Price movements in financial markets may appear to be based on the statistical calculations of fundamental metrics; however, prices are also influenced by an entire culture of speculation (Miyazaki, 2007). Speculators, who are typically short-term investors, trade on the anticipation of making profits due to incorrectly priced assets or securities (Malpezzi & Wachter, 2006). Economic theory suggests that speculation increases liquidity and price discovery in the market. For example, if speculators believe that the market is too optimistic about a firm’s future earnings, they will short the firm’s stock. This collective behavior will drive down the stock price and reflect the information known about the firm, thus creating a more informationally efficient market (Mengle, 2007). Economic principles also state that only investors with a comparative advantage in speculating will stay in the market because the competent speculators will impose losses on the incompetent ones and eventually weed them out (Bradfield, 2006).
It is important to analyze the effects of speculation because it has important implications for the design of the international financial architecture (Goh & Groenewold, 2000). For example, if price movements in currency markets are due to inconsistencies between fundamental and policy settings, the markets will just be doing its job. However, if wide swings in currency prices are due to speculative attacks, even when the fundamentals are sound, it follows that policy makers will need to consider measures that prevent the free movement of speculative capital (Goh et al., 2000).
While speculators account for a large share of total market activity, several studies have shown that speculators generally realize net trading losses (Mahani and Bernhardt, 2007). Some researchers suggest that large-scale speculation still manifests itself because of risk loving and utility from gambling. However, others have found that losses are too large to be reconciled solely by risk seeking and that traders mistakenly believe they can forecast prices (Mahani et al., 2007).
Speculative trading losses have been documented in the currency markets. Even though banks make large revenues and profits in the currency market through their customer business and market making operations, a study done by Mende and Menkhoff (2006) analyzed the profitability of a mid-sized German bank and found that speculative trades failed to become systematically profitable after a period of thirty minutes. Considering the competitive nature of the currency market, it is plausible to doubt that a market player could systematically make money in currency markets through long-term speculation.
Economic theory suggests that speculation serves to add liquidity in the market and improve price discovery; however, research has shown that speculation may also have negative effects such as creating asset price bubbles. This refers to when an asset or security is traded at prices significantly higher than its fundamental value. Simulation experiments showed that that price bubbles can emerge with prices reaching values of sixteen times their fundamental value. (Hommes, Sonnemans, Tuinstra, & De Velden, 2008). These experiments show that speculators do not seem to trade based on discrepancies of fundamental values but rather because they expect the price of the inflated asset to increase even more. This collective ‘trend following’ behavior does indeed increase the price of an asset and can lead to spiral movements in asset prices.
Lastly, speculation may also allow big market players to manipulate and possibly distort currency rates. Even considering the large size of the currency market, it may possible that sufficiently large market players may be able to influence lower volume currencies of small economies. Several studies have argued that the tipping point in the 1997 Asian Crisis was caused by the speculative attacks of hedge funds and other big currency market players. (Corsetti, Dasgupta, Morris, & Shin 2004). It must also be noted that the effect of these manipulations by big market players do not typically arise only from the size of their position but rather from the herding and signaling effects that it creates. If, for example, smaller investors saw the positions of the hedge funds as an indication of the fundamentals of the Asian currencies (which was acquired through their comparative advantage), they would short the currency. This type of behavior would eventually be spread to other ‘trend followers’ and consequently create a depreciation of the currency that may not truly reflect the fundamentals.
In sum, speculation may generate behaviors that decrease the informational value of prices. Even though currency speculation may not be profitable on average, it still manifests itself and creates ‘trend following’ behaviors. We have also seen that speculation may give room for market players to distort prices and exchange rates in order to follow their agenda. Succinctly, whether speculation is beneficial or not, will depend on its net effect. If its benefits toward liquidity and price discovery, as common economic theory suggests, are higher than its costs caused by the negative outcomes articulated in this post, then there should be no restriction on the movement of speculative capital. However, if the negative outcomes outweigh the benefits, it follows that there should be such restrictions.
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