IMPACTS OF FINANCIAL DERIVATIVES MARKET ON OIL PRICE VOLATILITY

Istemi Berk

IzmirUniversity of Economics

+905332903117

Overview

Risk management in energy industry has been a rising issue in the 20thCentury. Introduction of financial derivative instruments into the energy market in 1983 with the first contract of NYMEX WTI futures, took place in the name of handling the risk of price volatility which has emerged in the presence of domination of OPEC in market. Most common view of executives of oil market was that futures exchange would diminish price volatility of oil and at the same time “invisible hand” would lead a fair equilibrium of price and quantity in terms of supply-demand approach. It was a crucial issue because, as the most important input for all the industries, crude oil has been a term of foreign trade for developed countries. On the other hand, from the perspective of industrial agents modelling volatility of crude oil price has been crucial because of value at risk measurements and one step ahead forecasting of prices. Thereforeoil price volaitility had to be controlled for a sustainable energy policy and strategy. The main objective of this paper is to analyse whether the financial market transactions have reduced oil price volatility or not.

Methods

To investigate the impact of oil futures on the volatility of the underlying spot market, we have done twoanalyses includingvolatility models; GARCH (generalised autoregressive conditional heteroskedasticity) covering monthly data of U.S. F.O.B. cost of a barrel of crude oil for the period 1973:10 – 2008:12 and EGARCH (exponential GARCH) covering weeklydata of Cushing Oklahoma WTI F.O.B. spot prices and Cushing Oklahoma WTI nearest month futures prices for the period 1986-2008. In the first model, introduction of futures exchanges is controlled by dummy variable and significance of this parameter has been tested. In the second analysis, asymmetric volatility models have been set on both spot and futures marketreturns to measure the impact of news in the market. Afterwards, lead-lag analysis with Granger causality test is conducted to estimate which market is dominating and leading oil price volatilty. In this paper we extend the model conducted in study of Flemming and Ostdiek (1999). Due to the absence of availability, daily futures trading volume data was not included in to the model.

Results

The preliminary results indicate thatthe introduction of the financial derivatives into the crude oil market has increased the volatility yet the coefficient of dummy variable, which controls the impact of existence of derivatives market on FOB cost of a barrel crude oil, is positive and significant. Moreover, the model covering data of spot and futures returns of crude oil from1986 to 2008 implies that for both spot and futures volatility, coefficient of asymetric effect term is negative and significant indicating the fact that negative return shockshas a larger impact on volatility than positive shocks.One otherfinding of this paper is that bidirectional causality between futures and spot market variance series exists implying that the derivative instruments which are issued in order to hedge price volatility risk are increasing market volatility for crude oil.

Conclusions

This study examines the effect of financial derivative instruments on crude oil market volatility. According to our analysis, theintroduction of financial derivatives has increased the volatility of crude oil physical market. Although main objective of existence of futures exchange is hedging oil price volatility and uncertainity risk, deepening of market with derivatives have failed the mission of futures exchanges. Moreover, since 1986 price of crude oil has determined in both spot and futures exchanges. Analysis on the returns of these two prices implies that both market has a considerably high and asymmetric volatility structure. Existence of the asymmetric effect, i.e. impact of negative shocks on market volatility is higher than positive ones, makesone step ahead forecasting of crude oil prices and consistent value at risk measurements for industrial agents more complicated. Furthermore, lead-lag analysis conducted for spot and futures market volatility concludes the bidirectional causality between spot and futures market. The most important outcome of this paper is that for industrial agents risk of volatility has increased by the introduction and domination of futures exchanges.

References

Agnolucci, P. (2009) “Volatility in Crude Oil Futures: A Comparison of the Predictive Ability og GARCH and Implied Volatility Models” Energy Economics 31, 316 – 321.

Antoniou, A. Foster A. J. (1992) “The Effect of Futures Trading on Spot Price Volatility: Evidence for Brent Crude Oil Using GARCH” Journal of Business Finance & Accounting 19, 473 – 484.

Bollerslev, T. (1986) “Generalized Autoregressive Conditional Heteroskedasticity"Journal of Econometrics 31, 307-327.

Cuaresma, J. C. Jumah, A. , Karbuz, S. (2009) “Modelling and Forecasting Oil Prices: The Role of Asymmetric Cycles” The Energy Journal 30, 81 – 90.

Engle, R. F. (1982) “Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation” Econometrica 50, 987 – 1007.

Ferderer, P.J. (1996) “Oil Price Volatility and the Macroeconomy” Journal of Macroeconomics 18, 1-26.

Fleming, J. Ostdiek, B. (1999) “The Impact of Energy Derivatives on the Crude Oil Market” Energy Economics 21, 135 – 167.

Kaufmann, R.K. Ullman, B. (2009) “Oil Prices, Speculation and Fundamentals: Interpreting Casual Relations Among Spot and Futures Prices” Energy Economics 31, 550 – 558.

Narayan, P. K. Narayan, S. (2007) “Modelling Oil Price Volatility” Energy Policy 35, 6549 – 6553.

Nelson, D. B. (1991) “Conditional Heteroskedasticity in Asset Returns: ANew Approach” Econometrica 59, 347 – 370.

Regnier, E. (2007) “Oil and Energy Price Volatility” Energy Economics 29, 405 – 427.

Sadorsky, P. (2006) “Modelling and Forecasting Petroleum Futures Volatility” Energy Economics 28, 467 – 488.

Sanders, D. Boris, K. Manfredo, M. (2004) “Hedgers, Funds and Small Speculators in the Energy Futures Market: An Analysis of CFTC’s Commitments of Traders Reports ”Energy Economics 26, 425 – 445.

Silvapulle, P. Moosa, I. A. (1999) “The Relationship Between Spot and Futures Prices: Evidence from the Crude Oil Market” The Journal of Futures Markets 19, 175 – 193.