Bulls, bears and excess volatility: can currency intervention help?

Abstract

Asset mis-pricing may reflect investor psychology, with excess volatility arising from switches of sentiment. For a floating exchange rate where fundamentals follow a random walk, we show that excess volatility can be generated by the repeated entry and exit of currency 'bulls' and 'bears' with switches driven by 'draw-down' trading rules. We argue that non-sterilised intervention -in support of 'monitoring band' -can reduce excess volatility by coordinating beliefs in line with policy. Strategic complementarity in the foreign exchange market suggests that sterilised intervention may also play a coordinating role. JEL: D52, F31, G12.

Modeling Optimism and Pessimism in the Foreign Exchange Market

“…Our model di¤ers from theirs in the way agents choose to be bulls or bears. As will be seen, in our model bears and bulls can coexist, which is not the case inCorrado, et al (2007) 2. The functional form of the di¤erent forecasting rules will be speci…ed in the next section.…”

“…Corrado, et al (2007) use a similar setup assuming the existence of "bears" and "bulls". Our model di¤ers from theirs in the way agents choose to be bulls or bears.…”

Impact of information cost and switching of trading strategies in an artificial stock market

“…Timmermann [23] point out that the parameters of the dividend process are important for the dynamic behavior of stock prices, and conclude that the agents' learning may generate predictability in stock returns and significantly increase the volatility of stock prices. Corrado et al [24] consider that asset mispricing may reflect investor psychology, and that excess volatility can arise from switching of sentiments. They show that excess volatility can be generated by the repeated entry and exit of currency 'bulls' and 'bears' with switches driven by 'draw-down' trading rules.…”