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

Robert B. H. Hauswald

No B 01-1999, ZEI Working Papers from University of Bonn, ZEI - Center for European Integration Studies

Abstract: 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.

Date: 1999
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://www.econstor.eu/bitstream/10419/39647/1/267713231.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:zbw:zeiwps:b011999

Access Statistics for this paper

More papers in ZEI Working Papers from University of Bonn, ZEI - Center for European Integration Studies Contact information at EDIRC.
Bibliographic data for series maintained by ZBW - Leibniz Information Centre for Economics ().