Short-Term Speculators and the Origins of Near-Random-Walk Exchange Rate Behavior

Abstract:     
This paper suggests that normal speculative activity could be a source of random-walk exchange rate behavior. Using a noise trader model to analyze very short-term exchange rate behavior, it shows that rational, risk-averse speculators will smooth the impact of shocks to exchange rate fundamentals. With sufficient speculative activity, an exchange rate could become statistically indistinguishable from a random walk, regardless of the generating processes of its fundamental determinants.

This result may help resolve the apparent inconsistency between the observed behavior of floating exchange rates and the behavior predicted by existing theoretical models given the actual behavior of exchange rate fundamentals. The result also suggests that heavy speculative activity could cause exchange rates to be forecast better via random-walk than via structural models--even when structural forces are correctly identified. Finally, the paper provides an explanation for the observed extended response of exchange rates to sterilized intervention.

JEL Classification: G12, G14

working papers series