Risk management with options and futures under liquidity risk

Futures hedging creates liquidity risk through marking to market. Liquidity risk matters if interim losses on a futures position have to be financed at a markup over the risk‐free rate. This study analyzes the optimal risk management and production decisions of a firm facing joint price and liquidity risk. It provides a rationale for the use of options on futures in imperfect capital markets. If liquidity risk materializes, the firm sells options on futures in order to partly cover this liquidity need. It is shown that liquidity risk reduces the optimal hedge ratio and that options are not normally used before a liquidity need actually arises. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:297–318, 2009     

A Markov regime switching approach for hedging stock indices

In this paper we describe a new approach for determining time‐varying minimum variance hedge ratio in stock index futures markets by using Markov Regime Switching (MRS) models. The rationale behind the use of these models stems from the fact that the dynamic relationship between spot and futures returns may be characterized by regime shifts, which, in turn, suggests that by allowing the hedge ratio to be dependent upon the “state of the market,” one may obtain more efficient hedge ratios and hence, superior hedging performance compared to other methods in the literature. The performance of the MRS hedge ratios is compared to that of alternative models such as GARCH, Error Correction and OLS in the FTSE 100 and S&P 500 markets. In and out‐of‐sample tests indicate that MRS hedge ratios outperform the other models in reducing portfolio risk in the FTSE 100 market. In the S&P 500 market the MRS model outperforms the other hedging strategies only within sample. Overall, the results indicate that by using MRS models market agents may be able to increase the performance of their hedges, measured in terms of variance reduction and increase in their utility. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:649–674, 2004     

A first look at the empirical relation between spot and futures electricity prices in the United States

In this article we investigate the statistical properties of wholesale electricity spot and futures prices traded on the New York Mercantile Exchange for delivery at the California–Oregon Border. Using daily data for the years 1998 and 1999, we find that many of the characteristics of the electricity market can be viewed to be broadly consistent with efficient markets. The futures risk premium for 6‐month futures contracts is estimated to be 0.1328% per day or about 4% per month. Using a GARCH specification, we estimate minimum variance hedge ratios for electricity futures. Finally, we study the dynamic relation between spot and futures prices using an Exponential GARCH model and between the spot and futures returns series using a vector autoregression. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:931–955, 2003     

Production and hedging under Knightian uncertainty

This article introduces Knightian uncertainty into the production and futures hedging framework. The firm has imprecise information about the probability density function of spot or futures prices in the future. Decision‐making under such scenario follows the “max‐min” principle. It is shown that inertia in hedging behavior prevails under Knightian uncertainty. In a forward market, there is a region for the current forward price within which full hedge is the optimal hedging policy. This result may help explain why the one‐to‐one hedge ratio is commonly observed. Also inertia increases as the ambiguity with the probability density function increases. When hedging on futures markets with basis risk, inertia is established at the regression hedge ratio. Moreover, if only the futures price is subject to Knightian uncertainty, the utility function has no bearing on the possibility of inertia. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20: 397–404, 2000     

Trading activity in stock index futures markets: The evidence of emerging markets

This study investigates the trading activity of the Taiwan Futures Exchange (TAIFEX) and Singapore Exchange Derivatives Trading Limited (SGX‐DT) Taiwan Stock Index Futures markets by analyzing the intraday patterns of volume and volatility. In addition, the market closure theory, which may explain such patterns, is examined. Overall, the trading pattern appears to be U‐shaped for the TAIFEX futures and U+W‐shaped for the SGX‐DT. For the SGX‐DT futures, volatility follows the same pattern as that of the number of price changes. For the TAIFEX futures, however, after the peak at the close of the spot market, the volatility in the TAIFEX futures drops consistently until the end of the day while volatility in the SGX‐DT still reaches a smaller peak at the close of the futures market. In addition, a visual inspection of the intraday patterns of these two markets shows that the market closure theory can effectively explain the intraday patterns of these two markets. The empirical results support the market closure theory in that liquidity demand from traders rebalancing their portfolios before and after market closures creates larger volume and volatility at both the open and close. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:983–1003, 2002     

Futures hedging under mark‐to‐market risk

This article introduces mark‐to‐market risk into the conventional futures hedging framework. It is shown that a hedger concerned with maximum daily loss will considerably reduce his futures position when the risk is taken into account. In case of a moderate hedge horizon, the hedger will hedge approximately 80% of his spot position. The effect of mark‐to‐market risk decreases very slowly as the hedge horizon increases. If the hedger is concerned with average daily loss, the effect is minimal for a moderate hedge horizon. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:389–398, 2003     

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     

Intertemporal volatility and price interactions between Australian and Japanese spot and futures stock index markets

Previous studies have examined causality within and between different spot and futures markets with a motivation to discover market comovements, price leadership effects, and, more recently, volatility spillovers across markets. However, the empirical framework within which this is accomplished tends not to analyze explicitly foreign spillover effects upon a spot–futures relationship, which may significantly alter the equilibrium between these markets. This will then have a direct impact upon the estimation of dynamic risk adjustments that occur from the interaction between these markets. This article develops a quadvariate simultaneous-equation EC-ARCH model with an emphasis on volatility spillovers as a better alternative methodology to evaluate these relationships from a different perspective. This model is applied to examine the interaction between the Australian and Japanese spot and futures stock index markets, which allows for an Australian or Japanese futures trader to analyze the impact of foreign cash and futures markets, as well as the local cash market, on the local futures market in a single coherent framework. This type of analysis is not possible using previous paradigms, because they allow the trader only to examine the impact of local cash and foreign futures markets in separate settings. © 1999 John Wiley & Sons, Inc. Jrl Fut Mark 19: 523–540, 1999     

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.     

货币流动性和市场流动性:波动与风险

目前,货币流动性和市场流动性的关系成为股票市场参与者关注的焦点。本文分析了货币流动性与市场流动性的联系,实证研究了货币流动性和市场流动性的波动关系,以及货币流动性对市场流动性风险的影响,发现货币流动性M2、M1和市场非流动性动态负相关,M0与市场非流动性动态不相关;货币流动性M2和M1的正向冲击能一定程度降低市场流动性波动风险,而M0会增加市场流动性波动风险,市场流动性风险自身是影响市场后期流动性风险的最大因素。     

Hedging performance analysis of energy markets: Evidence from copula quantile regression

This study investigates hedging performance with respect to different market structures for energy-related commodities, including West Texas Intermediate crude oil, Brent crude oil, Chinese crude oil, and Heating oil. Copula quantile regression functions and the generalized autoregressive conditionally heteroscedasticity model are combined to analyze the nonlinear impact of dependence and the heterogeneous impact of market structure changes on hedging performance. Results show that hedging performance presents nonlinearity and market structure changes have surprisingly strong heterogeneous effects on the quantile hedge ratio, where bearish and bullish have lower hedge ratios than normal markets, which is captured better by Clayton copula quantile regression. Additionally, the trend of hedging effectiveness over different market structures also shows an inverted U shape. After changing data frequency or the types of futures contracts, the conclusions remain the same. Our empirical findings imply that hedgers are supposed to adjust the hedging number of futures according to market structure changes to hedge price risk effectively.     

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.     

中美玉米期货市场功能效率比较

价格发现与套期保值是期货市场的基本功能,能够反映期货市场的运行效率。通过对比中美贸易摩擦前后期货市场的价格发现和套期保值功能,分析中美玉米期货市场效率间的差距,探究我国玉米期货市场运行效率低的原因。利用格兰杰(Granger)因果分析、协整检验、分位信息份额模型、套期保值比率及绩效分析方法,定量对中美两国2013—2019年玉米期货及现货的数据进行分析,结果表明,中国玉米期货市场存在较强的价格发现功能,但套期保值绩效不佳。使用前沿分位信息份额模型和滚动格兰杰因果法分析中美两国期现货市场动态关系的区别,发现中国仅存期货市场对现货市场的单向引导,而美国在中美贸易摩擦前表现为玉米期现货市场具有相近的引导能力,套期保值效率较高,中美贸易摩擦增强了其现货市场对期货市场的引导能力,降低了期货市场运行效率。从期现货市场双向引导关系视角来看,中国玉米期货市场效率低的原因主要是现货市场的信息不完全、发展不完善,期现货市场缺少长期稳定的双向引导关系抑制了期货市场功能发挥。中国应全面加强期货市场建设,提升期货市场定价效率,推动农产品期货市场快速健康发展。     

Hedging,liquidity, and the competitive firm under price uncertainty

In this paper, the behavior of the competitive firm under price uncertainty when the firm has access to an intertemporally unbiased futures market is examined. Futures contracts are marked‐to‐market and thus require interim cash settlement of gains and losses. The firm is subject to a liquidity constraint in that it is forced to prematurely close its futures position on which the interim loss incurred exceeds a threshold level. It is shown that the liquidity constrained firm optimally opts for an under‐hedge should it be prudent. Furthermore, the prudent firm cuts down its optimal level of output in response to the presence of the liquidity constraint. As such, the liquidity risk created by the interim funding requirement of a futures hedge adversely affects the hedging and production decisions of the competitive firm under price uncertainty. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:697–706, 2004     

Is there an illiquidity premium in frontier markets?

We perform a comprehensive examination of the role of stock-level liquidity in the cross-section of frontier market stock returns. Using several popular liquidity measures and a battery of asset pricing tests, we investigate the illiquidity premium in 22 countries for the years 1991–2019. Contrary to typical relationships in developed and emerging markets, we find no evidence of illiquidity premium in frontier equities. Our findings support the hypothesis that for countries not fully integrated with the global economy, the diversification benefits offset the illiquidity, which, in turn, proves less important.     

Flight-to-liquidity: Evidence from China's stock market

In an order-driven and strictly regulated stock market, illiquidity risks' effects on asset pricing should be highlighted, particularly in such extreme market conditions as those in China. This paper utilizes panel data from China's stock market in an attempt to answer whether the illiquidity risk in various dimensions—including price impacts, the transaction speed, trading volume, transaction costs, and asymmetric information—can explain stock returns. We find that almost all dimensions of stock illiquidity are positively associated with excess stock returns. More importantly, smaller, less-liquid stocks suffer more liquidity costs, providing a strong evidence for “flight-to-liquidity.” Additionally, the transaction costs and asymmetric information, denoted by bid-ask spreads, robustly account for these illiquidity effects on stock pricing and differ from the findings in the U.S. market. We also find that the “flight-to-liquidity” can partially explain the idiosyncratic volatility puzzle, investors' gambling, and herding psychologies. This study provides substantial policy implications in regulation and portfolio management for emerging markets.     

Optimal hedge ratios in the presence of common jumps

This study derives optimal hedge ratios with infrequent extreme news events modeled as common jumps in foreign currency spot and futures rates. A dynamic hedging strategy based on a bivariate GARCH model augmented with a common jump component is proposed to manage currency risk. We find significant common jump components in the British pound spot and futures rates. The out‐of‐sample hedging exercises show that optimal hedge ratios which incorporate information from common jump dynamics substantially reduce daily and weekly portfolio risk. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 30:801–807, 2010     

When stock futures dominate price discovery

This paper revisits the role of leverage in price discovery, using one of the most liquid single-stock futures (SSFs) markets in the world. Price discovery is analysed as a dynamic intraday process. We find that the information share of the SSFs is 55% during news arrivals. It increases to 61%, when the news is negative and the futures is preferred because of short-sales restrictions on the spot. A partial equilibrium analysis predicts that the trade-off between leverage and market liquidity determines price discovery across securities. These predictions are validated by empirical evidence.     

A novel risk management framework for natural gas markets

This paper examines dynamic hedges in the natural gas futures markets for different horizons and explores the gains from devising risk management strategies. Despite the substantial progress made in developing hedging models, forecast combinations have not been explored. We fill this gap by proposing a framework for combining hedge-ratio predictions. Composite hedge ratios lead to significant reduction in portfolio risk, whether spot prices are partially predictable or not. We offer insights on hedging effectiveness across seasons, backwardation-contango conditions and the asymmetric profiles of long-short hedgers. We conclude that forecast combinations better reconcile realized performance with the hedging process, mitigating model instability.