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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 errors 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 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. A priori, it is difficult to identify the noise traders. We know that a certain amount of speculation must exist, in an efficient market, to offset the net hedging pressure. The questions are whether there is too much speculation, and whether the speculation is rational or based upon noise trading. Holbrook Working and Anne E. Peck (1985) have developed a measure of excess speculation in markets, which they refer to as the M index. It measures the amount of speculation in excess of what is necessary to accommodate the hedgers. For example, if there is net short hedging in a market, the minimum amount of speculation should be long equal to the net short hedging. Any short speculation would be excessive. Most studies focus upon the contemporaneous relation between speculation and price variability. This paper analyzes the dynamics of interaction between excess speculation M and price variability V, where both V and M are endogenous. The dynamics are as follows. Variability (V) is produced by the fundamentals (F) and by excess speculation (M). We investigate whether