The ability to predict the foreign exchange rate is important. For example, a currency exposure would like to know whether a hedge is desirable or not, and a currency trader would like to know which positions will be profitable. The demand for accurate forecasts is therefore high.
In order to predict the future exchange rate, the following question is relevant: what factors determine the current and thus the future exchange rate? Because the exchange rate is an important price in the economy, much research has been carried out to answer this question. The results of these efforts have been discouraging.
Meese and Rogoff (1983), for example, demonstrated that the predictive abilities of various exchange rate models were very low. Moreover, to quote Frankel and Froot (1990): "... the proportion of exchange rate movements that can be explained even after the fact, using contemporaneous macroeconomic variables, is disturbingly low".
Frankel and Froot (1986, 1990), therefore, called for a new theory called endogenous speculative bubbles. Within this new research area, the fact that various agents in financial markets, such as the foreign exchange markets, use technical analysis in their trade is taken into account. A degree of irrationality is thus introduced into the models.
However, to quote Shleifer and Summers (1990): "It is absolutely not true that introducing a degree of irrationality of some investors into models of financial markets "eliminates all discipline and can explain anything"".
Prof. Mikael Bask
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