Endogenous crashes in the foreign exchange market: a theoretical model
Résumé
We present a model of the foreign exchange market in which cash-constrained carry traders trade with short-sighted, boundedly rational chartists. This simple market structure provides a theoretical basis for the fact that the currencies of high interest rate countries tend to crash, sometimes without a fundamental trigger. Crash risk comes from a perverse interaction between carry traders and chartists, and is maximized when both investors are very active in the market.