The Exchange Rate in a Behavioral Finance

This book provides an alternative view of the workings of foreign exchange markets. The authors' modeling approach is based on the idea that agents use simple forecasting rules and switch to those rules that have been shown to be the most profitable in the past. This selection mechanism is based on trial and error and is probably the best possible strategy in an uncertain world, the authors contend. It creates a rich dynamic in the foreign exchange markets and can generate bubbles and crashes. Sensitivity to initial conditions is a pervasive force in De Grauwe and Grimaldi's model. It explains why large exchange-rate changes and volatility clustering occur. It also has important implications for understanding how the news affects the exchange rate. De Grauwe and Grimaldi conclude that news in fundamentals has an unpredictable effect on the exchange rate. Sometimes, they maintain, it alters the exchange rate considerably; at other times it has no effectwhatsoever. The authors also use their model to analyze the effects of official interventions in the foreign exchange market. They show that simple intervention rules of the "leaning-against-the-wind" variety can be effective in eliminating bubbles and crashes in the exchange rate. They further demonstrate how, quite paradoxically, by intervening in the foreign exchange market the central bank makes the market look more efficient. Clear and comprehensive,The Exchange Rate in a Behavioral Finance Frameworkis a must-have for analysts in foreign exchange markets as well as students of international finance and economics.

Paul De Grauwe is Professor of International Economics at the University of Leuven, Belgium. His books include "The Economics of Monetary Union" and "Exchange Rate Theories: Chaotic Models of the Foreign Exchange Markets". Marianna Grimaldi is an economist in the research department of the Sveriges Riksbank, Stockholm. Her research interests are international monetary relations and exchange rate economics.

Preface

ix

1 The Need for a New Paradigm

1

(12)

1.1 The Rational Representative Agent Paradigm

1

(1)

1.2 Cracks in the REEM Construction

2

(6)

1.3 Behavioral Finance: A Quick Survey

8

(2)

1.4 The Broad Outlines of an Alternative Approach

10

(2)

1.5 Appendix: The Asian Disease Problem

12

(1)

2 A Simple Behavioral Finance Model of the Exchange Rate

13

(36)

2.1 Introduction

13

(1)

2.2 The Model

14

(5)

2.3 Stochastic Simulation of the Model

19

(6)

2.4 The Steady State of the Model

25

(2)

2.5 Numerical Analysis of the Deterministic Model

27

(3)

2.6 Sensitivity Analysis of the Deterministic Model

30

(2)

2.7 Basins of Attraction

32

(2)

2.8 The Stochastic Model: Sensitivity to Initial Conditions

34

(1)

2.9 Why "Crashes" Occur

35

(4)

2.10 The Role of Memory

39

(4)

2.11 Is Chartism Evolutionarily Stable?

43

(2)

2.12 Conclusion

45

(2)

2.13 Appendix: Numerical Values of the Parameters Used in the Base Simulation

47

(1)

2.14 Appendix: Simulations of the Base Model with Different Stochastic Realizations

48

(1)

3 A Slightly More Complex Behavioral Finance Model

49

(22)

3.1 Introduction

49

(1)

3.2 The Model

49

(5)

3.3 Stochastic Simulation of the Model

54

(1)

3.4 Solution of the Deterministic Model

54

(6)

3.5 Informational Issues

60

(3)

3.6 Some Preliminary Remarks on Empirical Predictions of the Model

63

(1)

3.7 Rational and Behavioral Bubbles

64

(3)

3.8 Conclusion

67

(1)

3.9 Appendix: The Variance Ratio σ²f,t/σ²c,t, in the Steady State

68

(1)

3.10 Appendix: Numerical Values of the Parameters Used in the Base Simulation

69

(2)

4 Limits to Arbitrage

71

(96)

4.1 Introduction

71

(1)

4.2 Risk Aversion and Limits to Arbitrage

71

(4)

4.3 Transaction Costs and Limits to Arbitrage

75

(11)

4.4 Conclusion

86

(1)

5 Changes in the Perception of Risk

87

(16)

5.1 Introduction

87

(1)

5.2 Risk Perception and Misalignment

87

(3)

5.3 Risk Perception and Losses: Prospect Theory

90

(5)

5.4 Changing Risk Perception and Transaction Costs

95

(5)

5.5 Conclusion

100

(3)

6 Modeling the Supply of Foreign Assets and the Current Account

103

(14)

6.1 Introduction

103

(1)

6.2 Stochastic Simulations of the Model

104

(1)

6.3 Deterministic Analysis of the Model

105

(4)

6.4 Sensitivity to Initial Conditions and Informational Issues

109

(2)

6.5 Profitability of Chartist and Fundamentalist Rules

111

(1)

6.6 Conclusion

111

(2)

6.7 Appendix: The Steady State of the Model

113

(1)

6.8 Appendix: Transitional Dynamics

114

(3)

7 Risk Appetite in an Evolutionary Perspective

117

(12)

7.1 Introduction

117

(1)

7.2 The Extended Model

117

(4)

7.3 The Nature of Risk Appetite

121

(1)

7.4 Sensitivity to Initial Conditions

121

(1)

7.5 Sensitivity Analysis

122

(1)

7.6 The Effect of News

123

(4)

7.7 Conclusion

127

(2)

8 The Empirical Evidence

129

(24)

8.1 Introduction

129

(1)

8.2 The Distribution of Returns: A Tale of Fat Tails and Excess Kurtosis

129

(4)

8.3 Dependence Properties of Returns

133

(6)

8.4 The Disconnect Puzzle

139

(2)

8.5 Transaction Costs: Do They Matter?

141

(3)

8.6 Asymmetry of Bubbles and Crashes

144

(1)

8.7 Is Chartism Evolutionarily Stable?

145

(2)

8.8 Conclusion

147

(2)

8.9 Appendix: Hill Index and Kurtosis in Prospect Model

149

(1)

8.10 Appendix: Some More Results on Volatility Clustering

150

(1)

8.11 Appendix: Additional Results for the EC Model

151

(2)

9 Official Interventions in the Foreign Exchange Markets

153

(14)

9.1 Introduction

153

(1)

9.2 Modeling Official Interventions in the Foreign Exchange Market

154

(5)

9.3 Rule-Based Interventions in the Foreign Exchange Market

159

(3)

9.4 Target Intervention

162

(1)

9.5 Is Intervention Sustainable?

163

(1)

9.6 Conclusion

164

(3)

10 Chaos in the Foreign Exchange Markets

167

(18)

10.1 Introduction

167

(1)

10.2 What Is Chaos?

167

(2)

10.3 Conditions for Chaos to Occur

169

(6)

10.4 Foreign Exchange Market Intervention and Chaos

175

(2)

10.5 Target Intervention

177

(1)

10.6 Empirical Relevance of Chaotic Dynamics

178

(2)

10.7 Conclusion

180

(1)

10.8 Appendix: Sensitivity to Parameter Values

181

(1)

10.9 Appendix: Intermittency Phenomenon

182

(1)

10.10 Appendix: Target Intervention with Small Target Band

183

(2)

11 Conclusion

185

(6)

References

191

(6)

Index

197

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The Exchange Rate in a Behavioral Finance Framework

Summary

Author Biography

Table of Contents

Supplemental Materials