Speculation and Price Indeterminancy in Financial Markets

Abstract

We explore how speculative trading causes price indeterminacy in financial markets. Contrary to standard finance theory, we argue that speculating investors’ difficulty in forming rational expectations induces security prices to deviate from the fundamental values. We conducted a laboratory asset market experiment with overlapping generations of investors. We find that in markets with speculating investors (i) price deviations are larger; (ii) price deviations increase as the holding period of investors shrinks (and frequency of security transfers increases); (iii) speculative trading creates upward (downward) pressure on prices when liquidity is high (low); and (iv) price expectations are formed through forward induction from recent price changes, instead of backward induction from the fundamentals. The results suggest that speculation causes price indeterminacy when dynamic formation of inter-temporal rational expectations is infeasible.

Keywords: Experimental economics, speculating investors, rational expectations, price efficiency, overlapping generations, backward and forward induction

JEL Classification: C91, G11, G12