Research published in the November issue of the Economic Journal explains how differences of opinion – and therefore expectations – drive trading in foreign exchange markets. In the theory developed by Professors Nelson Mark and Yangru Wu, some market participants base their decisions solely on an objective evaluation of economic conditions, whereas others believe in the relevance of some extrinsic data – they are ”noise traders”. It is this latter group, trading irrationally, that cause the often massive temporary swings in exchange rates away from their fundamentally correct values.
The researchers” model is consistent with survey evidence on expectations formation as revealed by the forecasts of future exchange rates from professional foreign exchange dealers. These surveys reveal that, as a group, currency traders” forecasts (or expectations) appear not to be rational.
How economists interpret exchange rate fluctuations (and asset price movements in general) depends crucially on their assumptions about what financial market participants know – or think they know – about the way the actual economy works, and on how they evaluate and process new information.
The dominant working hypothesis for the last two decades is the theory of rational expectations. Here, all market participants are assumed to know the objective probability distributions governing financial and economic variables, and in making their investment decisions, they form their expectations about the future using these objective probabilities.
One central problem is that most versions of these theories can be refuted by the data and in order to make the theories ”work,” ever increasingly elaborate auxiliary assumptions need to be made in order to preserve rationality. A second problem is that surveys of forecasts of future exchange rates suggests that currency traders often behave irrationally.
Nelson and Mark”s theory is an example of what is called a ”noise trader” model where those who follow the extrinsic information introduce ”noise” into the trading dynamics. It is a notable departure from the rational expectations paradigm.
”Rethinking Deviations from Uncovered Interest Parity: the Role of Covariance Risk and Noise” by Nelson Mark and Yangru Wu published in the November 1998 issue of the Economic Journal. Mark is in the Economics Department at Ohio State University, 410 Arps Hall, 1945 North High Street, Columbus, Ohio 43210-1172; Wu is at Rutgers University, New Jersey.
Nelson Mark
001-614-292- 0413 | Mark.1@osu.edu
