Review of Futures Markets - Abstracts
The prestigious journal Review of Futures Markets, originally published by the Chicago Board of Trade, resumed publication with the Summer 2005 issue. Now published in cooperation with the Institute for Financial Markets, the financial journal publishes peer-reviewed, editor selected articles that expand the literature of futures, options, and derivatives research. Selected articles presented at the annual Futures Research Symposium also are published.
The purpose of the RFM is to provide an academic research journal that brings a unique balance of theory and practice to the derivatives trading and futures market industry.
Select abstracts and special editions are available below. An online archive of earlier articles is available at http://www.rfmjournals-archive.com/
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Summer 2012, Volume 21 Number 1
2012, Special IFM edition published Mar.2013
Spring 2012, Volume 20 Number 4
2012, Special IFM edition
Winter 2011-2012, Volume 20 Number 3
Fall 2011, Volume 20 Number 2
Summer 2011, Volume 20 Number 1
Spring 2011, Volume 19 Number 4
2011, Special IFM edition
Winter 2010-2011, Volume 19 Number 3
Fall 2010, Volume 19 Number 2
Summer 2010, Volume 19 Number 1
Spring 2010, Volume 18 Number 4
Winter 2009-2010, Volume 18 Number 3
Fall 2009, Volume 18 Number 2
Summer 2009, Volume 18 Number 1
Spring 2009, Volume 17 Number 4
Winter 2008-2009, Volume 17 Number 3
Fall 2008, Volume 17 Number 2
Summer 2008, Volume 17 Number 1
An online archive of earlier articles is available at http://www.rfmjournals-archive.com/
Special Edition Volume 21 — March 2013 (read it online)
The Tale of Two Regulations - Dodd-Frank Act and Basel III: A Review and Comparison of the Two Regulatory Frameworks
Ohannes George Paskelian and Stephen Bell (pages 7-29)
The worldwide financial crisis of 2008 highlighted the weaknesses of the financial regulatory environment. In the United States, the Dodd-Frank Act (2010) was passed to curb and prevent the financial and regulatory shortcomings that resulted in the meltdown. Likewise, the Basel III framework was developed to strengthen international banking sector regulation, supervision, and risk management. In this paper, we provide a comprehensive overview of the Dodd-Frank Act (2010) and Basel III. In addition, the paper provides an analysis of the impact of Dodd-Frank on United States financial system competitiveness when compared to worldwide financial systems. We also provide a discussion of the anticipated implementation procedures that will be necessary to comply with the regulations and quantitative requirements of the Dodd-Frank and Basel III regulatory frameworks. Finally, we empirically examine the impact of Basel III regulatory requirements on optimal equity holdings of large banks. Our results suggest that the implementation of Basel III by US large banks will increase bank lending rates, which in turn could counteract the effect of any economic growth policies.
OTC Derivatives: A Comparative Analysis of Regulation in the United States, European Union, and Singapore
Rajarshi Aroskar (pages 31-56)
This study compares the regulation of OTC derivatives in the United States, European Union, and Singapore. All jurisdictions require central clearing and reporting of OTC derivatives. The onus of reporting falls primarily on financial counterparties to an OTC contract. The main difference in regulation is that only the United States and the European Union require mandatory trading of cleared derivatives. Additionally, implementation is proceeding in different stages across jurisdictions. These two differences have the potential to result in regulatory arbitrage across jurisdictions.
Systemic Risk: Clustering and Contagion Mechanisms
Agostino Capponi and Peng-Chu Chen (pages 57-70)
We propose a general framework to capture both contagion and clustering mechanisms arising in financial networks when balance sheet linkages across entities exist. Building on Eisenberg and Noe (2001), we develop a multi-period clearing payment system, where the financial network evolves stochastically over time. We model explicitly the impact of default events on the state of the network and introduce a novel mathematical structure, the systemic graph, to measure the contagion and systemic effects propagating in the network over time. Numerically, we show that domino effects appear when the interbank liability structure is homogeneous, whereas clustering effects are noticeable when the structure is heterogeneous. Larger correlations between interbank liabilities reduce the domino contribution to systemic risk and increase default clustering, especially if liability exposures are highly volatile.
The Impact of Derivatives Regulations on the Liquidity and Pricing Efficiency of Exchange Traded Derivatives
Lorne N. Switzer, Qianyin Shan, and Jean-Michel Sahut (pages 71-103)
This paper looks at the impact of derivatives regulation on liquidity and mispricing of US derivatives markets. In particular, we test the hypothesis that Dodd-Frank derivative provisions may improve the efficiency of the exchange traded markets due to an increase of arbitrage by traders on the exchange traded markets, as opposed to the OTC markets. The alternative hypothesis is that Dodd-Frank adversely affects the OTC markets relative to the exchange traded markets, as trading in both the former and the latter may be confounded due to additional "noise." To test these hypotheses, we examine the impact of key Dodd-Frank events on market activity for financial derivatives (futures and option contracts on US T bonds, Eurodollar futures and options, and S&P 500 Futures contracts) and on foreign exchange derivatives (futures and options contracts on EUROs, British Pounds, and Canadian dollars). First, we look at how liquidity on the markets has been affected. Next, we test for mispricing of derivatives contracts. We find that measured liquidity does fall for US financial futures and options but rises for foreign exchange futures and options subsequent to the introduction of the Treasury guidelines for over-the-counter (OTC) trading. We also find that the efficiency of the US exchange traded futures markets has improved, as reflected by a reduction in mispricing in the S&P futures contracts; some improvement in pricing efficiency is also shown for nearby Eurodollar futures contracts. These results are consistent with an increase of arbitrage by traders on the exchange traded markets, as opposed to the OTC markets, in contrast to the "noise" model.
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Volume 21, Issue 1 (Summer 2012) (forthcoming May 2013)
Measuring the Interdependence of Banks in Hong Kong
Tom Fong, Laurence Fung, Lillie Lam and Ip-wing Yu (pages 7-26)
INTRADAY DYNAMIC HEDGING AND FUTURES MARKET VOLATILITY
Gerard L. Gannon and Ruipeng Liu (pages 7-30)
In this paper, we study the risk minimizing behavior of traders in financial markets dealing with intraday information. We focus on the optimal dynamic rebalancing of hedge positions. We extend the existing BEKK-GARCH models to power versions to generate dynamic hedge ratios. These are then compared with performance of Dynamic Conditional Correlation (DCC) models of Engle (2002) and Tse and Tsui (2002). We employ intraday 15 minute sampled data from the Commodity Futures Trading Commission (CFTC) trade databases for the S&P500 index futures contracts supplied by the CFTC. The futures price series is matched with underlying cash market prices. We have conducted both in sample and out of sample studies for comparisons. Our results recommend that the management of the risk of physical- and derivative-based portfolios can be substantially reduced by employing active hedging strategies.
Long Memory in VIX Futures Volatility
Bujar Huskaj (pages 31-48)
This study provides empirical evidence for long memory in the volatility process of VIX futures returns and investigates the practical importance of modelling it when calculating Value-at-Risk (VaR) for VIX futures and pricing VIX options. The analysis is performed using the GARCH, APARCH, FIGARCH and FIAPARCH models with the normal and skewed Student-t distributions. The VaR analysis shows that the long memory FIGARCH and FIAPARCH models produce the best out-of-sample VaR forecasts. The options analysis, however, shows that the long memory in the volatility has an insignificant impact on the prices of hypothetical VIX options.
The Information Content of Implied Covolatility and Covariance Swap
Christopher Ting (pages 49-75)
This paper discusses quanto spread trading strategy and introduces a simple model that allows the covariance to be implied from the quanto spread. A synthetic covariance swap is then constructed with the implied covariance as the fixed rate. This paper also provides an empirical analysis over the period spanning January 2005 through December 2010. Our empirical findings suggest that the proposed covariance swap is fair to both the buyer and the seller, which is consistent with the evidence that the implied covolatility can forecast future covolatility.
Net Buying Pressure, Volatility Smile, Trading Opportunities in Euribor Options, and Implication of Market Efficiency
I-Doun Kuo and Chi-Chou Chen (pages 77-108)
Previous explanations of time variation of volatility smile in interest rate options by proposing alternative models have not provided satisfactory explanations. This study explores the possibility that market makers set option prices with a model not radically different from Heath, Jarrow, and Morton jump model, and the shape of a smile is attributable to buying pressure for Euribor options markets. We find that buying pressure for short-term OTM options strongly affects the change in smile in Euribor options markets, leading to arbitrage opportunities. These relationships between net buying pressure and implied volatility are accounted for by the presence limit to arbitrage. Trading volatility smile with neutral portfolios generates abnormal profits before transaction costs, but the profits after transaction costs vanish implying that Euribor options markets are efficient in the examined period.
The Effects of Taiwan VIX Index on the Intraday Ordering Behavior of Stock Index Options
Chia-Hsing Huang, Kung-Fu Chang, and Chi-Hui Wang (pages 109-141)
This paper studies the relationships among stock index futures, stock index options ordering volume, and implied volatility from stock index options in Taiwan stock market. The intraday data of the VIX, stock index futures price, and stock index options ordering volume from the Taiwan Futures Exchange are used for the study. The empirical result shows that the futures prices lead the VIX, and the VIX leads the options ordering behaviors. Compared with the futures prices, the VIX has more impacts on the options ordering behaviors. The research results show that a percentage change in stock index futures price affects both the VIX percentage change and percentage change of put option buy order to sell order volume ratio. When the VIX percentage change increases, there will be a larger increase found in the percentage change of call option buy order volume than that of the percentage change of call option sell order volume. In addition, the percentage change in put option buy order volume will have a greater increase than the percentage change in put option sell order volume.
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Special Edition Volume 20 — (July 2012) (read it online)
Clearing and OTC Traded Derivatives: A Survey
Joseph K.W. Fung and Robert I. Webb (pages 7-19)
The financial economics literature on market microstructure — or the way a market is organized — has grown substantially since Garman's (1976) seminal article. Much of the focus of the existing literature is on the impact of market microstructure on price formation and price discovery. Market microstructure characteristics such as settlement and clearing arrangements have received less attention. The 2007–2009 Global Financial Crisis has highlighted the importance of clearing to practitioners, policymakers, and academics alike. A sharp rise in perceived counterparty risk during the financial crisis for some over-the-counter (OTC) traded derivative securities, coupled with uncertainty by regulators over the true size of outstanding positions in such securities by market participants, has led to calls for mandatory clearing through central counterparties (CCPs) of some (G-20 Leaders 2009) or virtually all (Hull 2010) OTC traded derivatives and centralized reporting of OTC derivative transactions to trade repositories (TRs).
Behavioral Finance and Pricing of Derivatives: Implications for Dodd-Frank Act
Rahul Verma (pages 21-67)
This study investigates the relevance of noise in the derivative market by examining the responses of returns and time varying risks in six futures and four stock index options markets to a set of investor sentiments. Consistent with previous studies, the estimation results suggest that noise is systematically priced in a wide variety of futures and options markets. Investor sentiments on gold, crude oil, wheat, copper, live cattle and sugar significantly impact the returns and conditional variances in precious metals, energy, oilseed, industrial metals, livestock and soft agricultural futures markets respectively. Similarly returns and volatilities in VIX, VXD, VXN and VXO are significantly affected by sentiments of professional analysts and institutional investors, while there is no such effect of individuals. There seem to be a significant greater response of these derivative markets to bullish than bearish sentiments. Lastly, there are evidences of positive feedback trading by investors and lead-lag relationships among their sentiments. Noise seems to affect risk and return in the derivative market in a similar fashion in which it affects those in stocks. The direct implication of these findings is that traditional measure of time variation in systematic risk in the derivative market omits an important source of risk: noise. It has wider implications for the newly enacted Dodd-Frank financial reform bill on derivative trading. They also have important implications for policies that seek to reduce spillover effects and investors who aim to improve their portfolio performance.
Optimizing the Cost of Customization for OTC Derivatives End Users
Sean Owens (pages 69-103)
This paper examines the regulatory treatment of OTC derivatives under the Dodd-Frank Act and the Basel III accord for market participants and financial institutions in the United States and abroad. It evaluates the capital and margin required for OTC derivative transactions under both frameworks and examines the potential impact on transaction costs applicable to end users for bilateral and centrally cleared transactions. Firms face a tradeoff between the costs associated with initial margin, regulatory capital, execution and structural factors for bilateral transactions relative to SEF-executed centrally cleared transactions. For many end users, minimizing these costs will be the primary objective behind their derivative hedging strategies. To illustrate this, we quantify many of the implicit and explicit costs for standardized cleared swaps and customized bilateral swaps for end users and examine the impact on them according to their credit quality. The paper evaluates transactions predominantly on a stand-alone basis, without the effects of risk netting. While this overstates both the capital and margin required for participants with offsetting portfolios, it reflects the marginal impact for many end users who hedge predominantly one-sided risk in the markets. It evaluates the limit of regulatory impact on participants, which many will seek to reduce through targeted hedging strategies and counterparty netting.
A Half-Century of Product Innovation and Competition at U.S. Futures Exchanges
Michael Gorham and Poulomi Kundu (pages 105-140)
This paper explores the last 55 years of product innovation and competition at U.S. futures exchanges. We find that in general innovations perform better than imitations and product extensions. We find that one exchange has been a more aggressive innovator, imitator, and product extender than other exchanges and has grown to dominate the market. We find that interest rate contracts have generally outperformed others, that the 1980s was the golden decade of successful product innovation, and that there is evidence of a first mover advantage in product competition and of a liquidity driven monopoly effect.
Transaction Tax and Market Quality of U.S. Futures Exchanges: an Ex-Ante Analysis
C. Johan Bjursell, George H. K. Wang, and Jot Yau (pages 141-177)
In this paper, we analyze the impact of a transaction tax on the market quality of U.S. futures markets by estimating the elasticity of trading volume and of price volatility with respect to bid-ask spread in a three-equation model framework for 11 financial, agricultural, metals, and energy futures for the period 2005–2010. We find that (1) Trading volume has a negative relationship with bid-ask spread and a positive relationship with price volatility after controlling for other factors; (2) bid-ask spread has a negative relationship with trading volume and a positive relationship with price volatility; and (3) price volatility has a positive relationship with bid-ask spread and with trading volume after controlling for other variables. We demonstrate that a transaction tax, which is analogous to a bigger bid-ask spread, will drastically reduce trading volume if the tax constitutes a significant increase in the total fixed trading cost, and/or the elasticity of trading volume with respect to transaction cost is high enough. Thus, a transaction tax may not raise substantial revenue for the government as suggested in other studies.
Margin Backtesting
Christophe Hurlin and Christophe Pérignon (pages 179-194)
This paper presents a validation framework for collateral requirements or margins on a derivatives exchange. It can be used by investors, risk managers, and regulators to check the accuracy of a margining system. The statistical tests presented in this study are based either on the number, frequency, magnitude, and timing of margin exceedances, which are defined as situations in which the trading loss of a market participant exceeds his or her margin. We show that these validation tests can be implemented at the individual level or at the global exchange level.
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Volume 20 Issue 4 (Spring 2012)
The Impact of Regulatory Changes on the Efficiency of the Phase II EU ETS European Carbon Futures
Andrew Lepone, Alexander Sacco, and Jin Young Yang (pages 323-347)
This study investigates long-horizon weak form market efficiency in the Phase II EU ETS (European Union Emissions Trading Scheme) Carbon Futures Market. Using data that encompasses exchange-based (ECX) trades in Phase I and Phase II ECX CFI futures contracts from January 1, 2008, to September 28, 2010, this study employs various tests of long horizon weak form market efficiency including variance ratio tests, tests of trading rule profitability, and serial correlation. In contrast to prior research that focuses on Phase I EU ETS, this study finds evidence of a significant structural change to the EU ETS from Phase I to Phase II, and supports the efficient market hypothesis during Phase II (2008–2010). Results suggest that documented improvements in market quality, increasing trading activity, and removal of Phase I market frictions have fostered improvements in market efficiency into and during Phase II.
The Implied Convenience Yield of Precious Metals: Safe Haven Versus Industrial Usage
Michael T. Chng and Grant M. Foster (pages 349-394)
During a financial crisis, investors conveniently seek refuge in gold (Gd) as a safe haven. But during good economic times, manufacturing firms find it convenient to stockpile platinum (Pl), palladium (Pd) and, in particular, silver (Si), for various industrial usages. We have three related objectives. First, we examine cross-market interactions among the convenience yields (cyit) of {Gd, Pl, Pd, Si}, which are implied from cost-of-carry relations. Second, we test if the more influential cyit of a given precious metal also affects the return, volatility and/or volume dynamics of other precious metals. Third, we analyze if the cyit of gold is enhanced (diluted) during (after) the Asian, Dotcom and Global financial crises. We find that, during crisis period, gold's cyit provides incremental information to the volatility series of {Gd, Pl, Pd, Si}. But during good economic times, it is silver's cyit that has the most influence on the return series across {Gd, Pl, Pd, Si}. This is not surprising given Si possesses the heaviest industrial usage among the four precious metals.
The Evolving Pattern of Price Discovery: Evidence from China's Gold and Copper Markets
Hui He, Qingfeng "Wilson" Liu, and Yan "Ann" Zhang (pages 395-417)
The Shanghai Futures Exchange (SHFE) launched its gold futures contracts in early 2008, whereas its copper futures contracts have been in existence since the 1990s. This study examines the price discovery patterns between these two futures markets and their underlying spot markets. We detect one and two structural breaks in the gold and copper data series, respectively, and use them to form subsamples. Employing a Vector Error Correction Model (VECM) and the Hasbrouck (1995) test, we find that the gold prices in the futures market and the spot market are only cointegrated in the second subsample, and it is the spot market that leads the price discovery process. For copper, in contrast, while the spot market leads price discovery in the earliest subsample, the futures market takes over the lead afterwards. These findings seem to reveal an evolving pattern of the futures market's price discovery function. In addition, we find strong weekend effects for the copper series, but not for gold. And our GARCH model results show strong bi-directional volatility spillovers between spot and futures markets for both gold and copper.
Dynamic Currency Hedging for International Stock Portfolios
Wei Opie, Christine Brown, and Jonathan Dark (pages 419-455)
The paper studies dynamic currency risk hedging of international stock portfolios using a currency overlay. A dynamic conditional correlation (DCC) multivariate GARCH model is employed to estimate time-varying covariance among stock market returns and currency returns. The conditional covariance is then used in the estimation of risk-minimizing conditional hedge ratios. The study considers seven developed economies over the period January 2002 to April 2010 and estimates daily conditional hedge ratios for portfolios of various stock market combinations. Conditional hedging is shown to dominate traditional static hedging and unconditional hedging in terms of risk reduction both in-sample and out-of-sample, especially during the recent global financial crisis. Conditional hedging also proves to consistently reduce portfolio risk for various levels of foreign investments.
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Volume 20, Issue 3 (Winter 2012)
The Impact of Automation on Bid-Ask Spreads: Evidence from Eurodollar Futures
Timothy T. Perry and Scott E. Hein (pages 207-241)
In 1999, the Chicago Mercantile Exchange introduced the use of its automated exchange system, Globex, for Eurodollar futures transactions. During regular trading hours, 7:20 a.m. to 2:00 p.m. CST, this created a hybrid market, where transactions could be executed simultaneously either via an open-outcry system or in an automated, electronic market. The empirical evidence provided in this paper indicates that Globex generally has come to provide narrower bid-ask spreads than the CME floor in transacting most contracts. However, contracts with the longest expirations continued to have smaller bid-ask spreads on the CME floor. Furthermore, the increased usage of Globex from 2000 to 2006 coincides with lower bid-ask spreads in both market structures.
Bivariate Option Pricing Under Regime-Switching Dependence
Henry H. Huang, Jr-Wei Huang, Howard Qi, and Puman Ouyang (pages 243-265)
This paper proposes a novel framework for pricing bivariate contingent claims using bivariate switching-regime auto-regressive conditional heteroskedasticity (BSWARCH) and switching-regime mixed copulas (SWMC). The BSWARCH models the conditional volatility of individual assets as a regime-switching ARCH process and assumes the regime dependence of the correlation coefficient between two assets. In contrast, SWMC indicates that dependence between two assets derives from regime-dependent mixed copulas that can model asymmetric tail dependence between two assets returns. The association between the underlying assets may change over time, following a regime-switching pattern with asymmetric tail dependence, and these stylized features are necessary to value bivariate contingent claims accurately. Illustrations of these approaches use better-of-two-markets options (max option) with Monte Carlo simulations. A comparison of the numerical results with the results obtained from a closed-form formula (e.g., Johnson 1987), and we have two main conclusions. First, the SWMC model captures the correlation structure of the bivariate option and suggests different option prices than those derived from the closed-form solution, possibly because of the restrictive assumptions of constant correlation. Second, when pricing options with a copula-based model, the misspecification of the copula function or the ignorance of regime-dependent copula weights may lead to a large-scale pricing error.
Modeling Long-Dated Agricultural Commodity Forward Prices
Jason West (pages 267-297)
Over the counter (OTC) forward contracts are regularly traded at maturities beyond the longest-dated futures contract. The presence of seasonality in agricultural commodities creates additional uncertainty for obtaining fair prices for over-the-counter (OTC) forward contract trades beyond the liquid futures strip. This paper employs an augmented Nelson-Siegel function to obtain seasonal agricultural commodity price estimates for OTC forward contracts beyond the longest available maturity of exchange traded futures contracts. A multifactor seasonal Nelson-Siegel model is chosen due to its internally consistent and parsimonious functional form. The Nelson-Siegel approach is used to model seasonally-adjusted corn, cotton, and sugar forward prices for OTC contracts out to five years maturity calibrated against shorter-dated futures contracts. Residual and contract liquidity testing indicates that the seasonal model provides efficient estimates of contract prices beyond the futures strip, which allows hedgers to obtain fair prices for OTC forward contracts.
The Relationship Between VIX Futures Term Structure and S&P500 Returns
Athanasios P. Fassas (pages 299-313)
The current paper tests and documents the relationship between the term structure of VIX futures and the underlying equity returns. Furthermore, it investigates the signaling effects of VIX futures term structure in respect to future stock index movements. The objective of this empirical analysis is to verify if a steep upward-sloping term structure indicates a late phase of a bullish trend and conversely if an extreme negative term structure suggests an over-sold market, as certain market participants believe. The proposed term structure measure is estimated as the slope of the term structure of six VIX future contracts and the spot VIX index. The empirical findings of this study suggest that there is a strong statistical significant positive contemporaneous relationship between the changes in the VIX futures term structure and the returns of the underlying equity index. Finally, the econometric analysis lends some support to the hypothesis that the term structure of VIX futures can be used as a contrarian indicator for investing in the equity market.
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Volume 20, Issue 2 (Fall 2011)
A Derivative Transaction Tax and Equivalent Measures
Victor A. Canto and Robert I. Webb (pages 123-140)
This study examines the economic impact of taxes on derivative security transactions. Particular attention is directed toward the effects of the imposition of a Tobin tax — which is primarily intended to curb speculation and secondarily intended to raise revenues — on financial market transactions. Specifically, we evaluate the Tobin tax and taxes imposed primarily to achieve objectives other than raising revenue, in terms of alternative "tax-equivalent policy actions." A distinction is drawn between the imposition of a Tobin tax on transactions in exchange-traded derivatives with centralized clearing and the imposition of a Tobin tax on transactions in over-the-counter traded derivatives that are not centrally cleared.
The Relationship Among Agricultural Futures, ETFS, AND THE U.S. Stock Market
Yiuman Tse (pages 143-159)
Agriculture-related exchange-traded funds (ETFs) have become popular investments in recent years. I investigate the return dynamics among the agriculture ETFs, DBA, and RJA (both traded on the New York Stock Exchange), their underlying futures, and the U.S. stock market. ETF and futures returns are highly correlated and the results indicate a strong link between prices and public information. Using intraday data, I find that Granger-causality in returns primarily runs from individual futures to the agriculture ETFs. However, DBA and RJA returns are also significantly caused by S&P500 index returns, showing that stock market sentiment influences pricing behavior. The results are also consistent with the impact of financialization of commodities on agriculture prices.
Speculation in Financial Markets
Robert I. Webb (pages 161-184)
This article surveys the state of the literature on the impact of speculation on the behavior of speculative prices and assesses the implications for policymakers and practitioners. Particular attention is directed toward the impact of speculation on derivative securities and markets and on extreme price moves.
Volatility Expectations in an Era of Dissonance
Bluford H. Putnam (pages 185-199)
Options pricing depends critically on expectations of future volatility. Risk measurement and time series research methods often assume that volatility is constant over a given time period. If volatility repeatedly shifts to elevated levels and then moderates, the robustness of many models may be called into question. Financial practitioners often characterize such conditions as being "risk-on" or "risk-off" states, and during 2007–2011 there were many examples. This paper discusses how probabilities may shift between two distinct scenarios for the future. The first scenario describes a state in which economies settle into steady growth patterns and financial markets adjust accordingly, while the second scenario encapsulates the potentially dire consequences of considerable economic and financial disruption. This approach focuses attention on the robustness of many common practices that embed assumptions of steady levels of volatility.
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Volume 20, Issue 1 (Summer 2011)
Measuring the Interdependence of Banks in Hong Kong
Tom Fong, Laurence Fung, Lillie Lam and Ip-wing Yu (pages 7-26)
This paper assesses systemic linkages among banks in Hong Kong using the risk measure "CoVaR" derived from quantile regression. The CoVaR measure captures the co-movements of banks' default risk by taking into account their nonlinear relationship when the banks are in distress. Based on equity price information, we show that the default risks of the banks were interdependent during the global financial crisis in 2009. Although local banks are generally smaller, their systemic importance is found to be similar to their international and Mainland counterparts. Regarding the impact of external shocks, we find that international banks are more likely to be affected by the equity price fall in the U.S. market, while local banks are relatively more responsive to funding liquidity risk.
Quality Delivery Options and the NYMEX Crude Oil Futures Contracts
Don N. MacDonald (pages 27-57)
Futures contracts often offer the short position options on the quality, timing, location and quantity associated with physical delivery. Delivery risk exists because the price of the futures contract is associated with the price of the expected cheapest to deliver asset rather than with the par delivery asset. In this paper, a futures equilibrium approach to the valuation of the delivery option is developed and applied to the NYMEX crude oil futures contract. The empirical results indicate that the delivery option implicit in the NYMEX contract is large, primarily due to nonparallel shifts in the underlying futures price series. The futures equilibrium value of the delivery option is compared to previous implicit methods used to evaluate the delivery option and related to recent developments in the crude oil swap and spread markets.
Pricing Convertible Bonds with Embedded Parisian Options: Theory and Evidence
Biao Guo and Fangyi Jin (pages 59-82)
We propose and empirically investigate a two-factor pricing model for convertible bonds with embedded Parisian options (soft call protection) and stochastic interest rate. The model is solved numerically by a finite element method. By studying the 46 convertible bonds and 47 months of daily market prices in China, we find that there is a slight underpricing; that is, the market prices are 0.16% lower than our model prices on average. Ignoring the embedded Parisian options, however, will dramatically decrease the model prices such that the market prices are overpriced by 5.61%. Our result shows that the Parisian options have a significant effect on pricing convertible bonds in the markets where soft call protection is prevailing.
On the Persistency of Global Futures Markets Interactions
Naseem Al Rahahleh and Peihwang Philip Wei (pages 83-114)
The paper examines the information links across futures markets around the world, particularly on the persistency of market interactions. To this end, we utilize the Dynamic Conditional Correlation (DCC) model by Engle (2002) that incorporates time-varying correlations. The sample encompasses futures on eight underlying assets traded in 12 futures exchanges in six countries. We find that the persistency of market interactions varies substantially across commodities. The degree of persistency is quite high for metal futures, compared to that of agricultural; the implication is that it is relatively harder to predict the interaction among futures markets on agricultural. We further hypothesize that the more diverse the information production, the more persistent is inter-market information transfer. Using some proxies for market power and liquidity, we find a negative relation between the concentration of market power and the persistency of market interactions, consistent with our expectation; for commodities with more concentrated market power, the interactions also tend to be more one-sided. Moreover, the markets with greater market power and liquidity, particularly the United States, often have greater effects on other markets.
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Special Edition Volume 19 — June 2011 (read it online)
High-Frequency Trading: Methodologies and Market Impact
Frank J. Fabozzi, Sergio M. Focardi, and Caroline Jonas
This paper discusses the state of the art of high-frequency trading (HFT), its requisite input, high-frequency data (HFD), and the impact of HFT on financial markets. The econometrics of HFD and trading marks a significant departure from the econometrics used when dealing with lower frequencies. In particular, ultra HFD might be randomly spaced, requiring point process techniques, while quantities such as volatility become nearly observable with HFD. At high frequency, forecasting opportunities that are different from those present at lower frequencies appear, calling for new strategies and a new generation of trading algorithms. New risks associated with the speed of HFT emerge. The notion of interaction between algorithms becomes critical, requiring the careful design of electronic markets.
- High-Frequency Trading: Methodologies and Market Impact
- Clearing House, Margin Requirements, and Systemic Risk
- Would Price Limits Have Made any Difference to the "Flash Crash" on May 6, 2010?
- Direct Market Access in Exchange-Traded Derivatives: Effects of Algorithmic Trading on
Liquidity in Futures Markets
Clearing House, Margin Requirements, and Systemic Risk
Jorge A. Cruz Lopez, Jeffrey H. Harris, and Christophe Pérignon
Margins are the major safeguards against default risk on a derivatives exchange. When the clearing house sets margin requirements, it does so by only focusing on individual clearing firm positions (e.g., the SPAN system). We depart from this traditional approach and present an alternative method that accounts for interdependencies among clearing members when setting margins. Our method generalizes the SPAN system by allowing individual margins to increase when clearing firms are more likely to be in financial distress simultaneously.
Would Price Limits Have Made any Difference to the "Flash Crash" on May 6, 2010?
Bernard Lee, Shih-fen Cheng, and Annie Koh
On May 6, 2010, the U.S. equity markets experienced a brief but highly unusual drop in prices across a number of stocks and indices. The Dow Jones Industrial Average (see Figure 1) fell by approximately 9% in a matter of minutes, and several stocks were traded down sharply before recovering a short time later. The authors contend that the events of May 6, 2010 exhibit patterns consistent with the type of "flash crash" observed in their earlier study (2010). This paper describes the results of nine different simulations created by using a large-scale computer model to reconstruct the critical elements of the market events of May 6, 2010. The resulting price distribution provides a reasonable resemblance to the descriptive statistics of the second-by-second prices of S&P500 E-mini futures from 2:30 to 3:00 p.m. on May 6, 2010. This type of simulation avoids "over-fitting" historical data, and can therefore provide regulators with deeper insights on the possible drivers of the "flash crash," as well as what type of policy responses may work or may not work under comparable market circumstances in the future. Our results also lead to a natural question for policy makers: If certain prescriptive measures such as position limits have a low probability of meeting their policy objectives on a day like May 6, will there be any other more effective counter measures without unintended consequences?
Direct Market Access in Exchange-Traded Derivatives: Effects of Algorithmic Trading on Liquidity in Futures Markets
Ahmet K. Karagozoglu
Algorithmic trading (AT) and high frequency trading (HFT) afforded by direct market access (DMA) may have a greater impact, due to existence of multiple contract months and inter/intra market trading, on the exchange-traded derivatives markets than has been seen in the equity markets. This study, to the best of our knowledge, is the first to provide empirical evidence for the positive effects of AT on liquidity in the U.S. futures markets. To analyze the potential effects of electronic trading, this study provides an extensive review of the research in both equity and derivatives market microstructure. Using a unique dataset that directly and explicitly identifies algorithmic trading activity in exchange-traded derivatives, our research presents empirical evidence that AT decreases spreads (market width) and increases market depth in the Crude Oil, Euro FX, Eurodollar, S&P 500 E-mini, and 10-year U.S. Treasury Note futures contracts traded at the CME Group exchanges.
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Volume 19 Issue 4 (Spring 2011)
A Comprehensive Study of the Chinese Warrants Bubble
Tao L. Wu
We conduct the most comprehensive study to date of the Chinese warrants market in terms of the length of the sample period and the variety of the warrants investigated. During our sample period from August 2005 to September 2009, the underlying Chinese stock market peaked in October 2007 and then crashed dramatically. Starting by the end of October 2008, the market recovered steadily. We examine the pricing of put warrants, as well as covered call warrants and (uncovered) equity call warrants, during such market swings. Our analysis indicates that Chinese warrants exhibited large pricing bubbles as their market prices significantly deviated from those implied by option pricing models. We show empirically that the bubble size is positively related to turnover and daily price change, and negatively related to the total number of warrants outstanding. These results are consistent with the prediction of the Greater Fool Theory: An investor buys securities without regard to their fundamental value, but with the hope of quickly selling them off at a higher price to another investor who might also be hoping to flip them quickly. Moreover, we find evidence that the stock price declines associated with the conversion of previously state-owned non-tradable shares into tradable ones dampened the bubble behavior for those companies' covered call warrants, relative to warrants on companies that did not participate in share conversions.
Response to Public Information in Futures Markets: Evidence from the Financial Crisis
James Richard Cummings and Esther Yoon Kyeong Lee
This paper examines the impact of macroeconomic news announcements on the Australian stock index futures market during the financial crisis of 2007-2008. The financial crisis is characterized by higher price volatility and trading activity, wider bid-ask spreads, and lower depth in the futures market. The responses of price volatility and trading volume to news announcements are more intense and short-lived than before the crisis. Bid-ask spreads widen further around announcements than before the crisis, while depth remains at diminished levels. These results imply that news announcements carry richer information content than before the financial crisis.
Regime Dependent Information Contents of Model-Free Volatility: Evidence from the Eurodollar Options Markets
I-Doun Kuo and Yi-Hsuan Chen
We assess the information efficiency of the Eurodollar options markets and find that model-free volatility is more informative than model-dependent volatilities, especially during a market downturn. The results of a Markov-switching test show that the information content differs between regimes because model-free volatility contains information in out-of-money options, and this information becomes valuable as the market becomes turbulent. In addition, our analysis of model-free interest rate volatility can benefit both interest rate risk management and fixed-income asset valuation.
The Importance of Skewness on Hedging: Evidence from Currency Futures Markets
Yongyang Su
We derive an Optimal Hedge Ratio (OHR) under the mean-variance-skewness framework, where investors are allowed to have a preference for skewness. Using spot and futures exchange rate data, we find that (i) skewness of futures returns influence hedging decisions. Investors with skewness preference seem to be choosing a hedge ratio in order to construct a mean-variance-skewness efficient portfolio, which may appear to be mean-variance inefficient; (ii) the preference for skewness and risk-avert level of investors are positively correlated. Investors with higher risk-aversion level construct a hedged portfolio with higher level of positive skewness in returns; (iii) the sign of futures returns are negatively correlated with hedging decisions of the mean-variance-skewness investors. When futures returns are positive (negative), investors with skewness preference tend to hedge less (more) than the mean-variance investors.
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Volume 19, Issue 3 (Winter 2011)
Investigating ICAPM in International Futures Markets
Turan G. Bali, K. Ozgur Demirtas, and Kishore Tandon
This paper investigates the significance of an intertemporal relation between expected return and risk for the futures markets. The paper takes a look at the domestic futures and the relationship between conditional risk, and return is examined in international futures markets as well. We test the significance of a daily risk-return tradeoff in stock index futures for G8 countries (United States, Canada, UK, Germany, France, Italy, Japan, and Australia). We use GARCH modeling with the thin-tailed normal and the fat-tailed Student t, generalized error, and generalized t distributions to simultaneously generate risk measures and forecast expected futures returns. The maximum likelihood parameter estimates indicate that the relation between risk and return is flat in futures markets. This result is robust across eight different countries.
The Roles of Speculation and Fundamentals in Commodity Markets: The Case of U.S. Natural Gas Futures Market
Mengzhu Ji, Hai Lin, and Zhen Zhu
The issue concerning the role of fundamentals and speculation is in the center of the analysis of financial and commodity market dynamics as well as policy- making processes. More recent history of energy market price and volatility has caused many market participants as well as policy makers to point to speculation as a source of price run-up and higher volatility. This paper provides a study of the roles of fundamentals and speculation by empirically investigating the connection between natural gas price change, its volatility and speculation in the U.S. natural gas futures market. To help understand the connection better, we also model gas returns and volatility by using fundamental supply and demand factors in the gas market. The empirical results suggest that gas returns and volatilities are mainly affected by market fundamentals rather than speculation.
Alchemy in the 21st Century: Hedging with Gold Futures
Caihong Xu, Lars Nordén, and Björn Hagströmer
The Shanghai gold exchange is the largest spot gold exchange in the world, and the Shanghai gold futures contract, introduced in 2008, is already the fourth largest gold futures contract in the world. This paper is the first to study the Chinese gold market, analyzing hedging strategies utilizing the Shanghai gold futures. The results show that hedging with gold futures reduces the variance of an unhedged gold spot position by about 88% in its first two years of existence. During the second half of 2008, however, when the global financial crisis escalated, the variance reduction dropped to about 70%. Overall, the new Chinese gold futures prove to be attractive and well-needed hedging vehicles for domestic Chinese gold producers, refiners, consumers, and investors. Furthermore, it is found that the regression hedge outperforms bivariate GARCH hedging strategies out-of-sample, even though the latter are better suited to describe the return processes in-sample.
Is There an Opportunity to Improve the Hedging of Jet Fuel by Airlines?
Michael Ellis, Eric Johnson, and C. Lockwood Reynolds
Fuel expenses not only are one of the largest categories of expenses for airlines but also can be highly volatile. This volatility makes strategies designed to hedge against movements in jet fuel prices more attractive if they can be successfully implemented. We demonstrate that variation in fuel expenses induces large variations in operating expenses for airlines and that attempts to pass off these fluctuating expenses to consumers are largely unsuccessful. Additionally, we demonstrate that current hedging activities by airlines using contracts on other petroleum products leave firms exposed to substantial basis risk, while over-the-counter contracts tend to be expensive and as constructed have typically involved significant downside risk. In particular, we demonstrate that not only is there less than perfect correlation between prices of jet fuel and other widely traded petroleum contracts, but that there is also substantial regional variation in prices. The results suggest that there may be a market for a well-constructed jet fuel futures contract in Asia.
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Volume 19, Issue 2 (Fall 2010)
Risk-Adjusted Stock Information from Option Prices
Ren-Raw Chen, Dongcheol Kim, and Durga Panda
As option's payoff depends upon future stock price, option prices contain important information of their underlying stocks. In this paper, we price options with the physical measure where we can jointly estimate expected stock return and implied volatility from market prices of options. Using S&P 500 Index options, we discover the following four results. First, our result shows that investors have higher expectations of stock returns in the short-term, but lower expectations in the long-term. Second, the term structure of volatilities in our model is much flatter than the term structure of the Black-Scholes model. Third, the empirical investigation shows that a combination of our implied expected return and implied volatility with Black-Scholes implied standard deviation provides a better model than Black-Scholes implied standard deviation alone to forecast future volatility of stocks for any combination of moneyness and maturity. Finally, the implied volatility of our model can predict much better future volatility over the life of the option than the implied volatility of the Black-Scholes model, more so for short maturities of 90 days or less.
An Options Implied Volatility Spread Model for the Taiwan Stock Index Futures-Options Arbitrage
Chia-Hsing Huang, Kung-Fu Chang, and Chi-Hui Wang
This paper uses five-second synchronous index futures and index options best bid and best ask prices from the Taiwan Futures Exchange to study arbitrage trading. Empirical evidence shows that there are extreme options implied volatility situations within the market. An in-the-money options price is lower than the intrinsic value, and the options implied volatility cannot be solved from the Black-Scholes options pricing model. The probability of having an extreme options implied volatility is negatively correlated with time to maturity and arbitrage strategy and is positively correlated with the degree of moneyness. The probability of having an extreme options implied volatility has a U shape pattern in a trading day.
Intranight Trading on The Sydney Futures Exchange
Alex Frino, Andrew Lepone, and Grant Wearin
This paper examines intranight patterns in quoted bid-ask spreads, quoted depth, price volatility, and trading volume in the SPI200, 90-Day BAB, 3-Year Bond and 10-Year Bond futures contracts traded on the Sydney Futures Exchange (SFE). Across all contracts, we document an elevation in both price volatility and trading volume at the open and close of the overnight trading session. In contrast to prior research, we document an inverted U-shaped pattern in quoted bid-ask spreads, while quoted depth follows a U-shaped pattern. These intranight patterns are predominantly driven by trading volume and price volatility, changes in the population of traders, the opening of U.S. markets (and U.S. information announcements) and pricing risk throughout the night session.
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Volume 19, Issue 1 (Summer 2010)
Dynamic Hedging Strategies: An Application to the Crude Oil Market
Delphine Lautier and Alain Galli
This article analyzes long-term dynamic hedging strategies relying on term structure models of commodity prices and proposes a new way to calibrate the models which takes into account the error associated with the hedge ratios. Different strategies, with maturities up to seven years, are tested on the American crude oil futures market. The study considers three recent and efficient models respectively with one, two, and three factors. The continuity between the models makes it possible to compare their performances, which are judged on the basis of the errors associated with a delta hedge. The strategies are also tested for their sensitivity to the maturities of the positions and to the frequency of the portfolio rollover. We found that our method gives the best of two seemingly incompatible worlds: the higher liquidity of short-term futures contracts for the hedge portfolios, together with markedly improved performances. Moreover, even if it is more complex, the three-factor model is by far, the best.
An Examination of Alternative Distributional Assumptions in Oil and Related Futures Markets
I-Yuan Chuang, Chiao-Yi Chang, and Pei-Hsuan Lee
This paper analyzes both unconditional distributions and GARCH models with fat-tailed conditional distributions based on 11 distributional assumptions in the context of oil and related futures markets. Results reveal that, in general, the scaled t distribution (ST) and Su-normal distribution (SN) are outstanding among the unconditional distributions. Moreover, the superiority of a model in forecasting volatility of energy futures returns depends on the underlying energy futures examined. This study also shows that the effectiveness of the underlying models may depend on the purpose of their application, that is, density fitting or volatility forecasting. However, the normal distribution often assumed in the literature is the least recommended.
An Economic Analysis of Reverse Exchangeable Securities: An Option-Pricing Approach
Rodrigo Hernández, Wayne Y. Lee, and Pu Liu
In this paper we provide economic and empirical analyses for reverse exchangeable bonds (REXs). We make a detailed survey of the $45 billion U.S. dollar-denominated market for 7,426 issues of bonds issued between May 1998 and February 2007. In addition, we also develop pricing models for four types of bonds and empirically examine the profits for issuing these bonds. The results of the survey suggest significant profits for the issuing financial institutions. We also show that the profit function for issuing REXs is independent of the initial price of the underlying securities. Finally, we show that a perfect hedge can be obtained through static and costless trading strategies and find that issuing REXs with the perfect hedging strategy has a payoff identical to the payoff of a call option.
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Volume 18, Issue 4 (Spring 2010)
Crisis, Value at Risk, and Conditional Extreme Value Theory via Garch-Jump Model
Samuel Yau Man Ze-To
This study develops a new conditional extreme value theory-based model (EVT) combined with the GARCH-Jump model to forecast extreme risks. This paper utilizes the GARCH-Jump model to asymmetrically feed back the past realization of jump innovation to the future volatility of the return distribution and uses the EVT to model the tail distribution of the GARCH-Jump-processed residuals. The model is compared to the GARCH-t model and the conditional EVT-GARCH model to evaluate its performance in estimating extreme losses in three major market crashes and crises. The results show that the conditional EVT-GARCH-Jump model outperforms the GARCH and GARCH-t models in depicting the non-normality and in providing accurate VaR forecasts in the in-sample and out-sample tests. The EVT-GARCH-Jump model, which can measure the volatility of extreme price movement in capital markets due to unexpected events, enhances the EVT-based model for measuring the tail risk.
Futures Trading and Oil Price Movements
Arjun Chatrath, Rohan A. Christie-David, Victoria Lugli, and Cynthia Santoso
In this study we examine the roles of speculative trading and crude oil fundamentals in recent oil price movements. To do this we employ futures prices on light-sweet crude traded on the NYMEX from January 1993 to June 2008. Our preliminary findings, using correlation tests, lends support to the notion that speculators played an important role in the recent rise in prices. However, this evidence might be considered insufficient, on the grounds that any meaningful conclusions must consider the mediating role of demand and supply pressures on crude prices. With this in mind, we employ a partial-equilibrium model that incorporates macro-and oil-related fundamentals. The findings from this model explain between 84% to 93% of oil price movements in the 1990s, as well as in more recent years. Moreover, other factors, including speculative trading in crude oil, generally explain less than 2% of the remaining variation in price movements.
Weather, Inventory, and Common Jump Dynamics in Natural Gas Futures and Spot Markets
Wing Hong Chan, George H.K. Wang, and Li Yang
This paper studies the common jump dynamics in natural gas futures and spot markets within a bivariate autoregressive jump intensity-GARCH framework (BARJI-GARCH). We particularly examine the role of weather as a short-run demand factor and inventory as a short-run supply factor in explaining price spikes and time-varying volatility in spot and futures returns. Using daily time series data from 1994 to 2004, we obtain several interesting empirical results: (1) conditional jump intensity is persistent and the likelihood of common jumps in the future depends on the past history of jump dynamics; (2) the magnitude of average jump size varies over time as a function of unanticipated low temperature and inventory surprise; and (3) both means of jump intensity and jump size are higher in the winter months and lower in the summer months. These results are consistent with theory suggesting that price jumps (spikes) often occur in the situation where there is sudden shift in short-run demand when short-run supply is inelastic.
An Analysis of Extreme Price Shocks and Illiquidity among Systematic Trend Followers
Bernard Lee, Shih-Fen Cheng, and Annie Koh
We construct an agent-based model to study the interplay between extreme price shocks and illiquidity in the presence of systematic traders known as trend followers.
The agent-based approach is particularly attractive in modeling commodity markets because the approach allows for the explicit modeling of production, capacities,
and storage constraints. Our study begins by using the price stream from a market simulation involving human participants and studies the behavior of various trend-following strategies,
assuming initially that their participation will not impact the market. We notice an incremental deterioration in strategy performance as and when strategies deviate further and further
from the theoretical strategy of lookback straddles
(Fung and Hsieh 2001), due to the negative impacts of transaction cost and imperfect execution. Next, the trend followers are allowed to participate
in the market, trading against "uninformed"
computer traders making randomized bids and offers. We notice that market prices begin to break down as the percentage of trend followers in the market reaches 80%.
In addition, in a market dominated by "smart traders,"
it becomes increasingly difficult for any of them to generate profits using what is supposed to be a "long gamma" strategy.
After all, trading is a zero-sum game: It is not feasible for any "long gamma"
trader to generate a consistent profit unless someone else is willing to be on the other side of his/her trades. In any such market dominated by "smart traders"
with low liquidity and extreme price instability, one proposed solution (as proposed earlier by the U.S. Commodity Futures Trading Commission) is to control position size limits,
by either decreasing them (in the original proposal) or increasing them (for completeness in our analysis). Based on our simulation results, we have found no evidence supporting
that such a solution will be effective; in fact, doing so will only lead to erratic price behavior as well as a variety of practical issues when imposing such changes to position size limits. An alternative proposal is to intervene in the market direct/indirectly, such as by using a market maker to inject/reduce liquidity. Our simulation
results show evidence that injecting and reducing liquidity by the market maker can both be effective. However, a market maker can accumulate a large negative P&L by buying in a
one-sided, falling market in which it is the only bidder, or vice versa. Therefore, in practice, no market maker may volunteer to participate in any such "market rescue" efforts unless
governments are willing to underwrite some of its large potential losses. In short, direct/indirect intervention by controlling liquidity is not a panacea, and there are practical
limits to its effectiveness.
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Volume 18, Issue 3 (Winter 2010)
The Impact of an Increase in Order-Book Transparency on Market Quality: Evidence from the Sydney Futures Exchange
Kiril Alampieski and Andrew Lepone
This paper examines the impact of an increase in order-book transparency on market quality in a futures market setting. Results indicate that both quoted depth and trading volume increase, while both bid-ask spreads and price volatility are not significantly affected. While this suggests that the increase in transparency leads to an increase in market quality, analysis of a control contract indicates similar improvements in market quality. Regression results, which control for both contract-specific and market-wide levels in trading activity and price volatility, confirm that the improvements in market quality are common to both the experimental and control contracts. These results are robust to the seasonality in futures trading. Overall, the results do not support the conclusion that an increase in transparency leads to an improvement in market quality.
Efficiency and Unbiasedness in the Indian Stock Index Futures Market
Prasad S. Bhattacharya and Harminder Singh
This paper explores potential efficiency and unbiasedness as well as the degree of efficiency in stock index futures of an emerging market using both monthly and daily data. Besides analyzing efficiency and unbiasedness with cointegration and error correction model, the degree of efficiency is further investigated after explicitly modeling the underlying state of the market (expansion or contraction) through the first-order Markov switching set-up. The results show that a relatively longer two-month horizon is more effective in eliminating arbitrage opportunities than the short run (one-month and daily) futures.
The Efficacy of Conditional Cost of Carry Models
Eric Girard, Amit Sinha, and Rita Biswas
This paper develops an empirical cost of carry model for pricing crude oil futures by introducing an exogenously conditioned convenience yield as well as stochastic volatility. The approach is tested using monthly prices of all light crude oil futures contracts traded on the New York Mercantile Exchange between 1985 and 2006. The results indicate that the model fits the data extremely well relative to the unconditional model. Though the paper focuses on oil, the approach can be used for any other consumption commodity with well-developed futures markets.
Price Discovery Process in the Copper Markets: Is Shanghai Futures Market Relevant?
Renhai Hua, Bing Lu, and Baizhu Chen
This paper examines the international linkage between the Chinese and other major world copper futures markets in order to study the information spillover process. We find that the copper futures prices of contracts traded on the three major exchanges, Shanghai, London and New York are cointegrated. Using both Gonzalo and Granger (1995) and Hasbrouck (1995) methods, we find that the London market still dominates the price discovery process, contributing over 45%. Though the Shanghai market contributes important information to the price discovery, its share of contribution is still the smallest among the three. The Shanghai Futures Exchange, the second largest copper futures market in the world, contributes about 25%.
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Volume 18, Issue 2 (Fall 2009)
When Does the Options Market Lead the Futures Market? Evidence from Taiwan's Emerging Derivatives Market
Scott Fung and Shih-Chuan Tsai
When does the options market lead the futures market? Using a unique setting from Taiwan's emerging derivatives markets, this study examines the interrelationship between the futures market and the options market and demonstrates that an implied volatility index from an informed options market can lead futures market returns. We construct the Taiwan Implied Volatility Index (TVIX) and find it to be a market-sentiment indicator capable of predicting index futures returns over a two-day horizon. Option-market conditions affect the informational efficiency of option prices, such that the TVIX has a greater impact on index futures returns during periods of high trading volume and low open interest. We also find that changes in the TVIX exhibit a non-linear, asymmetric effect on index futures returns. Finally, incorporating the TVIX into various trading strategies for index future contracts results in superior performance.
Cash Settlement of Lean Hog Futures Contracts Reexamined
Miguel I. Gómez, Julieta M. Frank, Eugene L. Kunda, and Philip Garcia
In 1997 the Chicago Mercantile Exchange replaced its live hog futures contract with a cash-settlement mechanism based on a Lean Hog Index. Producers and packers are concerned convergence between cash and futures prices is not occurring and that basis volatility has increased in recent years. Our results indicate that basis has widened and its variability prior to expiration has increased in the cash-settlement period. Despite some evidence that ex-ante basis risk has increased, the ability to forecast basis prior to expiration has not decreased appreciably with cash settlement. In the absence of forecasting procedures, producers and market participants have experienced additional variability in their selling prices. Hedging generally reduces the variability in cash prices, but its ability to do so has declined during the cash-settlement period due to increased basis variability.
Cospectral and Wavelet Analyses of Corn and Gasoline Futures Prices
Joseph McCarthy and Alexei G. Orlov
This research uses cospectral and wavelet methodologies to study the comovements of daily gasoline and corn futures prices, as well as the Commodity Research Bureau (CRB) index. Our findings show that there is a distinct structural break in the data series beginning in 2006, coincident with the enforcement date of the Energy Policy Act of 2005. It is also shown that prior to 2006 the relationship between corn and gasoline futures was largely driven by the increases in the overall price level, as reflected in the CRB index.
Keynes on Financial Markets: Why Didn't You Listen?
Paul Dawson, Michael A. Ellis, Mark E. Holder, and Richard J. Kent
John Maynard Keynes, the British economist, reputedly wrote or said that "Markets can stay irrational longer than you can stay solvent." Keynes had very extensive knowledge of financial markets, based on substantial personal experience. For many years he was a very active participant in a wide variety of markets, as an investor and as a speculator, both for himself and for a number of organizations for which he was involved with establishing investment policy. In this paper a number of passing remarks, obiter dicta, by Keynes on financial markets and market participants, many of which are relevant to today's markets and recent developments, are presented. Keynes's experience as an investor and speculator is briefly discussed. Finally, whether Keynes wrote the above quote is discussed.
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Volume 18, Issue 1 (Summer 2009)
Common Industry Exposure in Seemingly Unrelated Commodities
Michael T. Chng
We propose and document robust evidence of cross-market return, volatility, and volume interactions among futures contracts written seemingly unrelated commodities exposed to a common industry. On the Tokyo Commodity Exchange, we find such evidence in natural rubber (NR), aluminum (AL) and gasoline (GA) futures markets, which are complementary commodities heavily consumed by Japan's automobile industry. Our VAR results indicate that (i) for shorter dynamics, NR and GA volatility both influence AL volatility; GA volume affects NR volatility and volume; the GA market is immune to both NR and AL trading activities; (ii) for longer dynamics, AL volume affects both NR volume and GA volatility; NR volume influences GA volume. These results are robust to lag-specifications, volatility measures and are consistent with full BEKK-GARCH estimates. Further analysis using the silver contract, TOCOM and TOPIX transportation indices, shows that a commodity market factor cannot explain our result. Our results offer insights into how commodity and equity markets relate at an industry level.
Copula-Based Dynamic Hedging Strategies in Stock Index Futures: International Evidence
Yi-Hao Lai
This article develops copula-GARCH models for estimating time-varying optimal hedge ratios, enabling various dependence structures between spot and futures returns. The results show that copula-GARCH models generally outperform the DCC GARCH and the OLS static hedging for both in- and out-of-sample evaluations in terms of variance reduction, implying the importance of asymmetric dependence in dynamic hedging. The Wilcoxon signed ranks test further indicates that Gumbel copula performs well for the in-sample period, and all copulas (except Clayton, which is inferior) provides similar hedging effectiveness for the out-of-sample period in accordance with the market conditions over the full sample period.
Day-of-the-Week Effects in the U.S. and Chinese Commodity Futures Markets
Kuei-Chih Lee, Hung-Gay Fung, and Tung Liang Liao
This study uses the stochastic dominance with and without risk-free assets (SDR and SD) to examine day-of-the-week effect patterns for the commodity futures markets in the U.S. and China. The results indicate that higher returns generally appear on Monday or Friday for the U.S. market but on Monday in the Chinese markets, which confirm the presence, but different patterns, of the day-of-the-week effect in two countries. The day-of-the-week patterns in the two countries appear to be related. Simulation results generally indicate that there are trading profits to be made according to the day-of-the-week effect patterns.
A New Look at Copper Markets: A Regime-switching Model
Wing Hong Chan and Denise Young
GARCH-jump models of metal price returns, while allowing for sudden movements (jumps), apply the same specification of the jump component in both 'bear' and 'bull' markets. As a result, the more frequent but relatively small jumps that occur in both bear and bull markets dominate the characterization of the jump process. Given that large jumps, although less frequent, are still quite common in copper (and other metal) markets, this is a potential shortcoming of current models. More flexibility can be added to the modeling process by allowing for regime-switching. In this paper we specify a model that allows for switching across two separate regimes, with the possibility of different jump sizes and frequencies under each regime, along with a regime-specific GARCH process for the conditional variance. This model is applied to daily copper futures prices over the period of January 2, 1980, through the end of July 2007. The model is estimated both with and without factors such as interest and exchange rate movements entering into the specification of the state-dependent mean of the conditional jump size. In some respects, a Regime Switching GARCH-Jump Model performs well when applied to the copper returns data. The results are mixed in terms of whether or not variations of the model that allow jump sizes to be a function of interest or exchange rates offer much of an advantage over a pure time series approach to the modeling of copper returns over the past three decades.
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Volume 17, Issue 4 (Spring 2009)
New Insights into India's Single Stock Futures Markets
Mao-wei Hung and Leh-chyan So
This study investigates correlations between India's bustling single stock futures (SSFs) and its peculiar Badla mechanism. Data from the world's most active SSF market, the National Stock Exchange (NSE) of India, are used. The results indicate that both the Badla mechanism and the introduction of SSFs seem to have contributed to the higher volatility of the spot markets. Our results show that the NSE's success with SSFs can be attributed to the peculiar trading conventions of the Badla system. However, we propose that this success could come at the cost of market disability, suggesting that there is justification for strengthening market regulations.
Synthetic Currency Cross-Hedge Using Gold Futures versus Currency Forwards under a DCC-GARCH Model
Bing-Huei Lin and Yueh-Neng Lin
This study investigates whether a synthetic currency cross-hedge using gold futures is effective and beneficial than over-the-counter currency forwards. The hedge ratio is adjusted to account for changing correlations and volatilities between the returns of the assets for the hedge. Time-varying covariances are parameterized in the DCC-GARCH specification, proposed by Engle (2002). Our results show that DCC-GARCH can help reduce constant-covariance model misspecification to manage the currency price risk. The currency forwards enhance hedging effectiveness relative to the benchmark, a synthetic currency futures contract that is formed by two gold futures contracts denominated in New Taiwan dollar and U.S. dollar traded on the TAIFEX.
Price Formation and Liquidity Surrounding Large Trades in Interest Rate and Equity Index Futures
Angelo Aspris, James Richard Cummings, and Alex Frino
This paper examines the effects of the direction of trade initiation and trade size on the resiliency of financial futures markets by analyzing quote prices, bid-ask spreads, and depths. The price and liquidity reactions reveal the unexpected information content of large trades. In the market adjustment process, the size of quotes posted by liquidity providers is shown to play a more important role in futures markets than in previous research for equity markets. The liquidity cost of a large futures trade is mainly a pecuniary externality borne by other traders by impairing their continued ability to trade.
Does Spurious Mean Reversion in Basis Changes Still Exist after the Introduction of Exchange Traded Funds?
Jayaram Muthuswamy, Nivine Richie, Reuben Segara, and Robert Webb
In their seminal Journal of Finance article, Miller, Muthuswamy, and Whaley (MMW, 1994) document that the observed mean reversion of changes in the basis of cash and stock index futures prices is likely illusory. MMW use a simple time-series model to suggest that the apparent mean-reversion in the basis is a spurious artefact of nonsynchronous prices between index futures and cash markets - rather than an indication of exploitable weak-form market inefficiency. Because the MMW effect is predominantly driven by liquidity differentials between cash and futures prices, the question naturally arises as to whether one would observe the same MMW phenomenon in the behavior of the basis or difference between more actively traded exchange traded funds (ETF) and cash market prices. This study attempts to answer that question by examining the basis behavior of the Standard and Poor's Depository Receipt (SPDR) ETF traded on the American Stock Exchange. Overall, we find that the MMW phenomenon still persists strongly after the advent of exchange traded funds. Moreover, an examination of the spread or basis between cash and ETF prices and the spread or basis between futures and ETF prices shows that the apparent mean reversion in both is even more pronounced than in the basis between cash and futures prices. This demonstrates that the MMW effect is extremely robust and unlikely to go away soon.
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Volume 17, Issue 3 (Winter 2008-2009)
Microstructure Evolution in the Credit Default Swaps Market
Pavel Pinkava and Paul Dawson
The considerable turbulence observed in financial markets during 2008 has focused much attention on the microstructure of the credit default swaps market. We argue here that (i) the microstructure of this market was evolving towards an exchange-traded model even prior to the events of 2008; (ii) practitioner and regulatory reaction to the events of 2008 will accelerate this evolution; and (iii) complete on-exchange trading, currently widely dismissed as impractical, is more feasible than many commentators suggest.
A Panel Cointegration Approach to the Relation between Spot and Future Commodity Prices
Benjamas Jirasakuldech, Sean M. Snaith, and Riza Emekter
Prior empirical studies using cointegration tests of efficiency in commodity markets provide inconclusive results. This paper analyzes the relationship between commodity spot and future prices using the panel cointegration techniques developed by Pedroni (2001, 2004). The application of Pedroni's panel cointegration techniques allows for heterogeneity and differences in short-run dynamics of individual members of the panel. We examine 28 commodities classified into five groups: energy, foodstuffs and industrial, grains and oilseeds, livestocks and meats, and metals. We find that the quarterly settlement prices of commodity spot and future prices in each panel are cointegrated, supporting evidence of both weak and strong forms of the efficient market hypothesis.
Realized Volatility and Correlation in Grain Futures Markets: Testing for Spillover Effects
Jae H. Kim and Hristos Doucouliagos
Fluctuations in commodity prices are a major concern to many market participants. This paper uses realized volatility methods to calculate daily volatility and correlation estimates for three grain futures prices (corn, soybean, and wheat). The realized volatility estimates exhibit properties consistent with the stylized facts observed in earlier studies. According to daily realized correlations and regression coefficients, the spot returns from the three grain futures are positively related. The realized estimates are then used to evaluate the degree of volatility transmission across grain futures prices. The impulse response analysis is conducted by fitting the vector autoregressive model to realized volatility and correlation estimates, using the bootstrap method for statistical inference. The results indicate that rich dynamic interactions exist among the volatilities and correlations across the grain futures markets.
Auction Designs and Futures Price Behavior: Evidence from the Taiwan Futures Market
Hsiu-Chuan Lee, Cheng-Yi Chien, Yi-Fen Hsieh, and Yen-Sheng Huang
This paper analyzes the impact of the transfer from a call auction to continuous trading on futures price behavior. Using tick by tick data from the Taiwan Futures Exchange (TAIFEX), the empirical results show that the reduction in the costs of information asymmetry and an improvement in price efficiency are achieved at the expense of the decrease in market liquidity when the TAIFEX transfers from a call auction to continuous trading. Additionally, this paper finds that the relative rate of price discovery for heavily traded futures contracts increases following the transfer to continuous trading, implying that continuous trading is more suitable for heavily traded futures contracts. Overall, the empirical results indicate that auction designs have impact on futures price behavior.
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Volume 17, Issue 2 (Fall 2008)
Are the European Carbon Markets Efficient?
George Daskalakis and Raphael N. Markellos
This paper examines the efficiency of the European market for carbon dioxide emission allowances. To this end, spot and futures market data are analyzed from Powernext, Nord Pool and ECX, the three main exchanges under the European Union Emission Trading Scheme (EU ETS). The methodology employs econometric testing procedures and trading strategies based on technical analysis rules and naive forecasts. The empirical results suggest that the behavior of the markets under consideration is not consistent with weak form efficiency. This could be due to the immaturity of the EU ETS and to the restrictions imposed on short-selling and on "banking" of emission allowances. The results are particularly important for emission-intensive firms, policy makers, and risk managers and for active or passive investors in the emerging class of energy and carbon hedge funds.
Performance, Bias, and Efficiency of Foreign Exchange Correlation Forecasts
Stefano Mazzotta
This paper evaluates the performance, bias, and the efficiency of option-implied and return-based correlation measures using 12 years of daily data on foreign exchange and over-the-counter (OTC) currency option. The sample includes five years of rates for the Polish zloty and the Czech koruna with respect to the euro and the U.S. dollar. The results show that implied correlation is a good predictor of realized correlation and is, generally, unbiased and efficient.
Option Prices as Predictors of Aggregate Stock Returns
R. Brian Balyeat and Bilal Erturk
The relative prices of S&P 500 index call and put options convey information regarding the future return of the S&P 500 index realized over the life of the options. When call options are relatively more expensive than put options, the index earns higher returns. Specifically, the natural log of the ratio of the out-of-the-money call price to the equally out-of-the-money put price at differing moneyness levels and maturities is positively related to the return of the index realized over the life of the options. This predictability is robust to controls for the cost of carry, past returns, implied volatility, and upper moments of the underlying. Furthermore, the results do not appear to be driven by the sign of the log ratio. Portfolios of the underlying, formed when the log ratio of the options prices is positive (when call options are more expensive), statistically outperform portfolios similarly formed when the log ratio is negative (when put options are more expensive). A simple investment strategy of increasing the S&P 500 weight in a portfolio when the ln(c/p) signal is positive and decreasing the weight when the value of the signal is negative significantly outperforms a static portfolio allocation.
The Non-Convergence of the VIX Futures at Expiration
Ivelina Pavlova and Robert T. Daigler
We examine the issue of non-convergence of the VIX futures to the cash VIX, the associated expiration day effects, and their sources. Significant disparities are found between the value of the cash VIX and the VIX futures at settlement of the contract. The reasons for this difference include the settlement procedure of the exchange and the underlying S&P 500 options order imbalances at settlement, the latter affected by traders unwinding arbitrage positions. We propose an alternative settlement procedure that mitigates these problems.
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Volume 17, Issue 1 (Summer 2008)
Hedging "Event" Risk
Philip McBride Johnson
On May 1, 2008, the same day when Soviet tanks used to rumble through
Red Square, the Commodity Futures Trading Commission announced that
it will consider whether instruments that are related to the outcome of events such as elections, sporting contests or population growth should be blessed with its regulatory approval or should be branded as gaming contracts. Of course, nearly all of the existing "futures contracts" and "commodity options" within the CFTC's remit involve patronage by large numbers of speculators, so the mere assumption of a foreign risk by people who could readily avoid it cannot be, in itself, a disqualification. Presumably, the outcome will hinge on whether any economic benefit inures from these instruments other than the thrill of the wager.
Discussion Regarding the Commentary on Hedging "Event" Risk
Kathryn M. Trkla
The CFTC issued its Concept Release to solicit comment on the appropriate regulatory treatment of event contracts under the Commodity Exchange Act (CEA). [73 FR 25669 (May 7, 2008)] As a threshold matter, if the contract is a commodity future or commodity option, it is covered by the CEA and subject to the CFTC's jurisdiction, with some exceptions. As the Commission notes, event contracts "can be designed to exhibit the attributes of either options or futures contracts." [73 FR 25670] From a layman's perspective, the obvious question is how, possibly, could events be considered commodities. As explained in the Concept Release and the Commentary by Philip McBride Johnson in this issue, the CEA contains a broad definition of "commodity" that covers events. Thus, events can be (and already are) the subject of CFTC-regulated futures or options trading. In the amendments to the CEA in 2000, Congress even included within the new definition of "excluded commodity" - a subset of the broader commodity definition - events where the occurrence of the event is "associated with a financial, commercial, or economic consequence" and is "beyond the control of the parties to the relevant contract." [7 U.S.C. §1a(13)]
Public Information, Price Volatility, and Trading Volume in U.S. Bond Markets
Mardi Dungey, Alex Frino, and Michael D. McKenzie (G12, G14)
Prices in bond markets have been noted as moving extremely rapidly following macroeconomic news announcements - with a delayed increase in trading volume. New data allows us to demonstrate that the previously unexplained dichotomy between rapid price and sluggish volume movement in the U.S. Treasury's cash market originates with rapid price and volume change in the Treasury futures market. Consistent with research in other markets, the Treasury futures lead price discovery in the cash market.
Value-at-Risk Ananlysis for KOSPI 200 Index Futures: Evidence from Long Memory Volatility Models with a Skewed Student-t Distribution
Sang Hoon Kang and Seong-Min Yoon (C32, C52, G11)
We computed daily Value-at-Risk (VaR) for KOSPI 200 Index futures returns using two long memory volatility models (FIGARCH and FIAPARCH) based on the normal, Student-t, and skewed Student-t innovation distributions. We considered asymmetric long memory in the conditional variance and asymmetric fat-tailed distributions. Both the in-sample and out-of-sample VaR analyses indicated that the FIGARCH and FIAPARCH models with the skewed Student-t distribution innovation provide more accurate volatility forecasting for KOSPI 200 Index futures than do the models with the normal and Student-t distribution innovations. These VaR analyses provide an optimal margin level of risk in the KOSPI 200 Index futures market.
Volatility Estimation and the Performance of Multifactor Term Structure Models for Pricing and Hedging Euribor Options
I-Doun Kuo, Cheng-Hsiang Lin, and Min-Teh Yu (G12, G13)
This paper provides an empirical comparison of several competing term structure models in pricing and hedging of Euribor options with alternative approaches to volatility estimation using data of options prices or their underlying futures prices. The empirical results show that models using the option prices perform better than those using the futures prices in predicting Euribor option prices. In particular, when volatility is assumed to be time-varying, a more accurate prediction of option prices is obtained. When the volatility is further assumed to be time-varying and time-homogenous, it reduces the moneyness and maturity biases found in the literature. There is no clear pattern showing that one term structure model consistently predicts better than others under alternative approaches of volatility estimation. In contrast to prediction results, hedging results show that the stability of volatility is critical in ensuring hedging performance. The two-factor models produce better hedging performance than the one- and three-factor models in most cases. Finally, this study demonstrates that choosing an appropriate method of volatility estimation is more important than specifying the term structure model for pricing and hedging interest rate derivatives.
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