Frank Westerhoff

Nonlinearities and Cyclical Behavior: The Role of Chartists and Fundamentalists

We develop a behavioral exchange rate model with chartists and fundamentalists to study cyclical behavior in foreign exchange markets. Within our model, the market impact of fundamentalists depends on the strength of their belief in fundamental analysis. Estimation of a STAR GARCH model shows that the more the exchange rate deviates from its fundamental value, the more fundamentalists leave the market. In contrast to previous findings, our paper indicates that due to the nonlinear presence of fundamentalists, market stability decreases with increasing misalignments. A stabilization policy such as central bank interventions may help to deflate bubbles.

The Use of Agent-Based Financial Market Models to Test the Effectiveness of Regulatory Policies

Summary Models with heterogeneous interacting agents have proven to be quite successful in the past. For instance, such models are able to mimic the dynamics of financial markets quite well. The goal of our paper is to explore whether this approach may offer new insights into the working of certain regulatory policies such as transaction taxes, central bank interventions and trading halts. Although this strand of research is rather novel, we argue that agent-based models may be used as artificial laboratories to improve our understanding of how regulatory policy tools function.

Speculative markets and the effectiveness of price limits

Abstract The aim of this paper is to study the effectiveness of price limits in speculative markets. We construct a nonlinear stochastic asset pricing model in which traders rely on technical and fundamental analysis to determine their orders. The dynamics of the model mimic stylized facts such as the emergence of bubbles, excess volatility, fat tails for returns or volatility clustering quite well. Using this model as a laboratory, we find that price limits have the potential to reduce both volatility and deviations from fundamentals. The more traders lend themselves to trend-extrapolating behavior, the better price limits work.

A Simple Agent-based Financial Market Model: Direct Interactions and Comparisons of Trading Profits

In the recent past, a number of interesting agent-based financial market models have been proposed. These models successfully explain some important stylized facts of financial markets, such as bubbles and crashes, fat tails for the distribution of returns and volatility clustering. These models, reviewed, for instance, in Chen, Chang, and Du (in press); Hommes (2006); LeBaron (2006); Lux (in press); Westerhoff (2009), are based on the observation that financial market participants use different heuristic trading rules to determine their speculative investment positions. Note that survey studies by Frankel and Froot (1986);Menkhoff (1997);Menkhoff and Taylor (2007); Taylor and Allen (1992) in fact reveal that market participants use technical and fundamental analysis to assess financial markets. Agent-based financial market models obviously have a strong empirical microfoundation.

Exchange Rate Dynamics: A Nonlinear Survey

Complexity research draws on complexity in various disciplines. This Handbook provides a comprehensive and current overview of applications of complexity theory in economics. The 15 chapters, written by leading figures in the field, cover such broad topic areas as conceptual issues, microeconomic market dynamics, aggregation and macroeconomics issues, econophysics and financial markets, international economic dynamics, evolutionary and ecological–environmental economics, and broader historical perspectives on economic complexity.

Tobin tax and market depth

This paper investigates—on the basis of the Cont–Bouchaud model—whether a Tobin tax can stabilize foreign exchange markets. Compared to earlier multi-agent studies, this paper explicitly recognizes that a transaction tax-induced reduction in market depth may increase the price responsiveness of a given order. We find that the imposition of a transaction tax may still achieve a triple dividend: (1) exchange rate fluctuations decrease, (2) currencies are less mispriced and (3) central authorities raise substantial tax revenues. However, if the price impact function is too sensitive with respect to market depth, stabilization may turn into destabilization.

Expectations Driven Distortions in the Foreign Exchange Market

This paper explores the phenomenon of lasting deviations of the exchange rate from its fundamental value in the foreign exchange market. Motivated by empirical observations a chartists-fundamentalists model is developed in which boundedly rational agents repeatedly choose between technical and fundamental trading rules to determine their speculative investment positions. Crucial for the dynamics is how the traders perceive the fundamental exchange rate. This perception process is based on psychological evidence. Simulations give rise to bubbles but simultaneously display quite realistic exchange rate dynamics (unit roots in the exchange rates, fat tails for returns, and volatility clustering).

Effects of Inflation Expectations on Macroeconomic Dynamics: Extrapolative Versus Regressive Expectations

Abstract In this paper, we integrate heterogeneous inflation expectations into a simple monetary model. Guided by empirical evidence, we assume that boundedly rational agents, selecting between extrapolative and regressive forecasting rules to predict the future inflation rate, prefer rules that have produced low prediction errors in the past. We show that integrating this behavioral expectation formation process into the monetary model leads to the possibility of endogenous macroeconomic dynamics. For instance, our model replicates certain empirical regularities such as irregular growth cycles or inflation persistence. Moreover, we observe multi-stability via a Chenciner bifurcation.

Anchoring and Psychological Barriers in Foreign Exchange Markets

This paper develops a simple behavioral exchange rate model in which investor perception of the fundamental value is anchored to the nearest round number. Traders adjust their anchors in two ways. Some believe that exchange rates move toward (perceived) fundamentals, while others bet on a continuation of the current exchange rate trend. The behavior of the traders causes complex dynamics. Since the exchange rate tends to circle around its perceived fundamental value, the foreign exchange market is persistently misaligned. Central authorities have the opportunity to reduce such distortions by pushing the exchange rate to less biased anchors, but to achieve this, they have to break psychological barriers between anchors.

On the inherent instability of international financial markets: natural nonlinear interactions between stock and foreign exchange markets

We develop a novel financial market model in which the stock markets of two countries are linked via and with the foreign exchange market. To be precise, there are domestic and foreign speculators in each of the two stock markets which rely either on linear technical or linear fundamental trading strategies to determine their orders. Since foreign stock market speculators require foreign currency to conduct their trades, all three markets are connected. Our setup entails a natural nonlinearity which may cause persistent endogenous price dynamics. Moreover, we analytically show that market interactions can destabilize the models fundamental steady state.