Can the interaction between a single long-term attractor and heterogeneous trading explain exchange rate behaviour? A nonlinear econometric investigation

Over the last 15 years, exchange rate movements have been smoother and slower than expected, given the entity of the sharp shifts in the fundamental variables brought about by the international financial crisis. Since the beginning of the ’90s researchers have explored different approaches in order to understand high frequency exchange rate dynamics. Among them the model that assumes heterogeneous trading strategies, where ‘fundamentalists’ coexist with ‘chartists’ in nonlinear transitional specifications, plays an increasingly relevant if puzzling role. We study the US dollar, the British pound and the Japanese yen vs the euro over the period 2002 to 2016 using weekly data. The most important contribution of this paper is that we find empirical evidence that both types of agent react to the same transition variable, viz. the absolute distance of the actual exchange rate to its relative PPP value. The spot foreign currency demand of fundamentalists is driven by the size of the misalignment both directly and through a transition function, which models the adoption of fundamental strategies by newcomers. The number of chartists also varies according to the absolute distance of the exchange rate change from its fundamental value. Evidence supports the existence of stabilizing and destabilizing behaviour not only by chartists but also by fundamentalists.