Friday, September 09, 2005

Speculation & Volatility

A common misperception is that speculation causes price volatility to increase; that is, spikes and drops in prices become more pronounced with increased speculation. It is true that we observe a positive correlation between increased speculation and price volatility. Usually speculation in futures markets and other derivatives precede the rise or fall in prices. However, the jump from correlation to causation is not to be made simply on the basis of which came first, thereby committing the post hoc ergo propter hoc (lit. "after this, therefore because of this") fallacy. If we use econometric analysis and run regressions that include both speculation and volatility as explanatory variables, we encounter the problem of multicollinearity* that prohibits us from drawing any statistical inference from the data; however, identifying the varying external causes of both speculation and volatility in order to test for correlation is also a challenge because many causes exist and causes may be different for each case. With the rising and falling gas prices, many people have blamed speculation and the existence of futures markets for creating this volatility. In doing so, they have ignored the fundamental causes of both speculation and market volatility. The prior knowledge or expectation of a significant rise or fall in prices (enough to cover transactions costs at minimum) is what causes speculation. That is, if I have reason to believe that the price of computers will increase twofold in the next week, I will approach a supplier of computers and ask if I may make a contract to purchase one thousand computers next week at a price higher than today's price, but lower than what I anticipate next week's price to be. I don't put a lot of money behind my bets unless I'm pretty sure they are right, so I'm not going to make this contract based on a pure guess. Instead, I might know that a report will come out stating that computers make children ten times smarter, thereby increasing parents' demand for computers. When the price of computers is high next week, am I to blame? Of course not. Assuming I hold the contract for delivery** rather than selling it earlier for a profit, I will have a thousand computers that I want to sell. If I charge the same price as everyone else, they might not sell as quickly as I'd like (I don't have room for a thousand computers in my house), so I charge less than my competitors. In doing so, I have actually decreased price volatility from where it would have been.

But suppose the scientists who originally drafted the report recognized that they had made a calculation error and what they meant to say was that computers cause children to lose focus on their homework and obtain poor grades in school. The existence of my futures contract didn't affect the price of computers, but the supplier with whom I made the contract is happy. I have acted as an insurance and reduced his loss on computers by my contract to purchase them at a higher price than he would have received otherwise.

Based on the nature of speculation, it is more likely that speculation reduces volatility from what it would have been had no speculation occurred. Speculation mitigates the volatility caused by other factors, such as hurricanes and reports that computers make your child smarter/less studious.

* Multicollinearity results when two explanatory variables are related and occurs in varying degrees; perfect collinearity (generally theoretical), and near-perfect or high multicollinearity distort the regression analysis.
**Forward or futures contracts are rarely held in order to acquire the good; rather they are held to close a position or hedge another investment.


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