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Bubbles and Crashes in a Behavioural Finance Model

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  • De Grauwe, Paul

    ()
    (University of Leuven)

  • Grimaldi, Marianna

    ()
    (Research Department, Central Bank of Sweden)

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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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    File URL: http://www.riksbank.se/upload/WorkingPapers/WP_164.pdf
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    Bibliographic Info

    Paper provided by Sveriges Riksbank (Central Bank of Sweden) in its series Working Paper Series with number 164.

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    Length: 44 pages
    Date of creation: 01 May 2004
    Date of revision:
    Handle: RePEc:hhs:rbnkwp:0164

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    Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
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    Fax: 08-21 05 31
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    Web page: http://www.riksbank.com/
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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. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, Econometric Society, vol. 50(5), pages 1163-81, September.
    2. 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.
    3. Shang-Jin Wei & Jungshik Kim, 1999. "The Big Players in the Foreign Exchange Market: Do They Trade on Information or Noise?," CID Working Papers, Center for International Development at Harvard University 5, Center for International Development at Harvard University.
    4. Evans, Martin D. & Lyons, Richard K., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance, Working Paper Series, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley qt0dh1c16w, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
    5. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers, University of California at Berkeley, Economics Department _124, University of California at Berkeley, Economics Department.
    6. 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.
    7. Thomas Lux & D. Sornette, 1999. "On Rational Bubbles and Fat Tails," Papers cond-mat/9910141, arXiv.org.
    8. Mordecai Kurz & Maurizio Motolese, 1999. "Endogenous Uncertainty and Market Volatility," Working Papers, Fondazione Eni Enrico Mattei 1999.27, Fondazione Eni Enrico Mattei.
    9. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262150476, December.
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    11. 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.
    12. Kenneth A. Froot & Jeffrey A. Frankel, 1989. "Interpreting Tests of Forward Discount Bias Using Survey Data on Exchange Rate Expectations," NBER Working Papers 1963, National Bureau of Economic Research, Inc.
    13. 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.
    14. Brock, W.A. & Hommes, C.H., 1996. "A Rational Route to Randomness," Working papers, Wisconsin Madison - Social Systems 9530r, Wisconsin Madison - Social Systems.
    15. Isard,Peter, 1995. "Exchange Rate Economics," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521460477.
    16. Isard,Peter, 1995. "Exchange Rate Economics," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521466004.
    17. 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.
    18. 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.
    19. 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.
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    Cited by:
    1. Ravi Dhar & William Goetzmann, 2005. "Bubble Investors: What Were They Thinking?," Yale School of Management Working Papers, Yale School of Management ysm446, Yale School of Management, revised 01 Aug 2006.

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