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This paper suggests a structural connection between rational speculative activity and exchange rate volatility. We note that, when Friedman originally claimed that rational speculators must smooth exchange rate, he excluded interest rate differentials from his interpretation of speculator behavior. If interest rates matter, rational speculators could sometimes violate Friedman's description, and buy a currency whose value is relatively high or sell a currency whose value is low. In consequence, the presence of rational, fully informed speculators might increase the volatility of a floating exchange rate. Speculation is stabilizing at low levels of speculative activity and destabilizing at high levels.

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Public news can be expected to change market prices but, unlike ''public information,'' there are differing expectations about the impact. Hence trading is necessary for the market to process these divergent views. A surprise announcement of an increase in German interest rates coupled with concurrent transactions data enables us to study in detail dealers' reactions. The patterns observed are consistent with dealers' practice to book targeted profits immediately if possible in the face of uncertainty. Evidence also shows that the speculative activity by traders in initial reaction to the news destabilized the market for the next 2 h.