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Expectations Driven Distortions in the Foreign Exchange Market

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  • Frank H. Westerhoff

Abstract

This paper explores the phenomenon of lasting deviations of the exchange rate from its fundamental value in the foreign exchange market. Motivated by empirical observations a chartists-fundamentalists model is developed in which boundedly rational agents repeatedly choose between technical and fundamental trading rules to determine their speculative investment positions. Crucial for the dynamics is how the traders perceive the fundamental exchange rate. This perception process is based on psychological evidence. Simulations give rise to bubbles but simultaneously display quite realistic exchange rate dynamics (unit roots in the exchange rates, fat tails for returns, and volatility clustering).

Suggested Citation

  • Frank H. Westerhoff, 2001. "Expectations Driven Distortions in the Foreign Exchange Market," Computing in Economics and Finance 2001 48, Society for Computational Economics.
    • Handle: RePEc:sce:scecf1:48
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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