General Equilibrium Pricing of Currency and Currency Options with Variable Disasters and Recursive Utility

This paper proposes a preference-based general equilibrium model that explains various pricing features of currency and currency options. The central ingredients are i) a variable disaster component that is highly but imperfectly shared across countries, and ii) the separation of EIS from risk aversion facilitated by the Epstein-Zin preference which enables the direct pricing of disaster risks. The predominant global disaster component reconcile the discrepancy between poorly shared consumption shocks and high risk sharing implied from the smooth exchange rate series. When investors strongly prefer earlier resolutions of intertemporal risks, positive shocks on home disaster intensity produce foreign currency premium large enough to offset the associated decreases of home interest rate. As the result, the foreign currency which pays higher interest rate tends to appreciate. Country-specific disasters move independently, and they induce skewness in exchange rate changes with opposite signs, which generates the substantial variations in option risk reversal as a measure of the skewness. The model also accounts for the aggregate stock and option market behaviors