Excess Volatility and Speculative Bubbles in the Canadian Dollar: Real or Imagined?
Greater intervention by the public sector is often proposed as a solution to the increased speculation and excessive price volatility thought to characterize today's competitive world financial system. However, before any ambitious policy responses can be contemplated, the question of whether asset prices are in fact subject to excess volatility needs to be answered. This paper tries to answer the question by using the Canadian dollar as a representative asset and testing for excess volatility and speculative bubbles.
In the main, the empirical sections of the paper provide little support for the excess volatility argument and the subsequent need for government intervention. The short-term variability of the dollar, like that of most other financial assets, has not shown any tendency to increase over time. The evidence also suggests that most of the broad movements in the dollar can be explained by changes in market fundamentals as opposed to aberrant speculative activity. While some evidence of noise trading and speculative behaviour was uncovered by the authors using a regime-switching model, periods of increased exchange rate volatility appeared to be associated with equilibrating trading activity, pushing exchange rates closer to fundamentals, rather than to destabilizing market forces. In short, the exchange market is performing more or less as it should and is not in any obvious need of remedial government action.