Chapter 11: Exchange Rate Dynamics: A Nonlinear Survey
Frank H. Westerhoff 11.1 Introduction The foreign exchange market is the broadest and most active financial market in the world. Trading volume is enormous. According to the Bank for International Settlement (2005), the global turnover in traditional foreign exchange market segments reached an estimated daily average of USD1.9 trillion in April 2004. Such a high trading volume clearly dwarfs that of other (financial) markets. The nature of foreign exchange markets seems to be highly speculative. The overwhelming part of the trading volume reflects very short-term transactions. For example, operations of intraday traders account for about 75 percent of the market volume. Moreover, international trade transactions represent only a small fraction of the total volume. Speculative transactions are roughly 20 times higher than the sum of world trade and international portfolio investment. Not surprisingly, the fast and hectic trading is also reflected in the dynamics of exchange rates. Foreign exchange markets are characterized by a very high volatility. For instance, the DEM/USD exchange rate changed by about 0.5 percent per day between 1974 and 1998. Even more important, the distribution of the returns displays fat tails. Extreme price changes, say above 3 percent, appear much more frequently than predicted by the normal distribution. Is such evidence in line with the efficient market hypothesis? The efficient market hypothesis states that prices always reflect their fundamental values. Hence, price changes are due to unexpected fundamental shocks. Clearly, if we observe an exchange rate movement by 5 percent, then this should correspond to a...
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