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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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4.3 A Prototype Behavioral Model of the Foreign Exchange Market

In this section, we present a prototype behavioral model of the foreign exchange market. The basic assumptions used in this model are the following. First, individual agents have cognitive limitations in processing and evaluating information. They are not capable of understanding the complexity of the underlying model. Secondly, as they know their cognitive limitations, they do not try to understand the full complexity of the world. Instead, they use simple rules (heuristics) to take positions in the market. Agents in our model are not rational in the traditional sense. That does not mean, however, that they are dumb. On the contrary, they are willing to change and adjust their behavior when the incentive to do so is strong enough. Quite often, a departure from RE is interpreted to imply moving into a world of irrationality. This is not the case in our model. The world in which individual agents cannot hope to understand the underlying complexity of that world, it is reasonable to use simple rules and to subject these rules to regular evaluation.6 This trial and error mechanism is probably the most fundamental learning mechanism of human beings.

We will assume that there are two types of heuristic rules. One rule is an extrapolative one (a chartist or trend following rule) and the other is a mean-reverting one (a fundamentalist rule). Traders use one of the two rules. The use of the fundamentalist rule leads to the ...

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