Heterogeneity of traders as a source of exchange rate volatility: Some simulation results based on a descriptive model

We argue, on the basis of a descriptive model, that exchange rate volatility can be explained in terms of the heterogeneity of traders with respect to their trading strategies. These strategies are based on expectation formation mechanisms, trading rules and fundamentals. Within these broad categories traders are then classified into 19 different types. Each type is assigned a market weight that reflects the profitability of the underlying trading strategy, and these weights are used to simulate an exchange rate series. It is found that the actual and simulated series exhibit the same volatility patterns and that they belong to the same statistical distribution. It is concluded that trader heterogeneity can generate exchange rate volatility.