"Weight of Money " Pricing and Speculative Dynamics

We investigate the role of "weight of money " pricing in generating spec-ulative dynamics. "Weight of money pricing " means that the market price of an asset is driven by the amount of liquidity that accumulates in the mar-ket for the asset. In our benchmark model, a contagion argument rules out speculation in presence of weight of money pricing. However, in asset mar-kets associated with leveraged trades, where maintaining a trading position creates funding externalities for other traders, speculative dynamics may take hold. Our results suggest that markets that combine low resiliency and signi\u85cant costs of carry (such as the foreign exchange market) have the pre-conditions for large and persistent deviations of price from funda-mentals followed by abrupt reversals. We show how the unique equilibrium trading strategies can be obtained through iterated deletion arguments, and how the assets stochastic price paths follow from the dominance solvable trading strategies combined with fundamental shocks.