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Time-varying risk attitude and the foreign exchange market behavior

Qian Zhang and Zeguang Li

Research in International Business and Finance, 2021, vol. 57, issue C

Abstract: This paper presents a heterogeneous agents model of the foreign exchange market in which agents’ risk attitudes vary over time due to psychological factors emphasized in prospect theory. We find that psychological component and risk-profit elasticity play significant roles in exchange rate expectations formation and investment behavior. Although all agents show more risk-averse after the crisis, the extent to which their risk attitude responds to the crisis varies due to heterogeneous forecasting rules as well as the changes of trading environment and central bank intervention. Moreover, time-varying risk attitudes can help explain the forward premium puzzle. These findings have implications for the exchange rate expectation formation theories and foreign exchange market stability policies.

Keywords: Time-varying risk attitude; Heterogeneous agents model; Exchange rates; Chinese yuan (search for similar items in EconPapers)
JEL-codes: F31 G15 G41 (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:eee:riibaf:v:57:y:2021:i:c:s0275531921000155

DOI: 10.1016/j.ribaf.2021.101394

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