Speculation and destabilisation

In the context of flexible exchange rates, Milton Friedman proposed that speculation must exert a stabilising influence on prices to remain profitable. This generated a substantial amount of predominantly theoretical research into the behaviour of speculators, for which the results seem to depend critically upon the assumptions. Such theoretical models need to be tested against empirical evidence to determine whether speculators behave in a destabilising manner. Using recent theoretical developments in the literature on modelling financial volatility, this paper tests the significance of speculators and their contributions to describing weekly volatilities across a series of currency, metals and commodity markets. As the time-varying conditional volatility GARCH model and its variants have been criticised for lacking economic content, incorporating speculators into such models contributes to an accommodation of this criticism. The economic implications from establishing the importance of speculators are far-reaching. Policymakers often discuss the imposition of a Tobin tax to curb speculation, so it must be established that speculators behave in economically destructive ways. The inclusion of speculators is also likely to yield superior forecasting models of volatility, and hence more efficient pricing of derivative instruments. (c) 2005 Published by Elsevier B.V. on behalf of IMACS.