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Chartists, fundamentalists, and trading in the foreign exchange market.

Annual Research Conference--II:

Chartists, Fundamentalists, and Trading in the Foreign Exchange Market

The overshooting theory of exchange rates seems ideal for explaining some important aspects of the movement of the dollar in recent years. From 1981-4, for example, when real interest rates in the United States rose above those of her trading partners (presumably because of shifts in the monetary/fiscal policy mix), the dollar appreciated strongly. This episode supported the overshooting theory: the higher rates of return had made U.S. assets more attractive to international investors, which is what caused the dollar to appreciate; the appreciation continued until the dollar's value was so far above long-run equilibrium that expectations of future depreciation were enough to offset the higher nominal interest rate in the minds of international investors. (Figure 1 shows the correlation of the real interest differential with the real value of the dollar, since exchange rates began to float in 1973.)

Bubble Episodes

At times, however, the path of the dollar has departed from what would be expected on the basis of macro-economic fundamentals. The most dramatic example was the period from June 1984 to February 1985. The dollar appreciated 20 percent over this interval, even though the real interest differential already had begun to fall. The other observable factors that are suggested in standard macroeconomic models--money growth rates, real growth rates, the trade deficit--also were moving in the wrong direction to explain the dollar's rise at this time.

Of course, standard observable macroeconomic variables cannot explain, much less predict, most short-term changes in the exchange rate. But what does this mean? It may be that the unexplained short-term changes are rational revisions in the market's perception of the long-run equilibrium exchange rate. These revisions are caused by shifts in "tastes and technologies," even if the shifts are not observable to macroeconomists as standard measurable fundamentals. A major difficulty with this interpretation, though, is that it is hard to believe that the world demand for U.S. goods (or U.S. productivity) could have risen enough to increase the equilibrium real exchange rate by more than 20 percent over a nine-month period, let alone that such a shift then would be reversed over an equally short period.

The second view is that the appreciation may have been an example of a speculative bubble: that it was unrelated to fundamentals, but rather was the outcome of self-confirming market expectations. In other words, the dollar "overshot the overshooting equilibrium." This also may have been the nature of the dollar appreciation of 1988-9.

Ken Froot and I have suggested that such episodes may be examples of speculative bubbles, and that they may be described best by models in which market participants are not necessarily assumed to agree on the correct way to forecast the exchange rate.(1)

Trading Volume in the Foreign Exchange Market

Supporting the idea that market participants differ widely in their forecasts is the tremendous volume of foreign exchange trading. If participants all agree on their forecasts, why do they trade so much? In April 1989, foreign exchange trading (adjusted for double-counting) in the United States totaled $128.9 billion a day, an increase of 120 percent from March 1986. Simultaneous counts in London and Tokyo reported $187 billion and $115 billion a day, respectively. Thus the worldwide total is over $430 billion of foreign exchange trading a day.

Interestingly, the banks in the New York Fed Census reported that only 4.9 percent of their trading was with a nonfinancial firm; for the nonbanks, only 4.4 percent of their trading was with a nonfinancial firm. In other words, 95 percent of trading takes place among banks and other financial firms, rather than with customers (importers and exporters). Clearly, trading among themselves is a major economic activity for banks.

Why is trading volume important? It may be that the higher the liquidity of the markets, the more efficiently news regarding economic fundamentals is processed and the smaller is "unnecessary volatility" in the exchange rate. Or, the foreign exchange market already may be perfectly efficient, so that trading volume is irrelevant and uninteresting. Alternatively, trading may be based largely on "noise" rather than "news," leading to excessive volatility.

Froot and I study the British pound, German mark, Japanese yen, and Swiss franc using weekly data, and we find evidence that trading volume, exchange rate volatility, and the dispersion of expectations among forecasters are all positively related. The degree of dispersion has strong effects on the market: an increase in dispersion causes trading volume to increase in three currencies out of four and causes volatility to increase in all four currencies. We also find that the contemporaneous correlation between trading volume and volatility is high. These results may support the existence of noise trading--the causation runs from dispersion to the volume of trading, and then from trading to volatility--although there are other possible interpretations.(2)

The Rising Importance of Chartists

If traders tend to forecast by extrapolating recent trends (that is, if they have "bandwagon expectations"), then their actions will exacerbate swings in the exchange rate. The reason is that they will buy on upswings, there-by driving the price higher, and sell on downswings, forcing the price lower. Many so-called "chartist" forecasters, or technical analysts, are thought to use extrapolative rules (such as, "Buy when the one-week moving average crosses above the twelve-week moving average").

How do speculators form expectations? Froot and I offer evidence from market survey data that, at short horizons, respondents tend to forecast by extrapolating recent trends; at long horizons, they tend to forecast a return to a long-run equilibrium, such as purchasing power parity. Table 1 reports an update of these estimates. The coefficients reported answer the question: "For every 1 percent that the dollar appreciates in a given week, what percentage change does the median respondent forecast for the dollar thereafter?" The answer at the one-week horizon is another 0.13 percent in the same direction. At the four-week horizon, the extrapolation is smaller. Respondents expect that by the time three months have passed, the dollar will be lower than at the day when they are formulating their forecasts, and lower still at six months. One year out, they expect the dollar to be 0.33 percent lower for every 1 percent that the dollar has appreciated this week.

Which type of forecasters dominate the market: those who think short term, and appear to destabilize the market by their bandwagon expectations, or those who think long term and stabilize the market by their regressive expectations? Or, if both groups are important, how do they interact?

Since Friedman, the standard argument against the importance of destabilizing speculators is that they will lose money on average and will be driven out of the market in the long run.(3) A number of special counter-examples to the Friedman argument have been constructed over the years, most involving heterogenous actors (for example, "suckers" who lose money and "sharpies" who win).(4) The simplest counterexample would be based, not on heterogeneous actors, but on the theory of "rational speculative bubbles," in which each participant loses money if he or she doesn't go along with the herd. The problem with this theory is that it has nothing to say about why a bubble starts. For example, what generated a speculative bubble in the period leading up to February 1985, if that is what the dollar surge evident in Figure 1 was?

The theory of speculative bubbles that I developed with Froot says that from 1981-5, the market shifted away from the fundamentalists and toward the technical analysts or "chartists." This was a natural response to the inferior forecasting record of the fundamentalists. The change in the (weighted-average) market forecast of future movement in the value of the dollar in turn changed the demand for dollars, and therefore the price of the dollar, in the foreign exchange market.

Is any sort of evidence available for testing this theory? Euromoney magazine runs a yearly August review of between 10 and 27 foreign exchange forecasting services. Summary statistics from these issues are reported in Table 2, and the trend is very clear. In 1978, 18 forecasting firms described themselves as relying exclusively on economic fundamentals, and only two on technical analysis. By 1985, the positions had been reversed: only one firm reported relying exclusively on fundamentals, and 12 on technical analysis. In summary, shifts over time in the weight given to different forecasting techniques may be a source of changes in the demand for dollars, and large exchange rate movements may take place temporarily with little basis in macroeconomic fundamentals. [Figure 1 Omitted] [Table 1 to 2 Omitted]

(1)J. A. Frankel and K. A. Froot, "Understanding the U.S. Dollar in the 1980s: The Expectations of Chartists and Fundamentalists," NBER Reprint No. 957, December 1987, and "The Dollar as an Irrational Speculative Bubble," NBER Reprint No. 959, January 1988. C. M. Engel and J. D. Hamilton, "Long Swings in the Exchange Rate: Are They in the Data and Do Markets Know It?" NBER Working Paper No. 3165, November 1989, find that this is a general property of exchange rates, that there are long-term swings not adequately reflected in the forward market. D. M. Cutler, J. M. Poterba, and L. H. Summers, "Speculative Dynamics," forthcoming as an NBER Working Paper, find that this is true not only of exchange rates, but also of stocks, bonds, and commodities. (2)The results are reported in J. A. Frankel and K. A. Froot, "Chartists, Fundamentalists, and Trading in the Foreign Exchange Market," American Economic Review, Papers and Proceedings, forthcoming. (3)M. Friedman, "The Case for Flexible Exchange Rates," in Essays in Positive Economics, M. Friedman, ed. Chicago: University of Chicago Press, 1953. (4)In J. B. De Long, A. Shleifer, L. H. Summers, and R. J. Waldmann, "The Economic Consequences of Noise Trading," NBER Working Paper 2395, October 1987, noise traders can survive and prosper, even though they trade on irrelevant information.
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Author:Frankel, Jeffrey A.
Publication:NBER Reporter
Date:Dec 22, 1989
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