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The Exchange Rate in a Behavioral Finance Framework - Paul de Grauwe

The Exchange Rate in a Behavioral Finance Framework


Published: 1st March 2006
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This book provides an alternative view of the workings of foreign exchange markets.

The authors' modeling approach is based on the idea that agents use simple forecasting rules and switch to those rules that have been shown to be the most profitable in the past. This selection mechanism is based on trial and error and is probably the best possible strategy in an uncertain world, the authors contend. It creates a rich dynamic in the foreign exchange markets and can generate bubbles and crashes.

Sensitivity to initial conditions is a pervasive force in De Grauwe and Grimaldi's model. It explains why large exchange-rate changes and volatility clustering occur. It also has important implications for understanding how the news affects the exchange rate. De Grauwe and Grimaldi conclude that news in fundamentals has an unpredictable effect on the exchange rate. Sometimes, they maintain, it alters the exchange rate considerably; at other times it has no effectwhatsoever.

The authors also use their model to analyze the effects of official interventions in the foreign exchange market. They show that simple intervention rules of the "leaning-against-the-wind" variety can be effective in eliminating bubbles and crashes in the exchange rate. They further demonstrate how, quite paradoxically, by intervening in the foreign exchange market the central bank makes the market look more efficient.

Clear and comprehensive, "The Exchange Rate in a Behavioral Finance Framework" is a must-have for analysts in foreign exchange markets as well as students of international finance and economics.

"DeGrauwe and Grimaldi have written a most stimulating book with many interesting ideas for students and researchers of modern economics and finance, economic policy makers as well as financial practitioners... It is a well balanced mixture of finance intuition, model simulations as well as rigorous analysis, described in a lucid way and illustrated by many clarifying figures."--Cars Hommes, International Review of Economics and Finance

Prefacep. ix
The Need for a New Paradigmp. 1
The Rational Representative Agent Paradigmp. 1
Cracks in the REEM Constructionp. 2
Behavioral Finance: A Quick Surveyp. 8
The Broad Outlines of an Alternative Approachp. 10
Appendix: The Asian Disease Problemp. 12
A Simple Behavioral Finance Model of the Exchange Ratep. 13
Introductionp. 13
The Modelp. 14
Stochastic Simulation of the Modelp. 19
The Steady State of the Modelp. 25
Numerical Analysis of the Deterministic Modelp. 27
Sensitivity Analysis of the Deterministic Modelp. 30
Basins of Attractionp. 32
The Stochastic Model: Sensitivity to Initial Conditionsp. 34
Why "Crashes" Occurp. 35
The Role of Memoryp. 39
Is Chartism Evolutionarily Stable?p. 43
Conclusionp. 45
Appendix: Numerical Values of the Parameters Used in the Base Simulationp. 47
Appendix: Simulations of the Base Model with Different Stochastic Realizationsp. 48
A Slightly More Complex Behavioral Finance Modelp. 49
Introductionp. 49
The Modelp. 49
Stochastic Simulation of the Modelp. 54
Solution of the Deterministic Modelp. 54
Informational Issuesp. 60
Some Preliminary Remarks on Empirical Predictions of the Modelp. 63
Rational and Behavioral Bubblesp. 64
Conclusionp. 67
Appendix: The Variance Ratio [sigma superscript 2 subscript f,t]/[sigma superscript 2 subscript c,t] in the Steady Statep. 68
Appendix: Numerical Values of the Parameters Used in the Base Simulationp. 69
Limits to Arbitragep. 71
Introductionp. 71
Risk Aversion and Limits to Arbitragep. 71
Transaction Costs and Limits to Arbitragep. 75
Conclusionp. 86
Changes in the Perception of Riskp. 87
Introductionp. 87
Risk Perception and Misalignmentp. 87
Risk Perception and Losses: Prospect Theoryp. 90
Changing Risk Perception and Transaction Costsp. 95
Conclusionp. 100
Modeling the Supply of Foreign Assets and the Current Accountp. 103
Introductionp. 103
Stochastic Simulations of the Modelp. 104
Deterministic Analysis of the Modelp. 105
Sensitivity to Initial Conditions and Informational Issuesp. 109
Profitability of Chartist and Fundamentalist Rulesp. 111
Conclusionp. 111
Appendix: The Steady State of the Modelp. 113
Appendix: Transitional Dynamicsp. 114
Risk Appetite in an Evolutionary Perspectivep. 117
Introductionp. 117
The Extended Modelp. 117
The Nature of Risk Appetitep. 121
Sensitivity to Initial Conditionsp. 121
Sensitivity Analysisp. 122
The Effect of Newsp. 123
Conclusionp. 127
The Empirical Evidencep. 129
Introductionp. 129
The Distribution of Returns: A Tale of Fat Tails and Excess Kurtosisp. 129
Dependence Properties of Returnsp. 133
The Disconnect Puzzlep. 139
Transaction Costs: Do They Matter?p. 141
Asymmetry of Bubbles and Crashesp. 144
Is Chartism Evolutionarily Stable?p. 145
Conclusionp. 147
Appendix: Hill Index and Kurtosis in Prospect Modelp. 149
Appendix: Some More Results on Volatility Clusteringp. 150
Appendix: Additional Results for the EC Modelp. 151
Official Interventions in the Foreign Exchange Marketsp. 153
Introductionp. 153
Modeling Official Interventions in the Foreign Exchange Marketp. 154
Rule-Based Interventions in the Foreign Exchange Marketp. 159
Target Interventionp. 162
Is Intervention Sustainable?p. 163
Conclusionp. 164
Chaos in the Foreign Exchange Marketsp. 167
Introductionp. 167
What Is Chaos?p. 167
Conditions for Chaos to Occurp. 169
Foreign Exchange Market Intervention and Chaosp. 175
Target Interventionp. 177
Empirical Relevance of Chaotic Dynamicsp. 178
Conclusionp. 180
Appendix: Sensitivity to Parameter Valuesp. 181
Appendix: Intermittency Phenomenonp. 182
Appendix: Target Intervention with Small Target Bandp. 183
Conclusionp. 185
Referencesp. 191
Indexp. 197
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ISBN: 9780691121635
ISBN-10: 069112163X
Audience: Tertiary; University or College
Format: Hardcover
Language: English
Number Of Pages: 224
Published: 1st March 2006
Publisher: Princeton University Press
Country of Publication: US
Dimensions (cm): 23.5 x 15.2  x 1.91
Weight (kg): 0.48