IFM Part2 Updated

Non-rational behavior: some facts
The role of chartism and ‘technical

trading” in foreign exchange markets:
a survey among London-based forex
dealers:
Taylor, M. and H. Allen, The Use of

Technical Analysis in the Foreign
Exchange Market, Journal of
International Money and Finance 11,
1992
International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Non-rational behavior: some facts

Noise Trading and Chartist Behavior in Foreign
Exchange Markets: Empirical Evidence
Cheung and Chinn (2001) conducted a survey among market

participants in the U.S. asking for the importance of various
factors for exchange rate movements over short, medium and
long horizons. The answers do speak even more against
fundamentals governing exchange rates over short or
medium horizons.

Question: “Do exchange rate movements
reflect changes in the fundamental value?”
Question: “What factors do determine exchange rate
movements over various horizons?”
Forecast comparison of chartists vs. fundamental models:
Source: H. Allen and

M. Taylor, Economic
Journal, 1990.
Chartists’ forecasts:
Source: H. Allen and

M. Taylor, Economic
Journal, 1990.
The evidence collected in these surveys showed that:
• a majority of traders does not only rely on information about

fundamental factors, but uses various sources of ’technical’
information (e.g. trend curves, moving averages etc.),
• a majority of traders believes that at least over short and

medium horizons, exchange rates are governed more by
speculative behavior, bandwagon effects and technical trading
rather than by macroeconomic fundamentals and pertinent
news.

Interaction of Chartists and Fundamentalists
• from the early 90s the literature takes the empirical

observations into account: models with chartists and
fundamentalists
• this implies a deviation form the concept of rational
expectations
• agents might have different degrees of bounded
rationality
• starting point: canonical model
s t = x t + δE t [s t +1 ] or St = X t ⋅ E t [St +1 ]δ

 Frankel and Froot (1986) tried to estimate the fractions of

chartists and fundamentalists over the period 1976 to 1985.
 they assumed that aggregate exchange rate expectations are
composed of those of fundamentalists and chartists (which
means that expectations are not necessarily consistent or
‘rational’):
Em [ ∆st +1 ] = wt E f [ ∆st +1 ] + ( 1 − wt )Ec [ ∆st +1 ]
Ec, Ef, Em: forecasts of chartists, fundamentalists, the market

(portfolio managers)
w: time-varying weight of fundamentalist forecast
 for chartists it is assumed that:

Ec [ ∆st +1 ] = 0
 idea: the diversity of chartist techniques generates

no clear overall tendency
 it follows that: Em [ ∆st +1 ]

wt =
E f [ ∆st +1 ]

• estimation of wt from:
Em [ ∆st +1 ]
wt =
E f [ ∆st +1 ]
• Em[.] is assumed to correspond to the forward premium
• Ef[.] is taken form forecasts of professional forecast

providers

Estimated Weights of Fundamentalists by Portfolio Managers
Estimates of time-changing weight of fundamentalists. From Frankel and Froot (1986),

p.29.
Note: Forward discount 1976-85 is at six month and includes data through September
1985 for the average of five currencies, the pound, French franc, mark, Swiss franc and
yen. Survey expected deprecation 1981-85 is from the Economist six-month survey
data, and for 1976-79 is from the AMEX survey data for the same five currencies.
Chartists in DeGrauwe et al. (1993)
• use historical data to forecast the future exchange rate

instead of the information about macro fundamentals.
• expect that the exchange rate can deviate substantially from

its fundamental value.
• specification of chartists' forecasting model: comparison of

short-run moving averages (SMA) and long-run moving
averages (LMA)

2γ
 St +1   SMA( St −1 ) 
Ec , t   = f ( St −1 ,..., St − n ) =  
 St −1   LMA( St −1 ) 
with
S t −1
SMA (S t −1 ) =
St −2
0,5 0,5
 S t −1   St −2 
LMA(S t −1 ) =    
 St −2   S t −3 

Compact Form:
γ
 St +1   St −1 / St − 2 
E c, t   =  
 St −1   St − 2 / St −3 
γ : parameter for the trend extrapolation of chartists

Fundamentalists
• expect that the exchange rate will gradually revert to its

fundamental value.
• if the exchange rate lies above (below) its fundamental

value, they expect a fall (rise) in the future.
• specification of fundamentalists' forecasting model:
α
 St +1   Sf , t −1 
Ef ,t   =  
 St −1   St −1 
The market expectation
Aggregated market expectation:
mt 1− m t
S t +1  S t +1  S t +1 
E m, t   = E c, t   ⋅ E f ,t  
 S t −1   S t −1   S t −1 
Idea: the chartists/fundamentalists are advisors of the forex

dealers who use a weighted average of their forecasts

with
m t = {1 + β(S t −1 − Sf , t −1 ) }
2 −1
as the time varying weight of the chartists' forecast

and β > 0, so that if
S t −1 − Sf , t −1 → ∞ then m t → 0
S t −1 − Sf , t −1 =0 then m t = 1

Solution of the model: third-order nonlinear difference equation

with possibly stochastic fundamentals Xt
St = g (St −1,St − 2,St −3,Sf , t −1, X t ,α, β, γ, δ)
i.e.
 γm t α (1− m t ) δ
  S /S   Sf , t −1  
St = X t St −1 ⋅  t −1 t − 2  ⋅   
  St − 2 / St −3   St −1  
with m t given above.

• dynamic steady state: fundamental equilibrium in the absence

of changes of X :
St = Sf = X1/(1-δ)
• stability depends on reaction parameters
• in contrast to RE models: backward-oriented dynamics

through chartists’ attempt at extracting information from past
trends
• simulations of out-of-equilibrium dynamics (note: market

equilibrium holds also outside the steady state)

Digression: Chaotic Dynamics
Simplest example: the logistic equation
y t +1 = αy t (1 − y t )
α : tuning parameter

Figure 5 : Phase Curve for Different α Values

Phase Diagrams
Chaotic Dynamics is characterized by:
• persistent non-periodic oscillations which may look like

realizations of a stochastic process
• sensitivity to initial conditions (butterfly effect)
• limited predictability of the future path of a time series

(despite entirely deterministic origin)

Figure 7: Trajectory of the Logistic Equation: Chaotic Case

Figure 8: Illustration of Sensitive Dependence on Initial

Conditions

Back to DeGrauwe et al.

A nicer version of the attractor


De Grauwe et al.:
sensitivity to initial
conditions
Simulation results
1. Variation of the extrapolation parameter γ :
• γ ·1 : convergence towards the fundamental value
• γ > 1 : cyclical exchange rate dynamics
• γ sufficiently large : chaotic solutions
2. Variation of the adjustment speed α :

• α small : chaotic dynamics relatively unlikely
• α large : chaotic dynamics more frequent

Explanatory Power: Pseudo-Empirical Results

from Simulated Time Series
1. Unit root tests of artificial data:
One can test the null hypothesis of a unit-root in the simulated

exchange rates,
i.e.
H o : a1 = 1
in
St = a1St −1 + rAR (1) + ε t

Time series resembles

random walk
although we know it is not
a random walk.
θ is a parameter for
interest rate smoothing in
an extension of the model

2. Explanation of the forward-premium puzzle:
Estimation of the standard test equation leads to rejection of the

null hypothesis :
s t +1 −s t = a + b(f t - s t ) + ε t
H 0 : a = 0 and b = 1
Assumption: Ft = Em,t[St+1], ft = ln(Ft)

Estimation yields negative slope coefficients!

Exchange rate is more volatile than forward premium
3. Exchange Rate Dynamics with Stochastic Fundamentals
and Exchange Rate Disconnect
Stochastic fundamentals
following a random walk
(Xt = Mt)
Table 4: Regression of the Exchange Rate on the Money Stock
For fundamentally determined exchange rates: slope = 1

Out-of-sample Forecasting
Performance
• Comparison of root mean

squared errors (RMSE) of
structural predictions with
simple random walk forecast
• Structural model
outperformed by random
walk prediction (replication
of Meese/Rogoff results)

Some caveats
• Model by DeGrauwe et al explains a great deal of the

empirical puzzles, yet
• exchange rates and other financial data do not follow low-

dimensional chaotic processes
• if they would, exchange rates could be predicted to some

extent via pattern recognition
• Another problematic feature: the dynamics is characterized

by permanent speculative fury

Structure in chaotic model vs. stochasticity of empirical series
DM/$, 1974 – 1998, High frequency data:

Daily returns The compass rose
A Stochastic Model of Speculation and Herding:
Kirman’s Ant Model
• again: two types of agents (e.g. chartists and

fundamentalists)
• agents switch between strategies or groups
• changes of opinion are modelled as a stochastic
process
• changes of opinion occur via interpersonal
communication (herding)
• inspiration form recruitment dynamics in ant
populations
The Ant Problem
• ants are offered to sources

of food (or two equivalent
pathways to one source)
• a majority of ants exploits
one of both sources
• recurrent random switches
of majority do occur
• tension between random
search and recruitment via
trails of pheromons
Kirman (1991, 1993)]
 autonomous changes of opinion occur with Poisson rates

ε
 pairwise contact leads to conversion of an agent with
prob. 1 - δ
N : number of agents,
k: agents in group 1
Group p1 p2
Group
1 2
The stochastic process
we have N agents
 state of the system is characterized by number of
agents k, choosing alternative 1 (N-k chose alternative
2)
 probability that a randomly chosen individual is of
type 1 (type 2) is k/N and (N-k)/N
 agents meet and exchange information. They change
opinion with probability is 1-δ.
 agents may also change their opinion autonomously with
probability ε.

Kirman (1991, 1993)
Fig. 1 Transition probabilities

Kirman (1991, 1993)
The number of individuals of type 1 changes within a small

time increment:
k + 1, with P(k → k + 1) = p1

k →  k , with P(k → k) = 1 − p1 − p 2
 k - 1, with P(k → k - 1) = p 2


Herd Behavior and Speculative Bubbles:
The Model of Kirman (1991, 1993)
Both can be determined by combinatorial considerations:
 N − k  k 
p1 = P ( k → k +1) =   ε + (1− δ) 
 N  N −1 
 k  N−k 
p 2 = P ( k → k −1) =   ε + (1− δ) 
 N  N −1 

Kirman (1991, 1993): The Herding Component
How does the distribution of both “opinions” evolve over time?
Limiting Cases:
1. δ=1:
only random autonomous changes determine the choice of
the opinion: convergence to binomial distribution
with E[k]=N/2:
()
N
Pr ob(k ) = B(k;0.5; N) = k 0.5 N
2. ε=0:
a uniform opinion will emerge due to herding tendency
this yields to either k=N or k=0
Kirman (1991, 1993): Herding Model
The general case: If both components affect individual choices,

the outcome depends on the relative strength of the herd component
to the autonomous switching component.
f ( x ) = const. ⋅ x α −1 (1 − x ) α −1
k ε( N − 1)
x= ,α =
N 1− δ
Bifurcation at ε0 = (1-δ)/(N-1) from behavior dominated by

autonomous movements to behavior dominated by herd
component
Kirman (1991, 1993)
The Equilibrium Distribution
Characterizes how often the system will be in one of the N+1

states k ∈{0,…,N}.
3 cases:
> uni - modal
 1− δ
ε = uniform
< N − 1 bi - modal


Kirman (1991, 1993)

Kirman (1991, 1993)

Kirman (1991, 1993)
Integration into a Foreign Exchange Market Model
Groups/strategies now represent chartists and fundamentalists
Fundamentalists expect reversal towards fund. value:

E f , t [∆s t +1] = υ(sf − s t −1)
Chartists expect continuation of trend:

E c, t [∆s t +1 ] = s t − s t −1

Market expectations is a weighted average of
fundamentalists’ and chartists’ predictions:
E m, t [∆s t +1 ] = ϖ t E f , t [∆s t +1 ] + (1 − ϖ t )E c, t [∆s t +1 ]
with ϖ t = k t / N
in monetary exchange rate model:
s t = x t + δE m, t [s t +1]
E m, t [s t +1 ] = E m, t [∆s t +1 ] + s t
Kirman (1991, 1993)
The foreign exchange market with stochastically switching

speculators
• large fraction of fundamentalists: exchange rate stays

near its fundamental value.
• large fraction of chartist traders: emergence of
speculative bubbles
• stochastic changes between episodes dominated by
fundamentals and phases with pronounced disconnect
• again: realistic time series properties

Kirman (1991, 1993)

Exchange rate and
time-varying
fundamentals
Pseudo-empirical results:
• non-rejection of unit root

• co-integration between s and sf depends on time interval
• model mimics long-term dependence of volatility (Kirman
and Teyssiere, 2001, 2005)
Problems:
• bubbles and crashes happen stochastically
• dependency on number of agents

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Non-rational behavior: some facts

The role of chartism and ‘technical

Taylor, M. and H. Allen, The Use of

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Cheung and Chinn (2001) conducted a survey among market

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Source: H. Allen and

Source: H. Allen and

The evidence collected in these surveys showed that:

• a majority of traders does not only rely on information about

• a majority of traders believes that at least over short and

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

• from the early 90s the literature takes the empirical

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

 Frankel and Froot (1986) tried to estimate the fractions of

Em [ ∆st +1 ] = wt E f [ ∆st +1 ] + ( 1 − wt )Ec [ ∆st +1 ]

Ec, Ef, Em: forecasts of chartists, fundamentalists, the market

 for chartists it is assumed that:

 idea: the diversity of chartist techniques generates

 it follows that: Em [ ∆st +1 ]

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

• Em[.] is assumed to correspond to the forward premium

• Ef[.] is taken form forecasts of professional forecast

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Estimates of time-changing weight of fundamentalists. From Frankel and Froot (1986),

Chartists in DeGrauwe et al. (1993)

• use historical data to forecast the future exchange rate

• expect that the exchange rate can deviate substantially from

• specification of chartists' forecasting model: comparison of

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

γ : parameter for the trend extrapolation of chartists

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

• expect that the exchange rate will gradually revert to its

• if the exchange rate lies above (below) its fundamental

• specification of fundamentalists' forecasting model:

The market expectation

Aggregated market expectation:

Idea: the chartists/fundamentalists are advisors of the forex

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

as the time varying weight of the chartists' forecast

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Solution of the model: third-order nonlinear difference equation

St = g (St −1,St − 2,St −3,Sf , t −1, X t ,α, β, γ, δ)

with m t given above.

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

• dynamic steady state: fundamental equilibrium in the absence

• stability depends on reaction parameters

• in contrast to RE models: backward-oriented dynamics

• simulations of out-of-equilibrium dynamics (note: market

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Digression: Chaotic Dynamics

Simplest example: the logistic equation

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Figure 5 : Phase Curve for Different α Values

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Chaotic Dynamics is characterized by:

• persistent non-periodic oscillations which may look like

• sensitivity to initial conditions (butterfly effect)

• limited predictability of the future path of a time series

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel

Figure 7: Trajectory of the Logistic Equation: Chaotic Case

International Financial Markets, SS 2017 Institut für Volkswirtschaftslehre, Christian-Albrechts-Universität zu Kiel