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Expectation formation in the foreign exchange market: a time-varying heterogeneity approach using survey data

  • Georges Prat
  • Remzi Uctum

Using Consensus Economics survey data on JPY/USD and GBP/USD exchange rate expectations for the 3- and 12-month horizons over the period November 1989 – December 2012 we first show that expectations fail to unbiasedness tests and do not exhibit a learning process towards rationality. Our approach is consistent with the economically rational expectations theory (Feige and Pearce, 1976), which states that information costs and agents’ aversion of misestimating future exchange rates determine the optimal amounts of information on which they base their expectations. The time-variability of the cost/aversion ratios justifies at the aggregate level a representation of expectations as a linear combination of the traditional extrapolative, adaptive and regressive processes augmented by a forward market component, whose parameters are allowed to change over time. This mixed expectation model with unstable heterogeneity is validated by our Kalman Filter estimation results for the two currencies and the two horizons considered. Although the chartist behavior, gathering the extrapolative and adaptive components, appears to dominate the fundamentalist behavior, described by the regressive and forward market components, the relative importance of the fundamentalists (chartists) is found to increase (decrease) with the time-horizon.

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Paper provided by University of Paris West - Nanterre la Défense, EconomiX in its series EconomiX Working Papers with number 2014-17.

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Length: 28 pages
Date of creation: 2014
Date of revision:
Handle: RePEc:drm:wpaper:2014-17
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