Abstract
This paper presents a heterogeneous agents model of the foreign exchange market in which agents’ risk attitudes vary over time due to psychological factors emphasized in prospect theory. We find that psychological component and risk-profit elasticity play significant roles in exchange rate expectations formation and investment behavior. Although all agents show more risk-averse after the crisis, the extent to which their risk attitude responds to the crisis varies due to heterogeneous forecasting rules as well as the changes of trading environment and central bank intervention. Moreover, time-varying risk attitudes can help explain the forward premium puzzle. These findings have implications for the exchange rate expectation formation theories and foreign exchange market stability policies.
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