Disaster risk and currency returns

A paper by Farhi and Gabaix explains how fear of global crisis leads to outperformance of risky versus less risky currencies. Carry trades have worked historically, because high risk premia conditioned both high interest rates and subsequent revaluation. As a practical conclusion, gaps between perceived risk (often based on historical variances and correlation) and actual fundamental risk (as indicated by fundamental macro factors) are key value generators in FX strategies.