Conventions in the foreign exchange market : Can they really explain exchange rate dynamics ?

The present article provides an unorthodox model exchange rate dynamics based on conventions that prevail among market participants. We build a theoretical model that highlights the mechanisms underlying the formation of market conventions. We then test this model empirically on the euro/dollar exchange rate between January 1995 and December 2008. We rely on two alternative methods : a macroeconomic analysis and an econometric analysis based on the estimation of a time varying parameter model. Both methods show that market switches between fundamentals considered in a bull convention and in a bear convention explain the euro/dollar dynamics between January 1995 and December 2008. Besides, at horizons longer than 1 month, the out-of-sample forecasting power of the convention model beats the traditional exchange rate models and the random walk.