlated. Hence, the theory provides an explanation for Hau and Rey (2006)’s evidence that the home-currency stock price is decreasing in the exchange rate. 7.2.2 Firm producing the domestic good We now turn to a domestic producer producing Ds quantities of the domestic good. Its stock price, in the international currency, is P ∗t = Et £P s≥tMsesDs ¤ , so that its domestic price is Pt = P ∗t /et, hence: Pt/Dt = Et £P s≥tMsesDs ¤ etDt (50) We postulate the following process for Dt Dt+1 Dt = ( exp (g) if there is no disaster at t+ 1 exp (g)F it if there is a disaster at t+ 1 F it is the recovery rate in the dividend of that firm. We postulate the F i t also follows a ... |

81 | Carry Trades and Currency Crashes - Brunnermeier, Nagel, et al. - 2009 |

76 | Implied Exchange Rate Distributions: Evidence from OTC Option Markets - Campa, Chang, et al. - 1998 |

75 | Interest Rates, and Exchange Rates with Endogenously Segmented Asset Markets,” - Alvarez, Atkeson, et al. - 2002 |

66 | Crises and Recoveries in an Empirical Model of Consumption Disasters”. - Barro, Nakamura, et al. - 2009 |

64 | Stochastic skew in currency options - Carr, Wu |

61 | An exchange rates forecast commodity prices?, - Chen, Rogoff, et al. - 2010 |

57 | Time-varying risk, interest rates, and exchange rates in general equilibrium ,” Working Paper - Alvarez, Atkeson, et al. - 2006 |

48 |
The time variation of risk and return in foreign exchange markets: a general equilibrium perspective,”
- Bekaert
- 1996
(Show Context)
Citation Context ... country. The above formulation could be used for many other models of the exchange rate. For instance, the stochastic discount factor M ∗ t+s could come from a model with habit formation (Abel 1990, =-=Bekaert 1996-=-, Campbell Cochrane 1999), long run risk (Bansal and Yaron 2004), or first order risk aversion (Bekaert, Hodrick and Marshall 1997). We choose to study disasters, in part because they have been less s... |

48 | Long Swings in the Dollar: Are They in - Engel, Hamilton - 1990 |

48 | Is there a peso problem? Evidence from the Dollar/Pound exchange rate”. - Kaminsky - 1993 |

48 |
Rethinking an Old Empirical Puzzle: Econometric Evidence on the Forward Discount Anomaly”,
- Maynard, Phillips
- 2001
(Show Context)
Citation Context ...e exchange rate, the forward premium puzzle regression coefficients, and near-random walk exchange rate dynamics. The model is very tractable, and expressions for the exchange rate, interest rate, risk premia, and forward premium puzzle coefficients are obtained in closed forms2. For this, it uses the modelling of environments with stochastic intensity of disasters proposed in a closed economy in Gabaix (2007b) (Rietz (1988) and Barro (2006) have constant intensity of disasters), and the "linearitygenerating" processes developed in Gabaix (2007a). Our framework is also very flexible. We show 1Maynard and Phillips (2001) argue that the forward premium puzzle is the result of misspecification issues. The Fama (1984) regression assumes short-memory stationarity of the data, but evidence contradicts this. Misspecification arises from long memory in the forward premium (the independent variable), and this may induce a bias away from 1. 2Pavlova and Rigobon (2007) also provide an elegant and tractable framework for analyzing the joint behavior of bonds, stocks and exchange rates, which is successful at accounting for comovements among international assets. However, the model is based on a tradition consumption CAP... |

47 | The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: Reply.
- Lustig, Verdelhan
- 2011
(Show Context)
Citation Context ... paper adds to a large body of theoretical work on the UIP condition. On the empirical side, Frankel and Engel (1984) show that a simple CAPM has difficulty explaining deviations from UIP. Most papers test the UIP condition on nominal variables. Two recent studies cast the puzzle in terms of real variables. Hollifield and Yaron (2003) decompose the currency risk premium into conditional inflation risk, real risk, and the interaction between inflation and real risk. They find evidence that real factors, not nominal ones, drive virtually all of the predictable variation in currency risk premia. Lustig and Verdelhan (2007a) find that real aggregate consumption growth risk is priced on currency markets. This provides support for a model which — like ours — focuses on real risk, abstracting from money and inflation. However, Burnside, Eichenbaum, Kleschelski and Rebelo (2007) document that forward premium strategies yield very high Sharpe ratios, but argue that the payoffs of such strategies are not correlated with traditional risk factors. This disagreement spurred a debate on whether or not consumption growth risk explains excess returns on currency speculation (Burnside 2007, Lustig and Verdelhan 2007b). Our ... |

46 | Do Asset—Demand Functions Optimize Over the Mean and Variance of Real Returns? A Six—Currency Test," NBER Working Paper No - Frankel, Engel - 1982 |

43 | Asset prices and exchange rates’,
- Pavlova, Rigobon
- 2003
(Show Context)
Citation Context ...ange rates and risk premia are perfectly correlated. This is an undesirable feature. In this section, we extend our framework to a two-factor model with a risk factor and a business cycle factor (see =-=Pavlova and Rigobon 2007-=-, 2008 for a different framework with several factors). We model country �’s export sector productivity as follows: ��� = ��� (1 + ���) where ��� is 21We take the mean of the absolute values of risk r... |

42 | Consumption-Based Asset Pricing" in Handbook of the Economics of Finance, edited by - Campbell - 2003 |

38 | Understanding the Forward Premium Puzzle: A Microstructure Approach. - Burnside, Eichenbaum, et al. - 2009 |

34 | Linearity-Generating Processes: A Modelling Tool Yielding Closed Forms for Asset Prices,”
- Gabaix
- 2007
(Show Context)
Citation Context ...ms in b���: b���+1 ' exp(−� �� ) b��� + � � ���+1. The “twist” term (1 + ��∗) � (1 + ���) is innocuous from an economic perspective but provides analytical tractability (see the technical appendix in =-=Gabaix 2007-=- for a discussion). 8 Linearity-generating processes allow the derivation of the equilibrium exchange rate in closed form. Proposition 2 (Level of the exchange rate) In terms of the “international cur... |

34 | Risks for the long run and the real exchange rate, - Croce - 2011 |

34 | François “Disaster Risk and - Gourio - 2012 |

30 | 2007), “The cross-section of foreign currency risk premia and consumption growth risk: A comment.” NBER Working Papers 13129
- Burnside
(Show Context)
Citation Context ...offs of such strategies are not correlated with traditional risk factors. This disagreement spurred a debate on whether or not consumption growth risk explains excess returns on currency speculation (=-=Burnside 2007-=-, Lustig and Verdelhan 2007b). Our paper also contributes to the large literature on Peso problems in international finance. See Lewis (2008) for a recent survey. Of most interest to us is Kaminsky (1... |

30 | The Role of Portfolio Constraints - Pavlova, Rigobon - 2008 |

28 | A Long-Run Risks Explanation of Predictability Puzzles - Bansal, Shaliastovich - 2013 |

25 | Ambiguity aversion: Implications for the uncovered interest rate parity puzzle. - Ilut - 2012 |

23 | A Reexamination of the Uncovered Interest Rate Parity Hypothesis - Frachot |

19 | Risk and return on bond, currency and equity markets”. Working paper,
- Bansal, Shaliastovich
- 2007
(Show Context)
Citation Context ...on models pioneered by Abel (1990) and Campbell and Cochrane (1999). In his model, the domestic investor expects to receive a positive foreign currency excess return in bad times when he is more risk-averse than his foreign counterpart. Times of high risk-aversion correspond to low interest rates at home. Thus domestic investors expect positive currency excess returns when domestic interest rates are low and foreign interest rates are high. Finally, Colacito (2006) and Colacito and Croce (2006) apply Bansal and Yaron (2004)’s model with Epstein-Zin-Weil preferences to international economics. Bansal and Shaliastovich (2007) have two-country setting, rely on a perfect cross-country correlation among shocks to the long run components of consumption growth rates to reproduce the UIP puzzle. Turning to explanations based on behavioral biases, Bacchetta and van Wincoop (2006) develop a model where information is costly to acquire and to process. Because of these costs, many investors optimally choose to assess available information and revise their portfolios infrequently. This rational inattention mechanism produces a negative UIP coefficient along the lines suggested by Froot and Thaler (1990) and Lyons (2001): if ... |

16 |
Risks for the Long Run and the Real Exchange Rate.” Working Paper NYU.
- Colacito, Croce
- 2005
(Show Context)
Citation Context ...Atkeson and Kehoe (2006). Most recently, Verdelhan (2007) generates counter-cyclical risk premia via the varying habit formation models pioneered by Abel (1990) and Campbell and Cochrane (1999). In his model, the domestic investor expects to receive a positive foreign currency excess return in bad times when he is more risk-averse than his foreign counterpart. Times of high risk-aversion correspond to low interest rates at home. Thus domestic investors expect positive currency excess returns when domestic interest rates are low and foreign interest rates are high. Finally, Colacito (2006) and Colacito and Croce (2006) apply Bansal and Yaron (2004)’s model with Epstein-Zin-Weil preferences to international economics. Bansal and Shaliastovich (2007) have two-country setting, rely on a perfect cross-country correlation among shocks to the long run components of consumption growth rates to reproduce the UIP puzzle. Turning to explanations based on behavioral biases, Bacchetta and van Wincoop (2006) develop a model where information is costly to acquire and to process. Because of these costs, many investors optimally choose to assess available information and revise their portfolios infrequently. This rational ... |

15 |
Crash Risk in Currency Markets,” Working Paper,
- Farhi, Fraiberger, et al.
- 2014
(Show Context)
Citation Context ...rest rate level and volatility. The potential difficulty lies in calibrating option values at the same time. Using currency options, recent papers (Burnside, Eichenbaum, Kleschelski, and Rebelo 2011, =-=Farhi et al. 2009-=-, as well as Jurek 2009) have concluded that disaster risk plays an important role in currency markets. Still, to some extent, out-of-the-money put premia for risky currencies seemed somewhat low comp... |

15 | Crash-Neutral Currency Carry Trades,” - Jurek - 2014 |

14 | The foreign Exchange Risk Premium: Real and Nominal Factors,” Working paper The Wharton School,
- Hollifield, Yaron
- 2003
(Show Context)
Citation Context ... might be especially vulnerable to expectations errors. Although our model embodies rational expectations, it can also be interpreted along behavioral lines as a consistent framework to analyze the impact of investor sentiment on international asset prices3. Relation to the literature. This paper adds to a large body of theoretical work on the UIP condition. On the empirical side, Frankel and Engel (1984) show that a simple CAPM has difficulty explaining deviations from UIP. Most papers test the UIP condition on nominal variables. Two recent studies cast the puzzle in terms of real variables. Hollifield and Yaron (2003) decompose the currency risk premium into conditional inflation risk, real risk, and the interaction between inflation and real risk. They find evidence that real factors, not nominal ones, drive virtually all of the predictable variation in currency risk premia. Lustig and Verdelhan (2007a) find that real aggregate consumption growth risk is priced on currency markets. This provides support for a model which — like ours — focuses on real risk, abstracting from money and inflation. However, Burnside, Eichenbaum, Kleschelski and Rebelo (2007) document that forward premium strategies yield very ... |

14 | The importance of nontradable goods’ prices in cyclical real exchange rate fluctuations. - Burstein, Eichenbaum, et al. - 2006 |

13 | Motohiro Yogo, Efficient Tests of Stock Return Predictability, NBER Working Papers 10026 - Campbell |

13 |
Exchange rates and asset prices in an open economy with rare disasters! mimeo,
- Guo
- 2007
(Show Context)
Citation Context ...nfrequent switches from contractionary to expansionary monetary policy. She provides evidence that investors’ expectations are consistent with the model. However, she does not examine the forward premium puzzle, and only considers one exchange rate (dollar-sterling) and a short time period. Interestingly, Evans and Lewis (1995) show that a reasonably calibrated regime switching model induces important biases in Fama regressions in small samples — this bias disappears, however, in large samples. To the best of our knowledge, we are the first to adapt the Rietz-Barro paradigm to exchange rates. Guo (2007), subsequently, also adopts this paradigm, in the context of a monetary model, whereas the essence of our model is real. On the theory side, numerous studies have attempted to explain the UIP puzzle in rational expectations settings. Fewmodels, however, are able to reproduce the negative UIP slope coefficient. 3See Frankel and Froot (1989) for an empirical investigation of the irrrationality of investors’ expectations, and more recently Frankel (2007) for an insightful discussion. 4 Here we concentrate on some of the most successful studies. We start by reviewing arguments that rely on counter... |

13 | International Asset Pricing with Recursive Preferences - Colacito, Croce - 2013 |

11 | An Examination of Uncovered Interest Rate Parity in - Hollifield, Uppal - 1997 |

11 | Conditional Risk Premia in Currency Markets and Other Asset Classes. Working Paper 18844. National Bureau of Economic Research. - Lettau, Maggiori, et al. - 2013 |

10 | The Information in Long-Maturity Forward Rates: Implications for Exchange Rates and the Forward Premium Anomaly,” Working Paper, - Boudoukh, Richardson, et al. - 2006 |

10 | Six anomalies looking for a model. A consumption based explanation of international finance puzzles, - Colacito - 2009 |

10 | Global asset pricing, - Lewis - 2011 |

9 | The Forward Premium Puzzle in a Two-Country World,” Working Paper, - Martin - 2011 |

8 | Eichenbaum, Isaac Kleshchelski and Sergio Rebelo (2006) “The Returns to Currency Speculation,” NBER Working Paper 12489 - Burnside, Martin |

7 | The Returns to Currency Speculation.” National Bureau of Economic Research, working paper no - Burnside, Eichenbaum, et al. - 2006 |

7 |
Forward Discount Bias: Is it An Exchange Rate Risk Premium”,
- Frankel, Froot
- 1989
(Show Context)
Citation Context ...5) show that a reasonably calibrated regime switching model induces important biases in Fama regressions in small samples — this bias disappears, however, in large samples. To the best of our knowledge, we are the first to adapt the Rietz-Barro paradigm to exchange rates. Guo (2007), subsequently, also adopts this paradigm, in the context of a monetary model, whereas the essence of our model is real. On the theory side, numerous studies have attempted to explain the UIP puzzle in rational expectations settings. Fewmodels, however, are able to reproduce the negative UIP slope coefficient. 3See Frankel and Froot (1989) for an empirical investigation of the irrrationality of investors’ expectations, and more recently Frankel (2007) for an insightful discussion. 4 Here we concentrate on some of the most successful studies. We start by reviewing arguments that rely on counter-cyclical risk premia. We then discuss the literature that departs from rational expectations and introduces behavioral biases. Frachot (1996) shows that a two-country Cox, Ingersoll, and Ross (1985) framework can account for the UIP puzzle but it does not provide an economic interpretation of the currency risk premium. Backus, Foresi and ... |

6 | The Cross-Section of Foreign Currency - Lustig, Verdelhan |

6 | Common risk factors in currency markets. Working Paper - Lustig, Roussanov, et al. - 2010 |

5 | Getting Carried Away: How the Carry Trade and Its Potential Unwinding Can Explain Movements
- Frankel
- 2007
(Show Context)
Citation Context ...this bias disappears, however, in large samples. To the best of our knowledge, we are the first to adapt the Rietz-Barro paradigm to exchange rates. Guo (2007), subsequently, also adopts this paradigm, in the context of a monetary model, whereas the essence of our model is real. On the theory side, numerous studies have attempted to explain the UIP puzzle in rational expectations settings. Fewmodels, however, are able to reproduce the negative UIP slope coefficient. 3See Frankel and Froot (1989) for an empirical investigation of the irrrationality of investors’ expectations, and more recently Frankel (2007) for an insightful discussion. 4 Here we concentrate on some of the most successful studies. We start by reviewing arguments that rely on counter-cyclical risk premia. We then discuss the literature that departs from rational expectations and introduces behavioral biases. Frachot (1996) shows that a two-country Cox, Ingersoll, and Ross (1985) framework can account for the UIP puzzle but it does not provide an economic interpretation of the currency risk premium. Backus, Foresi and Telmer (2001) pursue a similar line of research and show that affine models of the term structure can only rationa... |

5 |
2007), “A Habit-Based Explanation of the Exchange Rate
- Verdelhan
(Show Context)
Citation Context ...e not correlated with traditional risk factors. This disagreement spurred a debate on whether or not consumption growth risk explains excess returns on currency speculation (Burnside 2007, Lustig and =-=Verdelhan 2007-=-b). Our paper also contributes to the large literature on Peso problems in international finance. See Lewis (2008) for a recent survey. Of most interest to us is Kaminsky (1993) and Evans and Lewis (1... |

5 | Asset Prices and Real Exchange Rates with Deep Habits,” Review of Financial Studies - Heyerdahl-Larsen - 1996 |

4 |
Accounting for U.S. Real Exchange-rate Changes,”
- Engel
- 1999
(Show Context)
Citation Context ...the same time, Eq. 3 gives us a stock view of the exchange rate: the exchange is a present value of future levels of productivity in the country. The above formulation 5In our model, the real exchange rate is the relative price of non-tradables in terms of tradables. The merit of this identity has been investigated in the literature. The debate has focused on whether the relative price of non-tradables is as volatile as the real exchange rate. An important obstacle that any study in this area has to overcome is the identification in the data of pure tradable goods and pure non-tradable goods. Engel (1999) used different measures of tradable goods to conclude that variations in their relative price accounted for a small fraction of real exchange rate movements. Burstein, Eichenbaum and Rebelo (2005, 2006) emphasize that that retail prices of tradable goods contain a substantial fraction of non-tradable inputs. Using prices of traded goods at the dock, they find that the price of nontradable goods relative to tradable goods accounts for a substantial fraction of the movements in the real exchange rate. 7 could be used for many other models of the exchange rate. For instance, the stochastic disco... |

4 | Forward and Spot Exchange Rates in a MultiCurrency World,” Working Paper, - Hassan, Mano - 2013 |

3 |
Peso Problem”, The New Palgrave Dictionary of Economics 2nd Edition,
- Lewis
- 2007
(Show Context)
Citation Context ...10) study numerically related and complementary models, respectively in a monetary and an RBC context. Our paper also contributes to an older literature on peso problems in international finance (see =-=Lewis 2008-=- for a recent survey). Under the “pure peso” view, the forward premium puzzle is due to a small sample bias: the UIP condition would hold in sufficiently large samples. There are no risk premia. By co... |

3 | General Equilibrium Pricing of Currency and Currency - Du - 2013 |

3 | The Term Structure of Currency Carry Trade Risk Premia,” Working Paper - Lustig, Stathopoulos, et al. - 2014 |

3 | Testing for Rational Expectations - Tryon - 1979 |

3 | Large Devaluations and the Real Exchange Rate,” Journal of Political Economy, - Burstein, Eichenbaum, et al. - 2005 |

3 |
Stochastic Skew in Currency
- Carr, Wu
- 2007
(Show Context)
Citation Context ...latilities for out of the money puts than out of the money calls. Indeed, the presence of extreme events generates a smile and the possibility for a country to be riskier than the other generates a skew. We show that in the model, the price of out of the money risk-reversals — and indicator of the premium of out of the money puts on out of the money calls — can be directly linked to currency risk premia. According to our theory, when out of the money puts are relatively more expensive, the corresponding currency should be depreciated and expected to appreciate. Campa, Chang and Reider (1998), Carr and Wu (2007) provide evidence that, as predicted by the model, when out of the money put prices increase relative to out of the money call prices, the corresponding currency simultaneously depreciates. Farhi, Gabaix, Ranciere and Verdelhan (2008) confirm this result on a larger sample of currencies for a longer time period; in addition, this paper shows that high risk-reversal prices predict currency appreciations and tests a number of other joint predictions of the model for currency option prices and other international and domestic asset prices. Finally, we provide a calibration of the model. We show t... |

2 | Eichenbaum and Sergio Rebelo, “The Importance of Nontradables Goods - Burstein, Martin - 2006 |

2 | Ranciere, Adrien Verdelhan, “Currency movements and options prices,” in preparation - Farhi, Gabaix, et al. - 2008 |

2 | Disaster risk and business cycles. Unpublished working paper - Gourio - 2010 |

2 | Disasterization: A Tractable Way to Fix the Asset Pricing - Gabaix |

2 | International Liquidity and Exchange Rate Dynamics,” Quarterly - Gabaix, Maggiori |

2 | Asset Prices and Risk Sharing - Stathopoulos - 2012 |

1 | Exchange Rates and Asset Prices in An Open Economy with Rare Disasters,” Working Paper - Kai - 2007 |

1 | Do Long Term Swings in the Dollar affect - Evans, Lewis - 1995 |

1 | International Risk Cycles. Unpublished working paper - Gourio, Siemer, et al. - 2010 |

1 | Exchange Rates Under Robustness: The Forward Premium Puzzle and Momentum,” Mimeo. - Li, Tornell - 2008 |

1 | Federico Gavazzoni and Robert Ready, “Currency Risk Factors in a Recursive Multi-Country Economy,” Working Paper - Colacito, Croce - 2015 |

1 | Disaster Risk and Recoveries - Gourio |

1 | Roussanov and Adrien Verdelhan, “Common Risk Factors - Lustig, Nikolai |