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. Since fundamentalists use buy-and-hold investment strategies and do not react to shocks, they have a negative impact on liquidity. As a consequence, speculators are pushed toward more aggressive trading. The destabilizing effect increases with the proportion of fundamentalists among traders. In conclusion, efficient markets are more volatile with a few speculators than with many speculators. The first-best situation still corresponds to the case where speculators are totally absent, but this is unlikely on real markets. Regulators should therefore be aware that efforts to limit speculation might, surprisingly, end up increasing volatility.