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Bubbles and crashes in a Behavioural Finance Model

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  • Paul De Grauwe

    (University of Leuven)

  • Marianna Grimaldi

    (Sveriges Riksbank)

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    Abstract

    We develop a simple model of the exchange rate in which agents optimize their portfolio and use different forecasting rules. They check the profitability of these rules ex post and select the more profitable one.This model produces two kinds of equilibria, a fundamental and a bubble one. In a stochastic environment the model generates a complex dynamics in which bubbles and crashes occur at unpredictable moments. We contrast these "behavioural" bubbles with "rational" bubbles.

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    Bibliographic Info

    Paper provided by Departamento de Economia, Gestão e Engenharia Industrial, Universidade de Aveiro in its series Working Papers de Economia (Economics Working Papers) with number 25.

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    Length: 41 pages
    Date of creation: Aug 2005
    Date of revision:
    Handle: RePEc:ave:wpaper:252005

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    Related research

    Keywords: exchange rate; bounded rationality; heterogeneous agents; bubbles and crashes; complex dynamics.;

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    References

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    1. Charles Engel & James Morley, 2000. "The Adjustment of Prices and the Adjustment of the Exchange Rate," Working Papers, University of Washington, Department of Economics 0009, University of Washington, Department of Economics.
    2. Martin D. D. Evans & Richard K. Lyons, 2002. "Order Flow and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 110(1), pages 170-180, February.
    3. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, Econometric Society, vol. 65(5), pages 1059-1096, September.
    4. Philippe Bacchetta & Eric Van Wincoop, 2006. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," American Economic Review, American Economic Association, American Economic Association, vol. 96(3), pages 552-576, June.
    5. Wei, S.J. & Kim, J., 1999. "The Big Players in the Foreign Exchange Market: Do They Trade on Information or Noise?," Papers, Chicago - Graduate School of Business 5, Chicago - Graduate School of Business.
    6. Yin-Wong Cheung & Menzie D. Chinn, 1999. "Macroeconomic Implications of the Beliefs and Behavior of Foreign Exchange Traders," NBER Working Papers 7417, National Bureau of Economic Research, Inc.
    7. Mordecai Kurz & Maurizio Motolese, 1999. "Endogenous Uncertainty and Market Volatility," Working Papers, Fondazione Eni Enrico Mattei 1999.27, Fondazione Eni Enrico Mattei.
    8. Thomas Lux & D. Sornette, 1999. "On Rational Bubbles and Fat Tails," Papers cond-mat/9910141, arXiv.org.
    9. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 36, pages 394.
    10. Yin-Wong Cheung & Menzie D. Chinn & Ian W. Marsh, 2000. "How Do UK-Based Foreign Exchange Dealers Think Their Market Operates?," NBER Working Papers 7524, National Bureau of Economic Research, Inc.
    11. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 84(6), pages 1161-76, December.
    12. Chiarella, Carl & Dieci, Roberto & Gardini, Laura, 2002. "Speculative behaviour and complex asset price dynamics: a global analysis," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 49(2), pages 173-197, October.
    13. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, Elsevier, vol. 14(1-2), pages 3-24, February.
    14. Menkhoff, Lukas, 1997. "Examining the Use of Technical Currency Analysis," International Journal of Finance & Economics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 2(4), pages 307-18, October.
    15. Lui, Yu-Hon & Mole, David, 1998. "The use of fundamental and technical analyses by foreign exchange dealers: Hong Kong evidence," Journal of International Money and Finance, Elsevier, Elsevier, vol. 17(3), pages 535-545, June.
    16. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
    17. Lux, T. & M. Marchesi, . "Volatility Clustering in Financial Markets: A Micro-Simulation of Interacting Agents," Discussion Paper Serie B, University of Bonn, Germany 437, University of Bonn, Germany, revised Jul 1998.
    18. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer, Springer, vol. 4(6), pages 877-900, October.
    19. Kandel, Eugene & Pearson, Neil D, 1995. "Differential Interpretation of Public Signals and Trade in Speculative Markets," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(4), pages 831-72, August.
    20. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, Elsevier, vol. 3(4), pages 387-389.
    21. Taylor, Mark P. & Allen, Helen, 1992. "The use of technical analysis in the foreign exchange market," Journal of International Money and Finance, Elsevier, Elsevier, vol. 11(3), pages 304-314, June.
    22. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198296980, October.
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