Abstract
This paper develops a non linear model for oil futures prices which accounts for pressures due to hedging and speculative activities. The corresponding spot market is assumed to maintain a long term equilibrium relationship with the futures prices in line with the presence of an arbitrage led time varying basis. The model combines an error correction relationship for the cash returns and a non linear parameterization of the corresponding futures returns with a bivariate CCC-TGARCH representation of the conditional variances. The dynamic interaction between spot and futures returns in the oil market has been investigated over the 1990–2010 time period. We have found clear evidence of the activity of hedgers and speculators on the futures markets and the role of the latter is far from negligible. Finally, in order to capture the consequences of the growing impact of financial flows on commodity market pricing, a two-state regime switching model for futures returns has been implemented. The empirical findings indicate that hedging and speculative behavior change across the two regimes, which we associate with low and high return volatility, according to a distinctive pattern.
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Notes
- 1.
Fagan and Gencay (2008) find that hedgers and speculators are often counterparties, since they tend to take opposing positions. Their respective long positions exhibit a strong negative correlation.
- 2.
The hedge ratio is also defined as the ratio between the number of futures and cash contracts.
- 3.
- 4.
The futures contract expires on the third business day prior to the 25th calendar day of the month preceding the delivery month. If the 25th calendar day of the month is a non-business day, trading ceases on the third business day prior to the business day preceding the 25th calendar day.
- 5.
The unit root test statistics are not reported due to lack of space.
- 6.
The t-ratios reported in the tables are based on the robust quasi-maximum likelihood estimation procedure of Bollerslev and Wooldridge (1992) since the J.B. test statistics reject the null of normality of the standardized residuals.
- 7.
- 8.
For a definition of this measure, see Achen (1982, pp. 72–73).
- 9.
CCC-TGARCH estimates
OLS estimates
Naive
Optimal hedge ratio β*
St. dev. of the optimal hedge portfolio
Optimal hedge ratio β*
St. dev. of the optimal hedge portfolio
St. dev. of the naive portfolio
0.75
0.016309
0.70
0.016416
0.018018
- 10.
In order to eliminate the potential errors-in-variables distortions due to the use of a two-step procedure, we follow Pagan (1984). We replace the conditional variances by the fitted value of a regression of the futures (cash) return conditional variance on a constant, on its own lagged values (up to two lags), on the lagged values (up to two lags) of the conditional variance of the cash (futures) returns and on the one period lagged cash rate of return. The estimated coefficients are consistent, whereas the corresponding standard errors may underestimate their true values. However, this potential bias does not affect the SPEC index, which is consistent.
- 11.
The average expected duration of being in state 1 is computed according to Hamilton (1989) as \( \sum\nolimits_{i = 1}^{\infty } {ip_{11}^{i - 1} \left( {1 - p_{11} } \right) = \left( {1 - p_{11} } \right)^{ - 1} = \left( {p_{12} } \right)^{ - 1} } \). If we posit that regime 1 (2) at time t holds if the probability of being in state 1 based on data through t is larger (smaller) than 0.5, the oil market is in the low volatility regime 1 for 4,777 days and in the high volatility regime 2 for 466 days.
- 12.
We detect therefore an overall increase in the share of agents that follow a speculative rationale and a corresponding decrease in the number of standard risk minimizing investors.
- 13.
According to the standard ADF unit root tests the time t regime 1 probability time series is I(0). The correlation coefficients between the regime 1 probability and the daily oil futures’ rate of return and standard deviation are, respectively, 0.035 (2.52) and −0.756 (−83.68), where the t-ratios are in parentheses. Regime 1 is to be associated with both low futures return variability and, to a lesser extent, with positive futures price rates of change (i.e. possibly with a bullish market), and regime 2 with high return variability and negative futures price rates of change (i.e. with a bearish market).
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Cifarelli, G., Paladino, G. (2014). Oil Futures Market: A Dynamic Model of Hedging and Speculation. In: Ramos, S., Veiga, H. (eds) The Interrelationship Between Financial and Energy Markets. Lecture Notes in Energy, vol 54. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-55382-0_6
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