Noise, Exchange Rate Trend and Volatility: Theory and Empirical Evidence

Exchange rates differ considerably with respect to exchange rate volatility, while they are very similar with respect to the macroeconomic fundamentals — the well known exchange rate disconnect puzzle. The microeconomic structure of foreign exchange markets, especially the existence of noise traders, may be responsible for the excessive volatility in flexible exchange rate regimes. The entry of noise traders into the market changes its composition and leads to excessive volatility, since noise traders do not only cause additional volatility but also take on the evolving risk. Our noise trader model predicts a continuum of equilibria and a U shaped relation between exchange rate volatility and trend, which is supported by the empirical evidence. The data show rapid changes of exchange rate volatility through time, but a relatively stable relation between trend and volatility, as predicted by the model. In such a situation monetary policy may be able to smooth the exchange rate without changing macroeconomic fundamentals. JELClassificationnumbers : F31, F33, G15