Advanced Search
MyIDEAS: Login

Expectations Driven Distortions in the Foreign Exchange Market

Contents:

Author Info

  • Frank Westerhoff

    (University of Osnabrück)

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 stylized facts with the empirical data. For instance, the model possesses the property of a non stable, fat-tailed distribution of the returns.

Download Info

To our knowledge, this item is not available for download. To find whether it is available, there are three options:
1. Check below under "Related research" whether another version of this item is available online.
2. Check on the provider's web page whether it is in fact available.
3. Perform a search for a similarly titled item that would be available.

Bibliographic Info

Paper provided by Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance in its series CeNDEF Workshop Papers, January 2001 with number 1A.3.

as in new window
Length:
Date of creation: 04 Jan 2001
Date of revision:
Handle: RePEc:ams:cdws01:1a.3

Contact details of provider:
Postal: Dept. of Economics and Econometrics, Universiteit van Amsterdam, Roetersstraat 11, NL - 1018 WB Amsterdam, The Netherlands
Phone: + 31 20 525 52 58
Fax: + 31 20 525 52 83
Email:
Web page: http://www.fee.uva.nl/cendef/
More information through EDIRC

Related research

Keywords: exchange rate theory; technical and fundamental trading rules; expectations and learning; market efficiency;

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. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, vol. 65(5), pages 1059-1096, September.
  2. J. Doyne Farmer, 2002. "Market force, ecology and evolution," Industrial and Corporate Change, Oxford University Press, vol. 11(5), pages 895-953, November.
  3. 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.
  4. 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.
  5. Culter, D.M. & Poterba, J.M. & Summers, L.H., 1990. "Speculative Dynamics And The Role Of Feedback Traders," Working papers 545, Massachusetts Institute of Technology (MIT), Department of Economics.
  6. 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.
  7. 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.
  8. William A. Brock & Blake D. LeBaron, 1995. "A Dynamic Structural Model for Stock Return Volatility and Trading Volume," NBER Working Papers 4988, National Bureau of Economic Research, Inc.
  9. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
  10. Takatoshi Ito, 1988. "Foreign Exchange Rate Expectations: Micro Survey Data," NBER Working Papers 2679, National Bureau of Economic Research, Inc.
  11. 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.
  12. Black, Fischer, 1986. " Noise," Journal of Finance, American Finance Association, vol. 41(3), pages 529-43, July.
  13. 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.
  14. 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.
  15. 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.
  16. 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.
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. Lukas Menkhoff & Mark P. Taylor, 2007. "The Obstinate Passion of Foreign Exchange Professionals: Technical Analysis," Journal of Economic Literature, American Economic Association, vol. 45(4), pages 936-972, December.
  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. 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.
  4. Stefan Reitz & Jan-Christoph Rülke & Georg Stadtmann, 2011. "Nonlinear Expectations in Speculative Markets - Evidence from the ECB Survey of Professional Forecasters," Kiel Working Papers 1706, Kiel Institute for the World Economy.
  5. Menkhoff, Lukas & Rebitzky, Rafael R. & Schröder, Michael, 2009. "Heterogeneity in exchange rate expectations: Evidence on the chartist-fundamentalist approach," Journal of Economic Behavior & Organization, Elsevier, vol. 70(1-2), pages 241-252, May.
  6. 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.
  7. Georges, Christophre, 2006. "Learning with misspecification in an artificial currency market," Journal of Economic Behavior & Organization, Elsevier, vol. 60(1), pages 70-84, May.
  8. 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.
  9. Frank Westerhoff, 2003. "Multi-Asset Market Dynamics," Computing in Economics and Finance 2003 88, Society for Computational Economics.
  10. 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.
  11. 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.
  12. 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.
  13. 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.
  14. 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.

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:ams:cdws01:1a.3. 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: (Christopher F. Baum).

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.