The excess volatility of foreign exchange rates: Statistical puzzle or theoretical artifact?

The inability to reconcile observed levels of foreign exchange rate volatility with predictions derived from rational expectations models represents one of the most persistent challenges in international finance. This paper shows that such excess volatility puzzles arise from informational assumptions by contrasting exchange rate equilibria under two different hypotheses: rational expectations and their generalization, rational beliefs. Under the latter agents hold data rather than model consistent expectations requiring learning and inference. Uncertainty arises endogenously as agents with diverse beliefs might trade even in the absence of new information. An analysis of currency volatility mechanisms now reveals that excess volatility is a theoretical consequence of rational expectations' structural knowledge assumptions. Markets only transmit volatility from exogenous variables to exchange rates without any amplification mechanism. Hence, rational expectations equilibria provide a lower volatility bound on more general exchange rate processes solving the excess volatility puzzle in terms of endogenous volatility generation. Finally, the results are applied to explore the structure of currency crises as short-lived rational deviations from economic fundamentals.