Financial Crises in Efficient Markets: How Fundamentalists Fuel Volatility

Abstract:     
When a financial crisis breaks out, speculators typically get the blame whereas fundamentalists are presented as the safeguard against excessive volatility. This paper proposes an asset pricing model where two types of rational traders coexist: short-term speculators and long-term fundamentalists, both sharing the same information set. In this framework, excess volatility not only exists, but is actually fueled by fundamental trading. Consequently, efficient markets are more volatile with a few speculators than with many speculators. Regulators should therefore be aware that efforts to limit rational speculation might, surprisingly, end up increasing volatility.

Keywords: Efficient markets, Speculators, Fundamentalists, Speculative bubbles, Liquidity

JEL Classification: G14, G12, G01, D84

Accepted Paper Series