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194CHAPTER 6. FOREIGN EXCHANGE MARKET EFFICIENCYof rational and irrational agents produce spot and forward exchange dynamicsthat is consistent with the Þndings from survey data. The modeladapts the overlapping-generations noise trader model of De Long et.al. [38] to study the pricing of foreign currencies in an environmentwhere heterogeneous beliefs across agents generate trading volume andexcess currency returns.The irrational ‘noise’ traders are motivated by Black’s [14] suggestionthat the real world is so complex that some (noise) traders areunable to distinguish between pseudo-signals and news. These individualsthink that the pseudo-signals contain information about assetreturns. Their beliefs regarding prospective investment returns seemdistorted by waves of excessive optimism and pessimism. The resultingtrading dynamics produce transitory deviations of the exchangerate from its fundamental value. Short-horizon rational investors bearthe risk that they may be required to liquidate their positions at a timewhen noise-traders have pushed asset prices even farther away from thefundamental value than they were when the investments were initiated.The ModelWe consider a two-country constant population partial equilibrium model.It is an overlapping generations model where people live for two periods.When people are born, they have no assets but they do have a fullstomach and do not consume in the Þrst period of life. People makeportfolio decisions to maximize expected utility of second period wealthwhichisusedtoÞnance consumption when old.The home country currency unit is called the ‘dollar’ and the foreigncountry currency unit is called the ‘euro.’ In each country, there is aone-period nominally safe asset in terms of the local currency. Bothassets are available in perfectly elastic supply so that in period t, peoplecan borrow or lend any amount they desire at the gross dollar rate ofinterest R t =(1+i t ), or at the gross euro rate of interest, R ∗ t =(1+i ∗ t ).The nominal interest rate differential—and hence by covered interestparity, the forward premium—is exogenous.In order for Þnancial wealth to have value, it must be denominatedin the currency of the country in which the individual resides. Thus inthe second period, the domestic agent must convert wealth to dollars