Should foreign exchange models focus on observed behavior of exchange rates, or should the focus be on observed behavior of currency traders? Since a main purpose of economic theory is to develop models that can explain observed regularities, there is an obvious advantage of the …rst point of departure. Nevertheless, in order to develop an economic theory of exchange rate movements, one cannot disregard the behavior of those who actually trade in the foreign exchange market. Modeling observed behavior of foreign exchange traders is, however, not sufficient in order to obtain an economic theory since one must also explain why traders act as they do. The level of ambition in the present paper is to take a …rst step towards developing an economic theory of exchange rate movements by taking into account observed behavior of currency traders.
In November 1988, Taylor and Allen (1992) conducted a questionnaire survey for the Bank of England on the foreign exchange market in London. The survey covered 353 banks and …nancial institutions, with a response rate of over 60 per cent, and was the …rst to ask speci…cally about the use of technical analysis[1], or chartism, among currency traders. The results of the survey were striking, with two per cent of the respondents reported never to use fundamental analysis in forming their exchange rate expectations, while 90 per cent reported placing some weight on technical analysis at the intraday to one week horizon.
At longer planning horizons, however, Taylor and Allen (1992) found that the importance of technical analysis became less pronounced. That technical analysis is extensively used in currency trade has also been con…rmed by Menkho¤ (1997), who conducted a survey in August 1992 on the German market, by Lui and Mole (1998), who conducted a survey in February 1995 on the Hong Kong market, by Oberlechner (2001), who conducted a survey in the spring 1996 on the markets in Frankfurt, London, Vienna and Zurich, and, as a …nal example, by Cheung and Chinn (2001), who conducted a survey between October 1996 and November 1997 on the U.S. market.
A general observation in these surveys is that a skew towards reliance on technical, as opposed to fundamental, analysis at shorter planning horizons was found, which became gradually reversed as the length of the planning horizon considered was increased. Frankel and Froot (1986) were the …rst to use a chartistfundamentalist setup in a foreign exchange model, where the heterogeneous behavior of currency traders was taken into account. In their model, a bubble in the exchange rate takes o¤ and collapses since the portfolio managers[2] learn more slowly about the model than they are changing it by revising the weights given to the chartists’and fundamentalists’exchange rate expectations.
A chartistfundamentalist model is also developed by De Grauwe and Dewachter (1993), where the weights given to the chartists’and fundamentalists’expectations depend on the deviation of the exchange rate from its fundamental value. Speci…cally, more (less) weight is given to the chartists’expectations when the exchange rate is close to (far away from) its fundamental value. In Levin (1997), however, as a …nal example, the relative importance of technical versus fundamental analysis does not change over time.
The specific purpose of this paper is to implement theoretically, the aforementioned observation that the relative importance of technical versus fundamental analysis in the foreign exchange market depends on the planning horizon in currency trade. For shorter planning horizons, more weight is placed on technical analysis, while more weight is placed on fundamental analysis for longer planning horizons. In the model developed, technical analysis is based on moving averages since it is the most commonly used technique among currency traders using chartism (e.g., Taylor and Allen, 1992, and Lui and Mole, 1998).
Further, fundamental analysis is based on a stickyprice monetary foreign exchange model due originally to Dornbusch (1976). The main questions in focus are: how is the dynamics of the exchange rate a¤ected when technical analysis is introduced into a stickyprice monetary model? Speci…cally, will the exchange rate “overshoot the overshooting equilibrium”? This phrase was coined by Frankel and Froot (1990) when discussing possible explanations to the dramatic appreciation of the U.S. dollar in the mid1980’ s.
The “overshooting equilibrium”refers, of course, to Dornbusch (1976). Further, how is the planning horizon and the overshooting e¤ect a¤ected when market expectations[3] are characterized by perfect foresight? The remainder of this paper is organized as follows. The benchmark model and the expectations formations are presented in Section 2. The formal analysis of the model is carried out in Section 3, and Section 4 contains a short concluding discussion of the main results in this paper.
1 For a theoretical description of technical trading techniques used in the foreign exchange market, the reader can turn to Neely (1997).
2 Without a¤ecting the theoretical results in this paper, we assume that it is the chartists and fundamentalists, and not the portfolio managers, who trade in currencies. Therefore, we leave the portfolio managers out of account in the model.
3 Market expectations are the weighted average of the chartists’and fundamentalists’expectations, i.e., in a model with portfolio managers, like in Frankel and Froot (1986), market expectations coincide with the portfolio managers’expectations. See also footnote 2.
By Mikael Bask and Carina Selander
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