Rare Disasters and Exchange Rates *

Rare Disasters and Exchange Rates

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 prod...

Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates

What is the best way to incorporate a risk premium into the discount rate schedule for a real investment project with uncertain payo¤s? The standard CAPM formula suggests a beta-weighted average of the return on a safe investment and the mean return on an economy-wide representative risky investment. Suppose, though, that the project constitutes a tail-hedged investment, meaning that it is expe...

Nonlinearity In Exchange Rates and Forecasting

Rare Disasters and Credit Market Puzzles

We embed systematic default, procyclical recovery rates and habit persistence into a model with a slight possibility of a macroeconomic disaster of reasonable magnitude. We derive analytical solutions for defaultable bond prices and show that a single set of structural parameters calibrated to the real economy—and not to bond prices—can simultaneously explain several key empirical regularities ...

Rare Disasters, Asset Prices, and Welfare Costs

In a previous study, Barro (2006), I used the Thomas A. Rietz (1988) idea of rare economic disasters to explain the equity premium and related asset-pricing puzzles. My quantitative examination of large macroeconomic contractions in 35 countries during the twentieth century suggested a disaster probability of roughly 2 percent per year. The size distribution of GDP contractions during these eve...