Bulls, Bears and Excess Volatility: can currency intervention help?

Abstract

Asset mis-pricing may reflect investor psychology, with excess volatility arising from switches of sentiment. For a floating exchange rate where fundamentals follow a random walk, we show that excess volatility can be generated by the repeated entry and exit of currency 'bulls' and 'bears' with switches driven by 'draw-down' trading rules. We argue that non-sterilised intervention - in support of 'monitoring band' - can reduce excess volatility by coordinating beliefs in line with policy. Strategic complementarity in the foreign exchange market suggests that sterilised intervention may also play a coordinating role.