Destabilizing speculation in foreign currency futures markets

Abstract

We investigate the effect of trading demands by type of traders on price volatility in six foreign currency futures markets. Evidence shows that expected trading demands do not affect futures prices. However, price volatility is positively associated with trading demand shocks (in either direction) of speculators and small traders, and negatively related to hedging demand shocks. This suggests that speculative trading destabilizes the market. Based on the microstructure literature and noise trading theories, speculators and small traders appear to be noise traders, while hedgers are informed traders. Our further evidence indicates that noise traders, on average, lose money over a short horizon in these markets.