Advanced Search
MyIDEAS: Login

Expectations driven distortions in the foreign exchange market

Contents:

Author Info

  • Westerhoff, Frank H.

Abstract

The aim of this paper is to explain the phenomenon of distortions in the foreign exchange market. Distortions in the sense of (lasting) deviations of the exchange rate from its fundamental value are a sign of market inefficiency. One well known example for such a phenomenon is the bubble path of the US Dollar in the eighties. The starting point for our investigation is a chartists-fundamentalists model. Motivated by empirical observations a model is developed where boundedly rational market participants choose at the beginning of each new trading period between a technical and a fundamental trading rule to determine their speculative investment positions. If one subscribes to the strong assumption that the agents are able to figure out the true fundamental value of the exchange rate, then the exchange rate fluctuates in a complex way around its fundamental value and the foreign exchange market is more or less efficient. However, the contribution of this paper is to model the perception process of the fundamental exchange rate more realistically on the grounds of psychological evidence. Within this framework forces which influence the distortion are analysed: While the agents follow the news arrival process closely, mistakes in the information processing occur. These mistakes are propagated over time since the agents tend to stick to their previously perceived fundamental value (anchor heuristic). Moreover, if the agents belief that the spot exchange rate itself contains relevant information and thus incorporate it into their "anchor", the exchange rate becomes even more disconnected with its true fundamental. Nevertheless, in the long run the agents react to macroeconomic imbalances and thus adjust their perception. By this learning procedure, the distortion eventually is corrected and some long-term mean-reversion sets in. Note that the results are not the outcome of curious exchange rate fluctuations but that the generated time series shares some basic

(This abstract was borrowed from another version of this item.)

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.sciencedirect.com/science/article/B6V8F-4691HPM-1/2/43da7ded46f5c971e87a853213ae900c
Download Restriction: Full text for ScienceDirect subscribers only

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Behavior & Organization.

Volume (Year): 51 (2003)
Issue (Month): 3 (July)
Pages: 389-412

as in new window
Handle: RePEc:eee:jeborg:v:51:y:2003:i:3:p:389-412

Contact details of provider:
Web page: http://www.elsevier.com/locate/jebo

Related research

Keywords:

Other versions of this item:

Find related papers by JEL classification:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. J. Doyne Farmer, 1999. "Market Force, Ecology, and Evolution," Computing in Economics and Finance 1999 651, Society for Computational Economics.
  2. Goodhart, Charles, 1988. "The Foreign Exchange Market: A Random Walk with a Dragging Anchor," Economica, London School of Economics and Political Science, vol. 55(220), pages 437-60, November.
  3. Frankel, Jeffrey A & Froot, Kenneth A, 1986. "Understanding the U.S. Dollar in the Eighties: The Expectations of Chartists and Fundamentalists," The Economic Record, The Economic Society of Australia, vol. 0(0), pages 24-38, Supplemen.
  4. Takatoshi Ito, 1990. "Foreign Exchange Rate Expectations: Micro Survey Data," NBER Working Papers 2679, National Bureau of Economic Research, Inc.
  5. Cutler, David M & Poterba, James M & Summers, Lawrence H, 1990. "Speculative Dynamics and the Role of Feedback Traders," American Economic Review, American Economic Association, vol. 80(2), pages 63-68, May.
  6. Menkhoff, Lukas, 1997. "Examining the Use of Technical Currency Analysis," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 2(4), pages 307-18, October.
  7. Brock, William & Lakonishok, Josef & LeBaron, Blake, 1992. " Simple Technical Trading Rules and the Stochastic Properties of Stock Returns," Journal of Finance, American Finance Association, vol. 47(5), pages 1731-64, December.
  8. Hommes, C.H. & Sonnemans, J. & Tuinstra, J. & van de Velden, H., 1999. "Expectation Driven Price Volatility in an Experimental Cobweb Economy," CeNDEF Working Papers 99-07, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  9. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, vol. 65(5), pages 1059-1096, September.
  10. Lux, Thomas, 1997. "Time variation of second moments from a noise trader/infection model," Journal of Economic Dynamics and Control, Elsevier, vol. 22(1), pages 1-38, November.
  11. Taylor, Mark P. & Allen, Helen, 1992. "The use of technical analysis in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 11(3), pages 304-314, June.
  12. Brock, William A & LeBaron, Blake D, 1996. "A Dynamic Structural Model for Stock Return Volatility and Trading Volume," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 94-110, February.
  13. Black, Fischer, 1986. " Noise," Journal of Finance, American Finance Association, vol. 41(3), pages 529-43, July.
  14. Brock, William A. & Hommes, Cars H., 1998. "Heterogeneous beliefs and routes to chaos in a simple asset pricing model," Journal of Economic Dynamics and Control, Elsevier, vol. 22(8-9), pages 1235-1274, August.
  15. Goodhart, Charles A. E. & McMahon, Patrick C. & Ngama, Yerima L., 1993. "Testing for unit roots with very high frequency spot exchange rate data," Journal of Macroeconomics, Elsevier, vol. 15(3), pages 423-438.
  16. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Menkhoff, Lukas & Taylor, Mark P., 2006. "The Obstinate Passion of Foreign Exchange Professionals: Technical Analysis," Diskussionspapiere der Wirtschaftswissenschaftlichen Fakultät der Leibniz Universität Hannover dp-352, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
  2. Kaltwasser, Pablo Rovira, 2010. "Uncertainty about fundamentals and herding behavior in the FOREX market," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 389(6), pages 1215-1222.
  3. Reitz, Stefan & Rülke, Jan-Christoph & Stadtmann, Georg, 2012. "Nonlinear expectations in speculative markets - Evidence from the ECB survey of professional forecasters," Discussion Papers of Business and Economics 1/2012, Department of Business and Economics, University of Southern Denmark.
  4. Lukas Menkhoff & Rafael R. Rebitzky & Michael Schröder, 2008. "Heterogeneity in Exchange Rate Expectations: Evidence on the Chartist-Fundamentalist Approach," CESifo Working Paper Series 2502, CESifo Group Munich.
  5. De Grauwe, Paul & Rovira Kaltwasser, Pablo, 2012. "Animal spirits in the foreign exchange market," Journal of Economic Dynamics and Control, Elsevier, vol. 36(8), pages 1176-1192.
  6. Murphy, Austin, 2008. "An empirical investigation of investor expectations in the currency market," International Review of Financial Analysis, Elsevier, vol. 17(1), pages 108-133.
  7. Frank Westerhoff, 2003. "Multi-Asset Market Dynamics," Computing in Economics and Finance 2003 88, Society for Computational Economics.
  8. Georges, Christophre, 2006. "Learning with misspecification in an artificial currency market," Journal of Economic Behavior & Organization, Elsevier, vol. 60(1), pages 70-84, May.
  9. Ling-Yun He, 2010. "Is Price Behavior Scaling and Multiscaling in a Dealer Market? Perspectives from Multi-Agent Based Experiments," Computational Economics, Society for Computational Economics, vol. 36(3), pages 263-282, October.
  10. Ahmad Naimzada & Marina Pireddu, 2014. "Real and financial interacting oscillators: a behavioral macro-model with animal spirits," Working Papers 268, University of Milano-Bicocca, Department of Economics, revised Feb 2014.
  11. Schmidt, Robert & Wollmershäuser, Timo, 2004. "Sterilized Foreign Exchange Market Interventions in a Chartist-Fundamentalist Exchange Rate Model," W.E.P. - Würzburg Economic Papers 50, University of Würzburg, Chair for Monetary Policy and International Economics.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:eee:jeborg:v:51:y:2003:i:3:p:389-412. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.