This paper extends previous work on speculative dynamics in the foreign exchange market. The analysis shows how the behavior of chartists, fundamentalists and rational speculators, together with uncertainty about the long-run equilibrium exchange rate level, can result in fluctuations of the spot rate triggered by a random shock to the market. Although the exact exchange rate path depends on the extent of the shock and on specific values of model parameters, the heterogeneity of expectations can explain several characteristics of short-term exchange rate developments, which have often been emphasized in empirical studies on exchange rate dynamics.

I began serious consideration of the issues and subject matter that comprise this book as a graduate student at the University of Massachusetts at Amherst. In need of a dissertation topic and vaguely curious about international monetary economics, I decided to sit in on Leonard Rapping's undergraduate course on international finance. Needless to say, I was soon hooked. Within several months I was teaching my own course on international money and beginning to write an outline of what would become my doctoral dissertation on foreign exchange speculation. Once completed the dissertation thesis became this basis for this book.

The careening path of the dollar in recent years has shattered more than historical records and the financial health of some speculators. It has also helped to shatter faith in economists' models of the determination of exchange rates.We have understood for some time that under conditions of high international capital mobility, currency values will move sharply and unexpectedly in response to new information. Even so, actual movements of exchange rates have been puzzling in two major respects. First, the proportion of exchange rate changes that we are able to predict seems to be, not just low, but zero. According to rational expectations theory we should be able to use our models to predict that proportion of exchange rate changes that is correctly predicted by exchange market participants. Yet neither models based on economic fundamentals, nor simple time series models, nor the forecasts of market participants as reflected in the forward discount or in survey data, seem able to predict better than the lagged spot rate. Second the proportion of exchange rate movements that can be explained even after the fact, using contemporaneous macroeconomic variables, is disturbingly low.

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.

We report findings from a survey of United States foreign exchange traders. Our results indicate that (i) technical trading best characterizes about 30% of traders, with this proportion rising from five years ago; (ii) news about macroeconomic variables is rapidly incorporated into exchange rates; (iii) the importance of individual macroeconomic variables shifts over time, although interest rates always appear to be important, and; (iv) economic fundamentals are perceived to be more important at longer horizons. The short run deviations of exchange rates from their fundamentals are attributed to excess speculation and institutional customer/hedge fund manipulation. Speculation is generally viewed positively, as enhancing market efficiency and liquidity, even though it exacerbates volatility. Central bank intervention does not appear to have a substantial effect, although there is general agreement that it increases volatility. Finally, traders do not view purchasing power parity as a useful concept, even though a significant proportion (40%) believe that it affects exchange rates at horizons of over six months.

We present a simple behavioral model with chartists and fundamentalists and analyze their trading behavior in both a floating and a target zone exchange rate regime. When applied to the floating regime, the model replicates the well-known stylized facts, such as excess volatility, fat tails, volatility clustering and exchange rate disconnect. Our main result is that when applied to a credible target zone, our model predicts that the exchange rate remains in the center of the band for a considerable period, even though the fundamental exchange rate does not exhibit mean reversion tendencies. This is consistent with the empirical evidence and contrasts with the traditional target zone model based on Krugman (1991), which predicts that the exchange rate in a target zone clusters close to the edges of the band. The hump-shaped distribution of the exchange rate obtained in our model greatly reduces the frequency of central bank intervention. We also conclude that the introduction of a target zone regime significantly reduces exchange rate volatility by decreasing speculative activity in the FX market.