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Views from Complexity Theory

In: Forecasting and Hedging in the Foreign Exchange Markets

Author

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  • Christian Ullrich

    (BMW AG)

Abstract

The behavior of exchange rates is puzzling and hard to explain. While all of the potential explanations for deviations from equilibrium conditions appear fairly reasonable and have theoretical merit, PPP and IRP (forward premium anomaly) puzzles have not yet been convincingly explained and continue to puzzle the international economics and finance profession. However, this inexplicability has nothing to do with economic and financial theorists being not capable enough but rather with the complex dynamics that drive exchange rates and therefore, with the nature of complexity itself. Shiller [366] notes that all economic models have one major flaw: a gross oversimplification that is based on the assumption that economic agents know the true state of economic structure and make rational decisions for their consumption and investment. In a similar way, [351] argues that the inexplicability of such complex systems may have to do with the existence of fundamental limits to knowledge: This would suggest that financial theory cannot hope to provide much more than a disjoint collection of highly simplified “ toy models” which are either sufficiently stylized to be solved analytically, or are simple enough to be approximately solved on digital computers. In fact, conventional economic and financial theory does not choose to study the unfolding of the patterns its agents create. By assuming behavioral equilibrium, it rather simplifies its questions in order to seek analytical solutions. For example, standard theories of financial markets assume rational expectations and ask: what forecasts (or expectations) are consistent with – are on average validated by – the prices these forecasts and expectations together create. But it does not account for actual market “ anomalies” such as unexpected price bubbles and crashes, random periods of high and low volatility, and the use of heavy technical trading. Hence, it is legitimate to ask whether economic and financial theory can provide sufficient explanations for reality.

Suggested Citation

  • Christian Ullrich, 2009. "Views from Complexity Theory," Lecture Notes in Economics and Mathematical Systems, in: Forecasting and Hedging in the Foreign Exchange Markets, chapter 5, pages 29-37, Springer.
    • Handle: RePEc:spr:lnechp:978-3-642-00495-7_5
    DOI: 10.1007/978-3-642-00495-7_5
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