Modeling optimism and pessimism in the foreign exchange market

In this paper we model how the existence of di¤erent beliefs about the underlying fundamental value of a currency a¤ects the dynamics of the exchange rate. We …nd that a divergence of beliefs creates the potential for waves of optimism and pessimism that alternate in an unpredictable way. These waves are disconnected from the underlying (objective) fundamental value. We also …nd that in such a world there is "sensitivity to initial conditions", i.e. small changes in beliefs can fundamentally alter the time path of the exchange rate. We thank Gerben de Zwart, Cars Hommes, Pelin Ilbas, Thomas Lux and Kristien Smedts for valuable comments. We are also indebted to the Research Foundation Flanders (FWO) for …nancial support.