3 Intelligent Well Technology: Status and Opportunities for Developing Marginal Reserves SPE

Option trading, volatility and efficiency in the EU ETS

Julien Chevallier, Imperial College London, UK, +44(0)20.7594.5796,

Yannick Le Pen, University of Nantes, France, +33(0)2.40.14.17.34,

Benoit Sevi, University of Angers, +33(0)2.40.14.17.34,

Overview

To what extent does the introduction of derivatives products tend to destabilize the underlying asset markets? On the one hand, most of the empirical evidence for equities, bonds and commodities suggests that derivatives products do not increase volatility, but rather increase the liquidity and the informational efficiency of the underlying market. On the other hand, the introduction of derivatives markets may affect the volatility of the underlying asset market since they affect producers' decisions through intertemporal arbitrage. Derivatives products may also guide producers' decisions based on a mix of true information and speculators' noise signals.

The introduction of carbon-based derivatives products naturally raises the question of their utility for market operators. There are mainly two uses of options: (i) for speculation purposes in order to take a risky position, and (ii) for hedging purposes in order to reduce/eliminate the risk of a position. The second use obviously allows industrials to lower the economic, political and financial risks and uncertainties attached to the development of the EU carbon trading scheme on the mid-term.

This paper investigates how the introduction of option prices may have impacted this efficiency of the allowance futures market. More specifically, we examine the following central questions: what is the impact of the creation of the carbon option market on the futures market and underlying allowance asset in terms of volatility, efficiency, and autocorrelation? is the option market introduction the only cause for a change in the underlying market volatility? We expect the introduction of derivatives products for carbon-based assets to have a stabilizing effect, and thus to decrease volatility. The latter question leads us to consider other market factors linked to institutional decisions and energy markets that may be atttributed to changes in volatility.

Methods

Our study of the carbon market departs from the methodology developed by Fleming and Ostdiek (1999) on crude oil markets on several points.

First, we proceed with a standard GARCH model analysis on daily data (Foster and Nelson (1996), Andreou and Ghysels (2002a), Fleming et al. (2003)). We also use high-frequency data to study realized volatility, which has not been applied yet to study the impact of the introduction of a derivatives market on the underlying asset market. This constitutes the first methodological contribution of our paper.

Second, we search for structural breaks in the parameters of our model following the well-known method developed by Antoniou and Foster (1992). With daily data, we estimate a GARCH model, and test with Chow and Cusum breakpoint tests whether the coefficients are statistically different before and after the introduction of the derivatives market (Andreou and Ghysels (2002b), Rapach and Strauss (2008) for recent contributions on daily data). An extension of this work with intraday data may be found in Liu and Maheu (2009), who test for breaks in realized volatility with bayesian estimation and an autoregressive modeling of realized volatility (Corsi (2004), Andersen et al. (2007, 2009)). These methods have not been used to detect structural breaks following the introduction of derivative products, which constitutes our second methodological contribution.

Third, we discuss autocorrelation and informational efficiency issues linked to the introduction of option prices, given the increasing liquidity of this derivatives market (Chan et al. (2002)).

Fourth, we study the impact of the introduction of the options market on the variance and higher order moments of the underlying assets. With daily data, we model the conditional skewness and kurtosis, and investigate whether their dynamics change overtime. This technique has not been applied yet to our research question, and constitutes our third methodological contribution.

Results

Our estimation results tend to indicate a decrease in the unconditional component of volatility for the futures contract of maturity December 2008. This decrease in volatily is consistent with what was expected. The introduction of option prices provides a more complete and liquid market, and a greater flexibility for market participants to hedge their position on the allowance market.

Besides, we include as sensitivity tests other factors coming from energy markets that might also impact the volatility of the carbon futures returns, and thus that would be also driving the results found earlier concerning the impact of the introduction of the option market. We test for influences from energy markets due to the fuel-switching behaviour of major power producers on the EU ETS.

Overall, our GARCH estimates suggest that the dynamics of the variance are quite different before and after the introduction of the options market. These effects are then further assessed using realized volatility measures with intraday carbon data.

Conclusions

Overall, this paper brings a better understanding of the newly created derivatives products for emissions markets, and their importance for market participants and brokers alike in the emissions trading community.

References

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