Microscopic models of financial markets

This review deals with several microscopic models of financial markets which have been studied by economists and physicists over the last decade: Kim-Markowitz, Levy-Levy-Solomon, Cont-Bouchaud, Solomon-Weisbuch, Lux-Marchesi, Donangelo-Sneppen and Solomon-Levy-Huang. After an overview of simulation approaches in financial economics, we first give a summary of the Donangelo-Sneppen model of monetary exchange and compare it with related models in economics literature. Our selective review then outlines the main ingredients of some influential early models of multi-agent dynamics in financial markets (Kim-Markowitz, Levy-Levy-Solomon). As will be seen, these contributions draw their inspiration from the complex appearance of investors' interactions in real-life markets. Their main aim is to reproduce (and, thereby, provide possible explanations) for the spectacular bubbles and crashes seen in certain historical episodes, but they lack (like almost all the work before 1998 or so) a perspective in terms of the universal statistical features of financial time series. In fact, awareness of a set of such regularities (power-law tails of the distribution of returns, temporal scaling of volatility) only gradually appeared over the nineties. With the more precise description of the formerly relatively vague characteristics (e.g. moving from the notion of fat tails to the more concrete one of a power-law with index around three), it became clear that financial markets dynamics give rise to some kind of universal scaling laws. Showing similarities with scaling laws for other systems with many interacting subunits, an exploration of financial markets as multi-agent systems appeared to be a natural consequence. This topic was pursued by quite a number of contributions appearing in both the physics and economics literature since the late nineties. From the wealth of different flavors of multi-agent models that have appeared by now, we discuss the Cont-Bouchaud, Solomon-Levy-Huang and Lux-Marchesi models. Open research questions are discussed in our concluding section. --

Intervention as information: a survey

Research has generally failed to find reliable connections between official exchange-market interventions and exchange rates that are consistent with either a monetary or a portfolio-balance theory of exchange-rate determination. Recently economists have suggested that intervention might sometimes influence exchange rates through its effects on agents’ expectations. This survey discusses newer research that analyzes informational aspects of intervention.Foreign exchange - Law and legislation

Central bank intervention with limited arbitrage

Shleifer and Vishny (1997) pointed out some of the practical and theoretical problems associated with assuming that rational risk-arbitrage would quickly drive asset prices back to long-run equilibrium. In particular, they showed that the possibility that asset price disequilibrium would worsen, before being corrected, tends to limit rational speculators. Uniquely, Shleifer and Vishny (1997) showed that “performance-based asset management” would tend to reduce risk-arbitrage when it is needed most, when asset prices are furthest from equilibrium. We analyze a generalized Shleifer and Vishny (1997) model for central bank intervention. We show that increasing availability of arbitrage capital has a pronounced effect on the dynamic intervention strategy of the central bank. Intervention is reduced during periods of moderate misalignment and amplified at times of extreme misalignment. This pattern is consistent with empirical observation.

The case for foreign exchange intervention: the government as an active reserve manager

This paper argues that major governments should actively manage their foreign exchange portfolios to maximize the risk-adjusted return to the taxpayer by exploiting long-term, fundamental based predictability in floating exchange rates. Such transactions—equivalent to foreign exchange intervention—would improve welfare by transferring risk from private agents to the risk-tolerant government. Interventions explicitly designed to profit the reserve management authority would be more likely to be successful and, to the extent that they are, would reduce resource misallocation.Foreign exchange

Technical analysis in the foreign exchange market

This article introduces the subject of technical analysis in the foreign exchange market, with emphasis on its importance for questions of market efficiency. Technicians view their craft, the study of price patterns, as exploiting traders’ psychological regularities. The literature on technical analysis has established that simple technical trading rules on dollar exchange rates provided 15 years of positive, risk-adjusted returns during the 1970s and 80s before those returns were extinguished. More recently, more complex and less studied rules have produced more modest returns for a similar length of time. Conventional explanations that rely on risk adjustment and/or central bank intervention are not plausible justifications for the observed excess returns from following simple technical trading rules. Psychological biases, however, could contribute to the profitability of these rules. We view the observed pattern of excess returns to technical trading rules as being consistent with an adaptive markets view of the world.Foreign exchange rates

Long Memory, Heterogeneity and Trend Chasing

Long-range dependence in volatility is one of the most prominent examples of applications in financial market research involving universal power laws. Its characterization has recently spurred attempts at theoretical explanation of the underlying mechanism. This paper contributes to this recent development by analyzing a simple market fraction asset pricing model with two types of traders fundamentalists who trade on the price deviation from estimated fundamental value and trend followers who follow a trend which is updated through a geometric learning process. Our analysis shows that the heterogeneity, trend chasing through learning, and the interplay of noisy processes and a stable deterministic equilibrium can be the source of power-law distributed fluctuations. Statistical analysis based on Monte Carlo simulations are conducted to characterize the long memory. Realistic estimates of the power-law decay indices and the (FI)GARCH parameters are found.asset pricing; fundamentalists and trend followers; market fraction; stability; learning; long memory

Heterogeneous expectations in the foreign exchange market : evidence from the daily Dollar/DM exchange rate

In this study a regime switching approach is applied to estimate the chartist and fundamentalist (c&f) exchange rate model originally proposed by Frankel and Froot (1986). The c&f model is tested against alternative regime switching specifications applying likelihood ratio tests. Nested atheoretical models like the popular segmented trends model suggested by Engel and Hamilton (1990) are rejected in favour of the multi agent model. Moreover, the c&f regime switching model seems to describe the data much better than a competing regime switching GARCH(1,1) model. Finally, our findings turned out to be relatively robust when estimating the model in subsamples. The empirical results suggest that the model is able to explain daily DM/Dollar forward exchange rate dynamics from 1982 to 1998

Financial assets, expected return and risk, speculation, uncertainty, and exchange rate determination

Purpose: The objective of this paper is to determine the movements (long-term trend) of the exchange rate by forecasting the rate of return and risk (return to variability ratio, RVR) that financial assets have in two economies and for four different investments. Design/Methodology/Approach: Risk averse speculators will try to maximize their return and minimize their risk by investing domestically or abroad, but these capital flows will affect the value of the two currencies (their exchange rate). Findings: The empirical results show that before 2001 the return in the U.S. was high and the dollar was appreciated; after 2001, the same return became negative and the dollar was depreciated, but after 2004 the returns have growing positively for the U.S., and the returns for the Euro-zone are falling. Practical Implications: We can say that the dollar may appreciate with respect to euro, except if we will have any other domestic or external shocks on the two economies. Still the results of this analysis are not very conclusive. Originality/value: International investors are investing in countries with higher return and lower risk. This increase in demand for these assets, increases the demand for currency in that country and its currency is appreciated.peer-reviewe

Government intervention in the foreign exchange market

This article offers a survey of the literature on foreign exchange intervention, including sections on the theoretical channels through which intervention might affect exchange rates and a summary of the empirical findings. The survey emphasizes that intervention is intended to provide monetary authorities with an means of influencing their exchange rates independent from monetary policy, and tends to evaluate theoretical channels and empirical results from this perspective.Foreign exchange administration