Impact of international energy prices on China's industries

This study examines how returns and volatility of future contracts for Brent crude oil (Brent), West Texas Intermediate crude oil (WTI), Henry Hub natural gas, and Newcastle thermal coal impacts industries in China. Using the firm-level data of 3,750 stock listings across both Shanghai and Shenzhen stock exchanges, segregated into 138 subindustries under the Global Industry Classification Standard, this study finds evidence that crude oil futures have the most significant influence. Further analysis suggests that stock returns of oil-related companies are more closely align to Brent and WTI's futures returns following China's key oil pricing reform on March 27, 2013. Overall, Chinese industries are also more exposed to global crude oil futures volatility after this event.     

Derivatives pricing with liquidity risk

This paper develops a novel, general derivative pricing model which introduces a liquidity risk factor. The model variants we outline offer a sufficient degree of flexibility so as to enable the valuation of various types of derivative classes including futures, American options, and mortgage backed security options, whereas existing derivative models can only price liquidity risk in European derivatives. We validate the model with oil and gold futures data and compare it to a classical benchmark model void of any liquidity risk. We find that our model is significantly more accurate than the classical model for pricing both oil and gold contracts.     

Derivative pricing model and time‐series approaches to hedging: A comparison

This research compares derivative pricing model and statistical time‐series approaches to hedging. The finance literature stresses the former approach, while the applied economics literature has focused on the latter. We compare the out‐of‐sample hedging effectiveness of the two approaches when hedging commodity price risk using futures contracts. For various methods of parameter estimation and inference, we find that the derivative pricing models cannot out‐perform a vector error‐correction model with a GARCH error structure. The derivative pricing models' unpalatable assumption of deterministically evolving futures volatility seems to impede their hedging effectiveness, even when potentially foresighted optionimplied volatility term structures are employed. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:613–641, 2005     

Minimum variance cross hedging under mean‐reverting spreads,stochastic convenience yields,and jumps: Application to the airline industry

Exchange traded futures contracts often are not written on the specific asset that is a source of risk to a firm. The firm may attempt to manage this risk using futures contracts written on a related asset. This cross hedge exposes the firm to a new risk, the spread between the asset underlying the futures contract and the asset that the firm wants to hedge. Using the specific case of the airline industry as motivation, we derive the minimum variance cross hedge assuming a two‐factor diffusion model for the underlying asset and a stochastic, mean‐reverting spread. The result is a time‐varying hedge ratio that can be applied to any hedging horizon. We also consider the effect of jumps in the underlying asset. We use simulations and empirical tests of crude oil, jet fuel cross hedges to demonstrate the hedging effectiveness of the model. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:736–756, 2009     

Valuation of futures and commodity options with information costs

In this article, futures and commodity options are analyzed in the context of Merton's (1987) model of capital market equilibrium with incomplete information. First, following Dusak (1973) and Black (1976), the conditions under which Merton's model can be applied to the valuation of forward and futures contracts are proposed. Then an application to futures markets is given. We provide a partial differential equation and the formulas for European commodity options, futures contracts, and American options in the same context. The models are simulated and compared to standard models with no information costs. We find that model prices are not significantly different from standard model prices. However, our models correct for some pricing biases in standard models. In particular, they reduce the overvaluation bias for European and American commodity options. It seems that the costs of gathering and processing information regarding the option and its underlying asset play a role in explaining the biases observed in standard models. This work can be applied to other futures markets. © 1999 John Wiley & Sons, Inc. Jrl Fut Mark 19: 645–664, 1999     

Hedging long‐term commodity risk

This study focuses on the problem of hedging longer‐term commodity positions, which often arises when the maturity of actively traded futures contracts on this commodity is limited to a few months. In this case, using a rollover strategy results in a high residual risk, which is related to the uncertain futures basis. We use a one‐factor term structure model of futures convenience yields in order to construct a hedging strategy that minimizes both spot‐price risk and rollover risk by using futures of two different maturities. The model is tested using three commodity futures: crude oil, orange juice, and lumber. In the out‐of‐sample test, the residual variance of the 24‐month combined spot‐futures positions is reduced by, respectively, 77%, 47%, and 84% compared to the variance of a naïve hedging portfolio. Even after accounting for the higher trading volume necessary to maintain a two‐contract hedge portfolio, this risk reduction outweighs the extra trading costs for the investor with an average risk aversion. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:109–133, 2003     

Return and volatility transmission between China's and international crude oil futures markets: A first look

We examine return and volatility transmission between the newly established crude oil futures in China and international major crude oil futures markets using intraday data. For the first time, we document evidence for cointegration relationships among these oil futures markets. Both China's and Oman's oil futures markets react to deviations from their long-run equilibrium with West Texas Intermediate and Brent oil futures. There is also new evidence for asymmetric volatilities and correlations across these oil futures markets. Furthermore, the Chinese oil futures have stronger linkages with the international major futures markets than Oman futures.     

Extracting the Expected Path of Monetary Policy From Futures Rates

Federal funds and eurodollar futures contracts are among the most useful instruments for deriving expectations of the future path of monetary policy. However, reading policy expectations from those instruments is complicated by the presence of risk premia. This paper demonstrates how to extract the expected policy path under the assumption that risk premia are constant over time, and under a simple model that allows risk premia to vary. In the latter case, the risk premia are identified under the assumption that policy expectations level out after a long enough horizon. The results provide evidence that the risk premia on these futures contracts vary over time. The impact of this variation is fairly limited for futures contracts with short horizons, but it increases as the horizon of the contracts lengthens. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:733–754, 2004     

Metal prices made in China? A network analysis of industrial metal futures

In addition to being the world's greatest consumer and producer of industrial metals, China now also features the most actively traded industrial metal futures contracts worldwide. To examine China's role in the global price formation process of industrial metal futures markets, we use a sample of 29 futures contracts traded on exchanges in the United States, the United Kingdom, India, and China. We estimate vector autoregressive models and conduct variance decompositions, which are then visualized in the form of networks. The results indicate that China, despite its role as key actor in both real and financial industrial metal markets, is a price taker.     

Revisiting the empirical estimation of the effect of margin changes on futures trading volume

This study revisits the empirical estimation of the effect of margin requirements on trading volume. Although theory suggests that margin requirements impose a cost to traders and will therefore likely reduce volume traded, empirical examinations have generally failed to find this association. The contention of this article is that the theory is correct, but empirical estimation has generally neglected to adjust margins for underlying price risk. After adjusting for risk, this analysis finds economically and statistically significant negative effects of margin requirements on trading volume as predicted by theory. This study examined 6 contracts over a 17‐year time period and found that financial futures contracts (gold, Dow Jones, and 10‐Year Treasury Notes) were considerably more sensitive to changes in margin requirements than agricultural futures (wheat, corn, and oats). © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:561–576, 2003     

Why do expiring futures and cash prices diverge for grain markets?

In recent years, cash and futures prices have failed to converge at expiration for selected corn, soybean, and wheat commodity contracts. This lack of convergence raises questions about the effectiveness of arbitrage activities, and increases concerns about the usefulness of these contracts for hedging. We describe the delivery process for these contracts, and show that it embeds a valuable real option on the long side—the option to exchange the deliverable for another futures contract. As the relative volatility of cash and futures prices increases, this option increases in value, which disconnects the cash market from the deliverable instrument in a futures contract. Our estimates of this option's value show that it may create significant price divergence. We parameterize an option pricing model using data on these three commodities from 2000 to 2008 and show that the option model fits closely to recent episodes of non‐convergence, which lends support to the importance of real option effects. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark

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No chills or burns from temperature surprises: An empirical analysis of the weather derivatives market

This article examines the efficiency of the weather futures market traded on the CME in both HDD and CDD futures contracts in 18 cities across the United States. Efficiency is examined in three ways. First, by comparing the market's implied forecasts for the weather against other forecasts. Second, by looking at whether market's overreact or under‐react to temperature surprises. Third, by looking at weather derivative patterns across cities. We find that generally the market seems very efficient despite its lack of liquidity. We also find risk premia that seem to vary across cities and over time. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark 31:1–33, 2011     

An analysis of the relationship between electricity and natural‐gas futures prices

This article analyzes the relationship between electricity futures prices and natural‐gas futures prices. We find that the daily settlement prices of New York Mercantile Exchange's (NYMEX's) California–Oregon Border (COB) and Palo Verde (PV) electricity futures contracts are cointegrated with the prices of its natural‐gas futures contract. The coefficient of natural‐gas futures prices in our model of COB electricity futures prices is not significantly different from the coefficient of gas prices in our model of PV electricity although there are differences in the production of electricity in these two service areas. The coefficients in our model do reflect differences in the consumption of electricity in the COB and PV service areas, however. Our trading‐rule simulations indicate that the statistically significant mean reversion found in the relationship between electricity and natural‐gas futures prices also is economically significant in both in‐sample and out‐of‐sample tests. © 2002 John Wiley & Sons, Inc. Jrl Fut Mark 22:95–122, 2002     

Production,liquidity, and futures price dynamics

This study examines the optimal design of a futures hedge program for the competitive firm under output price uncertainty. All futures contracts are unbiased and marked to market in that they require interim cash settlement of gains and losses. The futures price dynamics follows a first-order autoregression with a random walk serving as a special case. The firm's futures hedge program is constituted of an endogenous provision for premature termination, which depends on how the futures prices are autocorrelated. Succinctly, the firm voluntarily commits to premature liquidation of its futures position on which the interim loss incurred exceeds a predetermined threshold level if the futures prices are positively autocorrelated. In this case, the liquidity constrained firm optimally opts for an over-hedge if its preferences exhibit either constant or increasing absolute risk aversion. If the futures prices are uncorrelated or negatively autocorrelated, the firm prefers to be liquidity unconstrained and thus adopts a full-hedge to completely eliminate the output price risk. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:749–762, 2008     

What to do if a dollar is not a dollar? The impact of inflation risk on production and risk management

An entrepreneur faces two types of risk: one from income generation, one from income spending. His income from firm profits is risky due to output price fluctuations and other risks. As a consumer, he is also exposed to inflation risk since he maximizes expected utility of real income. This article focuses on optimal production and risk management decisions of a risk‐averse entrepreneur jointly facing tradable output price risk and untradable inflation risk. Inflation risk applies multiplicatively to the entrepreneur's entire nominal income. Relative risk aversion and the risks' joint distribution determine the effect of introducing a futures market on production. For dependent risks, this effect may be negative if relative risk aversion is above one. Relative risk aversion and the joint distribution also determine optimal risk management with futures contracts where speculation on a real risk premium and cross hedging may be conflicting objectives. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:371–386, 2002     

Forecasting oil price movements: Exploiting the information in the futures market

Relying on the cost of carry model, the long‐run relationship between spot and futures prices is investigated and the information implied in these cointegrating relationships is used to forecast out of sample oil spot and futures price movements. To forecast oil price movements, a vector error correction model (VECM) is employed, where the deviations from the long‐run relationships between spot and futures prices constitute the equilibrium error. To evaluate forecasting performance, the random walk model (RWM) is used as a benchmark. It was found that (a) in‐sample, the information in the futures market can explain a sizable portion of oil price movements; and (b) out‐of‐sample, the VECM outperforms the RWM in forecasting price movements of 1‐month futures contracts. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:34–56, 2008     

Information and Noise in U.K. Futures Markets

This paper examines the extent to which futures price changes are driven by noise and information for three U.K. futures contracts by utilizing T. Andersen's (1996) specification of the mixture of distributions hypothesis. Use of the generalized method of moments approach demonstrates that the link between futures volume and volatility can be attributed to the flow of information. More importantly, it is shown that price movements are dominated by informed rather than noise trading for the FTSE‐100, the Long Gilt, and the Brent Oil futures contracts. The results suggest that further regulation based on the notion that noise traders dominate futures trading is unwarranted. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:711–731, 2004     

Market quality and the connectedness of steel rebar and other industrial metal futures in China

We examine the market quality of China's steel rebar futures, along with three other important industrial metal futures. Steel rebar futures are the most active metal futures contracts in China. Our analyses show that while steel rebar and copper futures are comparable in terms of informational efficiency, they are more informationally efficient than iron ore and aluminum futures, with low bid–ask spread, volatility persistence, pricing error variance, and probability of informed trading. We find a bidirectional connection between iron ore and steel rebar futures. Furthermore, we show that these metal futures are weakly related to the Chinese stock market.     

A STRUCTURAL RISK‐NEUTRAL MODEL FOR PRICING AND HEDGING POWER DERIVATIVES

We develop a structural risk‐neutral model for energy market modifying along several directions the approach introduced in Aïd et al. In particular, a scarcity function is introduced to allow important deviations of the spot price from the marginal fuel price, producing price spikes. We focus on pricing and hedging electricity derivatives. The hedging instruments are forward contracts on fuels and electricity. The presence of production capacities and electricity demand makes such a market incomplete. We follow a local risk minimization approach to price and hedge energy derivatives. Despite the richness of information included in the spot model, we obtain closed‐form formulae for futures prices and semiexplicit formulae for spread options and European options on electricity forward contracts. An analysis of the electricity price risk premium is provided showing the contribution of demand and capacity to the futures prices. We show that when far from delivery, electricity futures behave like a basket of futures on fuels.     

Complements or substitutes? Equivalent futures contract markets—the case of corn and soybean futures on U.S. and Japanese exchanges

This article examines the relationship between corn and soybean futures volumes for contracts traded in the United States and Japan. Because the contract specifications for corn and soybeans futures traded on the Chicago Board of Trade (CBOT), the Tokyo Grain Exchange (TGE), and the Kanmon Commodity Exchange (KCE) are highly similar, the existence of interactions might be expected. Previous research has identified price relationships between these similar contracts. With the advent of agricultural trading on the CBOT's Project A overnight electronic trading system, an overlap of trading times of the U.S. and Japanese exchanges for these commodity contracts resulted. An analysis of TGE and KCE corn and soybean futures volumes indicates that these contracts, rather than acting as substitutes, exhibit a complementary relationship. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:355–370, 2002