IMPACTS OF FINANCIAL DERIVATIVES MARKET ON OIL PRICE VOLATILITY

Istemi Berk Department of Economics Izmir University of Economics

OUTLINE
MOTIVATION CRUDE OIL MARKET FUNDAMENTALS LITERATURE & CONTRIBUTION OF THIS PAPER DATA METHODOLOGY EMPIRICAL RESULTS CONCLUSION

MOTIVATION
Does Futures Trading Increase the Efficiency of Crude Oil Market? If not; What is the impact of this to Risk Management in Crude Oil Market?

MOTIVATION (contd)
This paper examines the impacts of crude oil futures on spot market volatility. The main aim of this paper is to analyze whether it is possible for industrial agents to handle volatility risk with using crude oil futures contracts.

CRUDE OIL MARKET FUNDAMENTALS

Real Prices of Crude Oil since 1940 and Market Domination

Source: BP Statistical Review of World Energy 2009

CRUDE OIL MARKET FUNDAMENTALS (contd)

Volume of Transactions Held in Spot Crude Oil Market and Futures Exchanges (Representative: Nymex WTI Crude Oil Nearest Month Contract)
Thousand Barrels Daily 600000

500000

400000

300000

200000

100000

0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

futures trading volume

crude oil production

Source: NYMEX & BP Statistical Review of World Energy 2008

LITERATURE
Sadorsky (2006) & Agnolucci (2009); GARCH models fit well for crude oil volatility modeling Several studies on commodities and indices;

LITERATURE (contd)
Researcher
Powers (1970)

Data Set

Findings

Pork Belly and Beef Variance has Spot and Futures Price decreased after the introduction of futures exchange SP500 spot and futures Volatility has increased returns in the short-run but does not carried in long-run ISE 100 spot and futures returns Introduction of futures exchange has decreased the spot market volatility

Edwards (1988) Darrat et. al. (2002) Kasman & Kasman (2008)

LITERATURE (contd)
Studies on Crude Oil;
Researcher
Antoniou and Foster (1992) Flemming and Ostdiek (1999) Silvapulle and Moosa (1998) Bekiros and Dicks (2008)

Data Set

Findings

Brent Crude Oil Futures Futures contract has and Spot Prices from decreased the volatility 1986 to 1990 of spot market WTI Crude Oil futures and spot prices from 1983 to 1997 WTI Crude Oil futures and spot prices from 1985 to 1996 WTI Crude Oil futures and spot prices from 1991 to 1999 Futures trading has increased spot market volatility Unidirectional Causality from spot to futures market Bidirectional Causality between spot and futures market

CONTRIBUTION
This paper would contribute to the literature with modeling crude oil spot and futures market volatilities and causality analysis on volatility series from 1986 to 2009 (post-futures period).

DATA
Two analysis with two sample periods
1) From October 1973 to December 2008 monthly data (US F.O.B. Cushing Oklahoma monthly) 2) From January 3, 1986 to February 27, 2009 weekly data (post-futures period) (WTI nearest month futures and spot weekly)

DATA (contd)
Summary Statistics of Series
Varible Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis J-B Stat # of observations rfob 0.005 0.005 0.380 -0.373 0.077 -0.36 8.53 546.98** 422 rf 0.001 0.002 0.255 -0.191 0.044 -0.29 6.37 591.84** 1208 rs 0.001 0.002 0.251 -0.192 0.046 -0.17 6.46 610.75** 1208

** denotes significance at 1% confidence level

DATA (contd)
The Ljung-Box Test for Standardized Residuals of Mean Equations
rfob Lag 1 2 3 4 5 10 20 AC 0.351 0.140 0.040 PACF Q-stat 0.351 0.019 -0.017 AC rf PACF Q-stat 0.122 -0.030 0.041 0.067 -0.013 0.012 -0.039 AC rs PACF Q-stat 0.111 0.048 0.063 -0.007 15.047 17.212 18.778 25.481 25.508 33.970 50.038

52.463 0.122 60.823 -0.015 61.508 0.035 62.426 0.076 62.930 0.003 72.297 0.002 117.89 -0.054

18.031 0.111 19.790 0.036 26.847 0.074 26.857 0.005

18.298 -0.042 -0.055

-0.046 -0.066 -0.034 0.003 0.183 0.092 0.180 0.061

34.675 -0.001 0.010 54.390 -0.052 -0.041

METHODOLOGY
1) Modeling F.O.B. Cushing Oklahoma spot price volatility
rfob t = # 0 + " 0 $ rfob t %1 + ! t

where, r fob t ; log return of F.O.B. price We have used EGARCH(1,1) model with dummy to capture asymmetries and overcome non-negativity conditions

METHODOLOGY (contd)
# t )1 # t )1 ln(" ) = ' 0 + &1 ( ln(" ) + %1 ( + $1 ( + !1 D fut 2 2 " t )1 " t )1
2 t 2 t )1

where; 2t ; conditional variance 2t-1 ; lag of variance

# t! j

; asymmetric term " t2! j # t! j ; size of asymmetry 2 " t! j Dfut ; post-futures dummy

METHODOLOGY (contd)
2) Modeling crude oil futures and spot market volatility for post-futures period. Log return series for both spot and futures prices; r f = # 1 + "1 $ r f ( t %1) + ! 1t
rs = # 2 + " 2 $ rs ( t %1) + ! 2t

where; rs and rf are spot and futures return series respectively

METHODOLOGY (contd)
EGARCH(1,1) model is conducted for both spot and futures market volatilities.
ln(# ) = ( 1 + '1 " ln(#
2 ft 2 ft !1

) + &1 "

$ 1( t !1) #
2 ft !1

+ %1 "

$ 1( t !1) # 2t !1 f

where; ! 2 ; variance of futures market f ! s2 ; variance of spot market

t t

METHODOLOGY (contd)
Moreover, Granger Causality test will be conducted on volatility series;
# s2t = &1 + ) % i '# s2t (1 + ) $ j ' # 2t (1 + "1 ' z t (1 + ! 1t f
i =1 j =1

# 2t = &2 + ) % i '# s2t (1 + ) $ j ' # 2t (1 + " 2 ' z t (1 + ! 2t f f

i =1 j =1

where; zt-1s are error correction terms

METHODOLOGY (contd)
Cointegration test is conducted on price series;
p ft = #1 + "1 $ pst + ! 1t
pst = # 2 + " 2 $ p ft + ! 2t

where; pf and ps are futures and spot prices respectively. 1t and 2t are residuals to be tested for unit root

EMPIRICAL RESULTS

EMPIRICAL RESULTS (contd)

1: statistically significant and negative; asymmetric effect 1: statistically significant and positive: introduction of futures contract has increased spot market volatility

EMPIRICAL RESULTS (contd)

EMPIRICAL RESULTS (contd)

Bidirectional causality exists between futures and spot crude oil market; decreases efficiency

EMPIRICAL RESULTS (contd)

CONCLUSION
Introduction of Crude Oil Futures Contracts has increased the volatility decreased the efficiency of spot market Asymmetric structure of crude oil price volatility deters precise forecasting consistent Value At Risk Measurement

Bidirectional causality/feedback and long-run cointegration between markets would be explained by market depth of futures transactions

CONCLUSION (contd)
What does it mean for Industrial Agents?
Handling volatility risk with futures contract would not be possible Market is under influence of
Large Investor Groups and Traders more than Industrial Agents Non-commercial and speculative Trading rather than Hedging

Forecasting & VAR measurements would not be consistent

THANK YOU
QUESTIONS?