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Deterministic Chaos in the Foreign Exchange Markets

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  • De Grauwe, Paul
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    Abstract

    Linear models in which exchange rates are driven by stochastic `news' are subject to a number of failings. In this paper we present a non-linear, deterministic model, incorporating concepts from chaos theory, which is capable of producing unpredictable exchange rate movements without `news'. Two non-linearities arise from a J-curve effect in the trade balance and the modelling of both `chartist' and `fundamental' influences in expectations formation. The model displays extreme sensitivity to only small changes in its initial conditions and its parameter values - one of the requirements for a model to generate chaotic behaviour. Only a few periods after such changes, the time path of the exchange rate appears to have been generated from a totally different model. This implies that forecasts based on exchange rate models are effectively impossible, because the tiniest errors generate totally different paths for the exchange rate. The results warn against excessive reliance on `news' to explain exchange rate movements.

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    Bibliographic Info

    Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 370.

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    Date of creation: Jan 1990
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    Handle: RePEc:cpr:ceprdp:370

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    Related research

    Keywords: Chaos; Exchange Rates Forecasting; Non-Fundamental Influences; Non-Linear Models;

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    Cited by:
    1. Lisi, Francesco & Schiavo, Rosa A., 1999. "A comparison between neural networks and chaotic models for exchange rate prediction," Computational Statistics & Data Analysis, Elsevier, vol. 30(1), pages 87-102, March.
    2. Federici, Daniela & Gandolfo, Giancarlo, 2012. "The Euro/Dollar exchange rate: Chaotic or non-chaotic? A continuous time model with heterogeneous beliefs," Journal of Economic Dynamics and Control, Elsevier, vol. 36(4), pages 670-681.
    3. Wan, Jer-Yuh & Kao, Chung-Wei, 2009. "Evidence on the contrarian trading in foreign exchange markets," Economic Modelling, Elsevier, vol. 26(6), pages 1420-1431, November.
    4. Sergio Da Silva, 2004. "The Dornbusch Model with Chaos and Foreign Exchange Intervention," International Finance 0405017, EconWPA.
    5. Fernando Fernández-Rodríguez & Simón Sosvilla-Rivero & Julián Andrada-Félix, . "Nearest-Neighbour Predictions in Foreign Exchange Markets," Working Papers 2002-05, FEDEA.
    6. Fernandez-Rodriguez, Fernando & Sosvilla-Rivero, Simon & Andrada-Felix, Julian, 1999. "Exchange-rate forecasts with simultaneous nearest-neighbour methods: evidence from the EMS," International Journal of Forecasting, Elsevier, vol. 15(4), pages 383-392, October.

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