A look into speculation. Something I wrote some time ago [with references :)].
Price movements in financial markets may appear to be based solely 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 states that speculation increases liquidity and price discovery in the market, and consequently, increases economic efficiency. 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 correct information 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).
This paper will aim to identify if there are any negative effects of speculation and how it plays a role in currency markets. We will first look at how speculating has proved to be unprofitable in currency markets. Followed by how speculation, in contrast to economic theory, may lead to negative outcomes such as trend following that decrease informational and economic efficiency. We will also analyze whether currency crises are caused by macroeconomic variables or speculative attacks. Lastly, we will look at how speculation may negatively affect an entity’s decision to undertake projects and whether big market players affect the market.
It is important to analyze the effects of speculation, especially on currency markets, 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 be 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 and that they tend to remember profits, but forget losses (Mahani et al., 2007). Therefore, it seems that speculators do not seem to trade fully on additional information acquired because of a comparative advantage, but also from overconfidence and an illusion that they can time the market. This conclusion suggests that speculation may distort the prices of securities and consequently reduce their informational value.
Speculative trading losses have also been documented in the currency markets. Even though banks make large revenues and profits in the currency market through their customer business and by being market makers, a study done by Mende and Menkhoff (2006) analyzed the profitability of a mid-sized German bank in speculating currency 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 any player could systematically make money by speculating. Therefore, two conclusions may be deduced from these results. First, it seems that a speculator’s marginal benefit of acquiring additional information on a currency is less than his or her marginal cost and, hence, could be abandoned. It may also be that speculators’ models cannot properly predict short-term price movements in the currency markets. Succinctly, if speculation generates any negative behaviors, investors should not have a strong financial incentive to oppose partial restrictions on the movements of speculative capital.
Read more: http://www.myinvestmentanalysis.com/speculation-and-forex-speculation/#ixzz0RBj9tQOK
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