This paper investigates the time-varying nature of expectation formation rules for institutional investors in the foreign exchange market. Using a unique dataset of survey expectations for four exchange rates, we first distinguish three different general rules. We find a momentum rule, a fundamental rule, and a rule that takes advantage of interest differentials between countries. Apart from heterogeneity in expectation formation rules, we show that the rules are time-varying conditional on a number of different factors, such as the sign of the most recent return, the forecast horizon, the distance to the PPP rate, and the extent to which the rule produces forecast errors vis-à-vis the market exchange rate. Although we find dynamics in expectation formation for all four exchange rates, the results for the currencies against the Japanese yen deviate from the others.

Abstract: My dissertation studies models of exchange rate determination that are standard in all respects except that market participants have incomplete knowledge about the economic structure, and employ adaptive learning rules to learn about the economic environment. My work on introducing model uncertainty into standard models is motivated by the well documented fact that when the underlying economic environment is known and is common knowledge to market participants, models under rational expectations cannot account for such basic features of the data as the relative volatility between exchange rate and fundamentals or the predictability of future exchange rate returns by the deviation of the exchange rate from the fundamentals. I partly response to this problem to use an alternative view of expectations, adaptive expectations, which can be a reasonable way to form expectations when the environment is excessively complex. I find that the model under adaptive expectations performs better than rational expectations in explaining why the forward exchange rate as a predictor of the future spot rate generates a large bias, why the maximal depreciation of a currency upon an unexpected monetary shock occurs some periods after the initial shock. I consider a standard monetary model where market participants learn about the economic structure using adaptive learning rules. While market participants are assumed to know the functional form of the stochastic process that drives the fundamentals, they do not know the parameter values which they assess by least squares learning. Market participants must also contend with unannounced regime shifts in the fundamental process. I compare the predictions of the model under adaptive learning to those generated under standard rational expectations and under adaptive expectations. I find that the model under adaptive learning dominates the alternative specifications of expectations in its ability to account for why the fundamentals predict exchange rate returns over long horizons, for generating exchange rate return volatility in excess of fundamentals volatility, and in generating persistent deviations of the exchange rate from the fundamentals. I conclude that the underlying model uncertainty goes far in helping to resolve some longstanding puzzles in the foreign exchange market.

Originally published in 1984. This book examines two important dimensions of efficiency in the foreign exchange market using econometric techniques. It responds to the macroeconomics trend to re-examining the theories of exchange rate determination following the erratic behaviour of exchange rates in the late 1970s. In particular the text looks at the relation between spot and forward exchange rates and the term structure of the forward premium, both of which require a joint test of market efficiency and the equilibrium model. Approaches used are the regression of spot rates on lagged forward rates and an explicit time series analysis of the spot and forward rates, using data from Canada, the United Kingdom, the Netherlands, Switzerland and Germany.

This paper examines the dynamics of the foreign exchange market. The first half addresses a number of key questions regarding the forecasts of future exchange rates made by market participants, by means of updated estimates using survey data. Here we follow most of the theoretical and empirical literature in acting as if all market participants share the same expectation. The second half then addresses the possibility of heterogeneous expectations, particularly the distinction between “chartists” and “fundamentalists,” and the implications for trading in the foreign exchange market and for the formation of speculative bubbles.

This book demystifies the foreign exchange market by focusing on the people who comprise it. Drawing on the expertise of the very professionals whose decisions help shape the market, Thomas Oberlechner describes the highly interdependent relationship between financial decision makers and news providers, showing that the assumption that the foreign exchange market is purely economic and rational has to be replaced by a more complex market psychology.

This paper re-investigates the implications of monetary policy rules on changes in exchange rate, in a risk-adjusted, uncovered interest parity model with unrestricted parameters, emphasizing the importance of modeling market expectations of monetary policy. I use consensus forecasts as a proxy for market expectations. The analysis on the Deutsche mark, Canadian dollar, Japanese yen, and the British pound relative to the U.S. dollar from 1979 to 2008 shows that, through the expectations of future monetary policy, Taylor rule fundamentals are able to forecast changes in the exchange rate, even over short-term horizons of less than two years. Furthermore, the market expectation formation processes of short-term interest rates change over time and differ across countries, which contributes to the time varying relationship between exchange rates and macroeconomic fundamentals, together with the time varying currency risk premia and exchange rate forecast errors.