Bet against the trend and cash in profits: An agent-based model of endogenous fluctuations of exchange rates

This paper intends to contribute to the literature on the determinants of exchange rate fluctuations. We build an agent-based model inspired by the literature on behavioral finance and by empirical surveys about the behavior of foreign exchange professionals. In our artificial economy, traders allocate their wealth across heterogeneous assets based on expectations about exchange and interest rate fluctuations. Fundamentalists use both fundamental and technical signals, but overweight the former, while chartists only employ technical signals, and are either trend followers or trend contrarians. Each class of traders represents a fixed share of total traders. We find that the simultaneous co-existence of heterogeneous strategies can explain most stylized facts of foreign exchange markets, despite the absence of short-run switching from less to more profitable rules. Moreover, contrary to the predictions of the Market Selection Hypothesis, we find that heterogeneity of expectations is an essential requirement for traders’ profitability, as no class of traders can dominate the market profitably.