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IMPACTS OF FINANCIAL
DERIVATIVES MARKET ON
OIL PRICE VOLATILITY
Istemi Berk
Department of Economics
Izmir University of Economics
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OUTLINE
MOTIVATION
CRUDE OIL MARKET FUNDAMENTALS
LITERATURE & CONTRIBUTION OF THIS
PAPER DATA
METHODOLOGY
EMPIRICAL RESULTS
CONCLUSION
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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?
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MOTIVATION (contd)
This paper examines the impacts of crude
oil futures on spot market volatility.
The main aim of this paper is to analyzewhether it is possible for industrial agents
to handle volatility risk with using crude oil
futures contracts.
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CRUDE OIL MARKET FUNDAMENTALS
Source: BP Statistical Review of World Energy 2009
Real Prices of Crude Oil since 1940 and Market Domination
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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)
Source: NYMEX & BP Statistical Review of World Energy 2008
0
100000
200000
300000
400000
500000
600000
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Year
Thousand Barrels Daily
futures trading volume crude oil production
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LITERATURE
Sadorsky (2006) & Agnolucci (2009);
GARCH models fit well for crude oil
volatility modeling
Several studies on commodities and
indices;
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LITERATURE (contd)
Introduction of futures
exchange hasdecreased the spot
market volatility
ISE 100 spot and
futures returns
Kasman & Kasman
(2008)
Volatility has increased
in the short-run but
does not carried in
long-run
SP500 spot and futures
returns
Edwards (1988)
Darrat et. al. (2002)
Variance has
decreased after the
introduction of futures
exchange
Pork Belly and Beef
Spot and Futures Price
Powers (1970)
FindingsData SetResearcher
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LITERATURE (contd)
Studies on Crude Oil;
Bidirectional Causality
between spot and
futures market
WTI Crude Oil futures
and spot prices from
1991 to 1999
Bekiros and Dicks
(2008)
Unidirectional Causality
from spot to futuresmarket
WTI Crude Oil futures
and spot prices from1985 to 1996
Silvapulle and Moosa
(1998)
Futures trading has
increased spot market
volatility
WTI Crude Oil futures
and spot prices from
1983 to 1997
Flemming and Ostdiek
(1999)
Futures contract has
decreased the volatility
of spot market
Brent Crude Oil Futures
and Spot Prices from
1986 to 1990
Antoniou and Foster
(1992)
FindingsData SetResearcher
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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 to2009 (post-futures period).
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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)
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DATA (contd)
Summary Statistics of Series
12081208422# of observations
610.75**591.84**546.98**J-B Stat
6.466.378.53Kurtosis
-0.17-0.29-0.36Skewness
0.0460.0440.077Std. Dev.
-0.192-0.191-0.373Minimum
0.2510.2550.380Maximum
0.0020.0020.005Median
0.0010.0010.005Mean
rs
rf
rfob
Varible
**denotes significance at 1% confidence level
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DATA (contd)
The Ljung-Box Test for Standardized Residuals of MeanEquations
50.038-0.041-0.05254.390-0.039-0.054117.890.0610.09220
33.9700.010-0.00134.6750.0120.00272.2970.1800.18310
25.508-0.0070.00526.857-0.0130.00362.9300.003-0.0345
25.4810.0630.07426.8470.0670.07662.426-0.066-0.0464
18.7780.0480.03619.7900.0410.03561.508-0.0170.0403
17.212-0.055-0.04218.298-0.030-0.01560.8230.0190.1402
15.0470.1110.11118.0310.1220.12252.4630.3510.3511
Q-statPACFACQ-statPACFACQ-statPACFACLag
rsrfrfob
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METHODOLOGY
1) Modeling F.O.B. Cushing Oklahoma spotprice volatility
where,
; log return of F.O.B. price
We have used EGARCH(1,1) model withdummy to capture asymmetries and
overcome non-negativity conditions
tfobr
ttfobtfobrr !"# +$+=
%100
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METHODOLOGY (contd)
where;
2t ; conditional variance
2t-1 ; lag of variance
; asymmetric term
; size of asymmetry
Dfut ; post-futures dummy
fut
t
t
t
ttt D12
1
112
1
11
2
110
2 )ln()ln( !"
#$
"
#%"&'" +(+(+(+=
)
)
)
)
)
2
jt
jt
!
!
"
#
2
jt
jt
!
!
"
#
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METHODOLOGY (contd)
2) Modeling crude oil futures and spot
market volatility for post-futures period.
Log return series for both spot and futuresprices;
ttff rr 1)1(11 !"# +$+= %
ttss rr 2)1(22 !"# +$+= %
where; rs and rfare spot and futures return
series respectively
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METHODOLOGY (contd)
EGARCH(1,1) model is conducted for bothspot and futures market volatilities.
2
)1(1
12
)1(1
1
2
11
2
11
1)ln()ln(
!!
!
!!
"+"+"+=
tt
tt
f
t
f
t
ff
#
$%
#
$'(#
where;; variance of futures market
; variance of spot market
2
tf!
2
ts
!
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METHODOLOGY (contd)
Moreover, Granger Causality test will be
conducted on volatility series;
where; zt-1s are error correction terms
tttttf
j
js
i
is z 1112
1
2
1
1
2
11
!"#$#% +'+'+'+= (==
(( ))
tttttf
j
js
i
if z 2122
1
2
1
2
2
11
!"#$#% +'+'+'+= (==
(( ))
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METHODOLOGY (contd)
Cointegration test is conducted on price
series;
where; pfand p
sare futures and spot prices
respectively. 1t and 2t are residuals to be
tested for unit root
tsf tt pp 111 !"#+$+=
tfs ttpp
222!"# +$+=
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EMPIRICAL RESULTS
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EMPIRICAL RESULTS (contd)
1: statistically significant and negative; asymmetric effect1: statistically significant and positive: introduction of
futures contract has increased spot market volatility
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EMPIRICAL RESULTS (contd)
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EMPIRICAL RESULTS (contd)
Bidirectional causality exists between futures and spot
crude oil market; decreases efficiency
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EMPIRICAL RESULTS (contd)
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CONCLUSION
Introduction of Crude Oil Futures Contracts has
increased the volatility
decreased the efficiency of spot market
Asymmetric structure of crude oil price volatility detersprecise forecasting
consistent Value At Risk Measurement
Bidirectional causality/feedback and long-runcointegration between markets would beexplained by market depth of futurestransactions
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CONCLUSION (contd)
What does it mean for Industrial Agents?
Handling volatility risk with futures contract would notbe possible
Market is under influence of Large Investor Groups and Traders more than Industrial
Agents
Non-commercial and speculative Trading rather thanHedging
Forecasting & VAR measurements would not beconsistent
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QUESTIONS?