Stern Professor Receives $400,000 NSF Grant to Study Rare Disasters and Exchange Rates

Stern School of Business associate professor of finance Xavier Gabaix, with Emmanuel Farhi, assistant professor of economics at Harvard University, has received a $402,342 grant from the National Science Foundation to study rare disasters and exchange rates. The project proposes a new model of exchange rates, which combines the possibility of rare economic disasters and an asset view of the exchange rate.
    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, where stock prices revert to a long-term level. Countries considered “risky” 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.
    The research offers the potential to understand the impact of exchange rate pegging. This is particularly relevant as a large fraction of emerging countries (e.g., China) peg their currency, and to analyze pegs, one needs a model that generates a volatile exchange rate in the absence of a peg. In addition, the model explains how the importance of large disasters can be detected in asset prices, which can help determine ways to prevent disasters in the first place—an important goal for policymakers.
    “Although our project began before the current U.S. market meltdown, the financial crisis shows that the possibility of rare disasters is actually very real,” notes Gabaix. “And while the crisis is unfortunate, it provides an opportunity for conducting useful research.”