Heterogeneous Expectations and Exchange Rate Dynamics

Carl Chiarella (), Xuezhong He () and Min Zheng

No 243, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: This paper presents a continuous-time model of exchange rates relying not only on macroeconomic factors but also having a market microstructure component. The driving macroeconomic factor is the interest rate differential, while the market microstructure element is described by the expectations of boundedly rational portfolio managers who use a weighted average of the expectations of fundamentalists and chartists. Within this framework, the different roles of the macroeconomic factors and market microstructure elements on the determination of the exchange rate are examined explicitly. We show that this simple model generates very complicated market behaviour, including the existence of multiple steady state equilibria, the deviations of the market exchange rate from the fundamental, and market fluctuations. Numerical simulation of the corresponding stochastic version of the model shows that the model is able to generate typical time series and volatility clustering patterns observed in exchange rate markets.

Keywords: Exchange rate; interest rate differential; heterogeneous expectations (search for similar items in EconPapers)
JEL-codes: F31 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mst
Date: 2009-01-01

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