FMM Working Paper

An agent-based model of endogenous fluctuations of exchange rates: Bet against the trend and cash in profits

This paper intends to contribute to the theoretical literature on the determinants of exchange rate fluctuations. We build an agent-based model, based on behavioral assumptions inspired by the literature on behavioral finance and by empirical surveys about the behavior of foreign exchange professionals. In our artificial economy with two countries, traders can speculate on both exchange and interest rates, and allocate their wealth across heterogeneous assets. Fundamentalists use both fundamental and technical analysis, while chartists only employ the latter, and are either trend followers or trend contrarians. In our model, trend contrarians and cash in mechanisms provide the sufficient stability conditions, and allow explaining and replicating most stylized facts of foreign exchange markets, namely (i) the excess volatility of the exchange rate with respect to its fundamentals, (ii) booms, busts and precarious equilibria, (iii) clusters of volatility, (iv) long memory and (v) fat tails.