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Market Imperfection Explanations for Exchange Rate Puzzles

There are several famous puzzles that relate to market imperfections, and these puzzles require a bit of explanation. Some of the basic assumptions about markets may not hold in foreign exchange markets.

  • The home bias in trade puzzle: People have a strong preference for consumption of their home goods.

  • The home bias in portfolio puzzle: Home investors prefer to hold home equities.

  • The Feldstein–Horioka puzzle: Savings and investment are highly correlated at the country level.

  • The consumption correlation puzzle: Consumption is much less correlated across countries than output.

  • The exchange rate disconnect puzzle: Short-term volatility in exchange rates doesn’t reflect that of the fundamentals.

  • The purchasing power parity puzzle: Short-term changes in exchange rates don’t reflect inflation differentials between countries.

In most economic models, market behavior has the following characteristics:

  • Trading costs and other frictions are small so that they don’t affect the market outcome (prices and quantities).

  • Whatever the nature of the shock is, market equilibrium prevails.

  • Market participants behave rationally.

These assumptions may reasonably explain goods markets, but they seem to not hold completely in financial markets. Because currency markets behave similarly to asset markets, the lack of efficiency in currency markets may partially explain the famous puzzles in international macroeconomics and finance. Even though usually one assumes that competitive markets determine exchange rates in floating exchange rate regimes, foreign exchange markets may be less than efficient.

As in the case of asset markets, the following assumptions of the efficient markets hypothesis may be systematically violated in foreign exchange markets as well:

  • Trading costs can be quite large. The most important of these costs is the information cost associated with acquiring and analyzing information to assess the risk and return of an asset or a currency.

    • Fragile expectations make assessing risk and uncertainty particularly difficult.

    • Information asymmetry persists. Sharing valuable information may not come with many incentives.

    • Information asymmetry can be a factor for not making use of arbitrage opportunities that are important for market efficiency.

  • A basic difference exists between commodity and asset markets. To appreciate this difference, consider expectations in any market. A market has a feedback system in terms of expectations. As a market participant, you consider past market behavior to form your expectations and, then your decision determines the current market behavior.

    An expectations-based market system can have a positive or negative feedback system. Supply-driven commodity markets have a negative feedback system. When producers expect future prices to be high, they increase production, which results in lower prices of their product. When firms expect future prices to be lower, they decrease production and have to deal with higher prices of their product. In this case, prices quickly converge to their equilibrium value.

    Financial markets are demand driven, and there is positive (self-confirming) feedback. When there’s an expectation of higher prices of an asset, market participants start buying it, increasing the demand for the asset and, thereby, its price. When market participants expect lower prices, they decrease their demand, and the price of the asset falls. Therefore, positive feedback in asset markets is capable of producing large fluctuations in the actual price of assets.

  • Herding behavior among asset market participants such as traders, fund managers, and analysts is an important deviation from market efficiency and implies information costs. It means that if you and a friend are the two traders in the foreign exchange market, the friend just watches you and sells or buys the currencies that you sell and buy.

    Why does your friend mimic your behavior? He must face a prohibitively high information cost, so instead of gathering information to base his trade on, he simply watches you and trades as you do. Information costs generate significant and sometimes persistent deviations from market equilibrium and create path-dependent prices.

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