Impacts of Financial Derivatives Market on Oil Price Volatility

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IMPACTS OF FINANCIAL DERIVATIVES MARKET ON OIL PRICE VOLATILITY

Istemi Berk

Izmir University of Economics

+905332903117

Overview

Risk management in energy industry has been a rising issue in the 20th century. Introduction of financial derivative instruments into the energy market in 1986 with the first contract of NYMEX WTI futures, took place in the name of handling the risk of price volatility which has emerged in the presence of domination of OPEC in market. Most common view of executives of oil market was that futures exchange would diminish price volatility of oil and at the same time “invisible hand” would lead a fair equilibrium of price and quantity in terms of supply-demand approach. It was a crucial issue because, as the most important input for all the industries, crude oil has been a term of foreign trade for developed countries. Therefore, for a sustainable energy policy, oil price volaitility had to be controlled. The main objective of this paper is to analyse whether the financial market transactions has reduced oil price volatility or not.

Methods

To investigate the impact of oil futures on the volatility of the underlying spot market, we use asymetric volatility models, GJR (Glosten, Jagannathan and Runkle (1993)) and EGARCH (exponential generalised autoregressive conditional heteroskedasticity), covering data for the period 1986-2008. In this paper we extend the model conducted in study of Flemming (1996). Also total daily trading volume in futures exchange are included inthe model. NYMEX WTI contract prices and Cushing Oklohama FOB spot prices are used to estimate ARCH effect on futures and spot markets respectively. Afterwards, lead-lag analysis with granger causality test is conducted to estimate which market is dominating and leading oil price volatilty.

Results

The preliminary results indicate that there is a significant ARCH effect on both futures and spot prices. Moreover, trading volume of futures exchange is the fundamental factor that lies behind the fact that futures exchange is dominating crude oil market. One main finding of this paper is that futures market volatility leading spot market one, which implies that the derivative instruments which are issued in order to hedge price volatility risk are increasing market volatility for crude oil.

Conclusions

This study examines the main effect of financial derivative instruments on crude oil market volatility. It has been reported in this study that daily trading volumes are one of the determining factors for market domination. It is concluded that introduction of financial derivative instrument into crude oil market has increased price volatility.

References

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