Representativeness of news and exchange rate dynamics

Guided by psychological evidence, we develop a behavioral exchange rate model in which investors' perception of fundamental shocks switches between two states. According to the representativeness heuristic, agents underestimate the informational content of news in calm periods, whereas they overreact to news if they encounter a series of distinct exchange rate changes. Simulations indicate that the model mimics the behavior of actual exchange rates quite well. For instance, we observe fat tails for the distribution of the returns and volatility clustering.