Dynamic Expectation Formation in the Foreign Exchange Market

This paper investigates the time-varying nature of expectation formation rules for institutional investors in the foreign exchange market. Using a dataset of survey expectations for four exchange rates, we first distinguish three different general rules. We find a momentum rule, a fundamental rule, and a rule that takes advantage of interest differentials between countries. Apart from heterogeneity in expectation formation rules, we show that the rules are time-varying conditional on a number of different factors, such as the sign of the most recent return, the forecast horizon, the distance to the PPP rate, and the extent to which the rule produces forecast errors vis-a-vis the market exchange rate.

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