The role of heterogeneous expectations in forward exchange market

Abstract

We build a Markov regime switching model to examine the role of heterogeneous expectations in the forward exchange market, where the regime could be fundamentalists or chartists. Our empirical analysis of EUR/USD and USD/JPY forward markets suggest that the fundamen-talists who follow negative feedback rule provide a mean-reverting dynamics into the market, while the chartists who follow positive feedback rule would reinforce the forward exchange rate movement. Finally, we find the chartists tend to switch to fundamentalists when the forward rate deviates away from its equilibrium.

Keywords:

• heterogeneous expectations
• foreign exchange rate
• fundamentalists
• chartists
• regime switching model

JEL Classification:

• F31
• F37

Acknowledgements

This study is supported by the National Science Foundation of China (Nos 71101093 and 71001071), the Innovation Program of Shanghai Municipal Education Commission (No. 12YS158) and the Leading Academic Discipline Project of Shanghai Municipal Education Commission (No. J51703).