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Expectations driven distortions in the foreign exchange market

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  • 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

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

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

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Handle: RePEc:eee:jeborg:v:51:y:2003:i:3:p:389-412

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Cited by:
  1. 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.
  2. Carl Chiarella & Xue-Zhong He & Min Zheng, 2009. "Heterogeneous Expectations and Exchange Rate Dynamics," Research Paper Series 243, Quantitative Finance Research Centre, University of Technology, Sydney.
  3. Menkhoff, Lukas & Taylor, Mark P., 2006. "The Obstinate Passion of Foreign Exchange Professionals : Technical Analysis," The Warwick Economics Research Paper Series (TWERPS) 769, University of Warwick, Department of Economics.
  4. 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.
  5. Reitz, Stefan & Rülke, Jan & Stadtmann, Georg, 2012. "Nonlinear Expectations in Speculative Markets," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 62045, Verein für Socialpolitik / German Economic Association.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. Westerhoff, Frank H., 2004. "Multiasset Market Dynamics," Macroeconomic Dynamics, Cambridge University Press, vol. 8(05), pages 596-616, November.
  11. Neslihan Topbas, 2014. "Tests of Rationality in Turkish Foreign Exchange Market," Central Bank Review, Research and Monetary Policy Department, Central Bank of the Republic of Turkey, vol. 14(2), pages 65-78.
  12. 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.
  13. Georges, Christophre, 2006. "Learning with misspecification in an artificial currency market," Journal of Economic Behavior & Organization, Elsevier, vol. 60(1), pages 70-84, May.
  14. 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.

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