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Price Volatility and Speculation

The relation between speculation and price volatility has been studied at both the theoretical and the empirical level. Consider a market with four types of participants: consumers, producers, professional speculators, and amateur speculators. The speculators operate in the futures market, because transactions costs are low. There are two sources of variation in the spot price. The first results from variations in the fundamentals, which affect consumption and production. The second results from the variance of the market Bayesian error. Define the Bayesian error as the difference between the subjective expectation and the objective (true) expectation of the relevant stochastic variable. The variance of the Bayesian error differs both within and among groups. A noise trader is defined as one with a high variance of Bayesian error, whereas one who has Muth Rational Expectations (MRE) has a Bayesian error equal to zero. The relative weight of the noise traders is defined as the ratio of their position in futures to the open interest. The larger the weight of the noise traders, the greater will be the second source of spot price variability. If an increase in speculation lowers the weight of the noise traders, it will be stabilizing. (See Black; Stein, ch. 3.) A priori, it is difficult to identify the noise traders. Milton Friedman argued that profitable speculation reduces the price variance. This insight has generated many empirical papers which examined the profitability of speculation. However, it was shown in many theoretical articles (Kemp, Farrell, Baumol, Salant, Hart, and Kreps) that his conclusion only follows under special conditions. Suppose that we consider a continuous time period [0, 11. If the nonspeculative inverse demand curves have constant slopes but stochastic intercepts, and the speculators’ position at t = 1 is the same as it was at t = 0, then the Friedman result follows. The transversality condition is designed to rule out Ponzi schemes or speculative bubbles. If the slope varies over time, then Friedman’s result does not follow. It is difficult, however, to know the extent to which the set of conditions required by Friedman’s, or anyone else’s, analysis approximate the conditions which prevail in different markets. It is desirable to focus directly upon the relation between speculation and price variability. We know that a certain amount of speculation must exist in an efficient market to offset the net hedging pressure. The questions