RDP 9307: Explaining Forward Discount Bias: Is it Anchoring? 6. Conclusion

Why should explanations outside the ‘rational’ paradigm be considered? And if they are, by what criteria can we distinguish between the almost endless possible types of irrational behaviour?

There are at least two answers to the first question. Firstly, for the foreign exchange market, explanations which rely on the full rationality of market participants have been remarkably unsuccessful in explaining the short-run behaviour of exchange rates. And secondly, as has been shown in other markets, small deviations from rationality can make a substantive difference to economic equilibria (Akerlof and Yellen (1985), Mankiw (1985), Cochrane (1989)).

In response to the second question, there are ways of assessing the plausibility of different types of irrational behaviour. As well as drawing on psychological evidence on people's observed behaviour, in the case of foreign exchange, a further check is provided by the actual responses of market participants.

Aside from the assumption of goods-price stickiness, our model of the foreign exchange market relies on two small deviations from full rationality. The first deviation is based on well-documented evidence that ‘anchoring’ is a common and systematic behavioural pattern. In the foreign exchange market, the forward rate fits very closely psychologists' definition of an anchor for exchange rate expectations. As we stress, compared to the range of possible exchange rate outcomes, being anchored to the forward rate induces only a small bias to exchange rate expectations.

The second deviation from full rationality which we invoke is the assumption that investors compare the relative performance of anchored and rational traders over a finite horizon. (We also assume that investors compare realised returns rather than realised utilities, but, as discussed, this distinction is not critical.) In this case as well, we do not require the deviation from full rationality to be a large one. As we have shown, the bias of the forward discount can be substantial even when investors use quite a long horizon (say, ten years) over which to make their investment decisions.

The message from this paper is that, together, these small deviations from full rationality can explain two well-established and enduring foreign exchange market puzzles.