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Liquidity-Induced Dynamics in Futures Markets

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  • Fagan, Stephen
  • Gencay, Ramazan

Abstract

Futures contracts on the New York Mercantile Exchange are the most liquid instruments for trading crude oil, which is the world’s most actively traded physical commodity. Under normal market conditions, traders can easily find counterparties for their trades, resulting in an efficient market with virtually no return predictability. Yet even this extremely liquid instrument suffers from liquidity shocks that induce periods of increased volatility and significant return predictability. This paper identifies an important and recurring cause of these shocks: the accumulation of extreme and opposing positions by the two main trader classes in the market, namely hedgers and speculators. As positions become extreme, approaching their historical limits, counterparties for trades become scarce and prices must adjust to induce trade. These liquidity-induced price adjustments are found to be driven by systematic speculative behavior and are determined to be significant.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 6677.

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Date of creation: 09 Jan 2008
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Handle: RePEc:pra:mprapa:6677

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Keywords: Liquidity; Futures Markets; Return Predictability; Volatility; Trader Positions; Directional Realized Volatility; Hedgers; Speculators; Position Bounds;

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References

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  1. Gary B. Gorton & Fumio Hayashi & K. Geert Rouwenhorst, 2007. "The Fundamentals of Commodity Futures Returns," NBER Working Papers 13249, National Bureau of Economic Research, Inc.
  2. Hasabrouck, Joel & Sofianos, George, 1993. " The Trades of Market Makers: An Empirical Analysis of NYSE Specialists," Journal of Finance, American Finance Association, vol. 48(5), pages 1565-93, December.
  3. Lebaron, B., 1990. "Some Relations Between Volatility And Serial Correlations In Stock Market Returns," Working papers 9002, Wisconsin Madison - Social Systems.
  4. Changyun Wang, 2003. "Investor sentiment, market timing, and futures returns," Applied Financial Economics, Taylor & Francis Journals, vol. 13(12), pages 891-898.
  5. Sanders, Dwight R. & Boris, Keith & Manfredo, Mark, 2004. "Hedgers, funds, and small speculators in the energy futures markets: an analysis of the CFTC's Commitments of Traders reports," Energy Economics, Elsevier, vol. 26(3), pages 425-445, May.
  6. Joelle Miffre, 2002. "The predictability of futures returns: rational variation in required returns or market inefficiency?," Applied Financial Economics, Taylor & Francis Journals, vol. 12(10), pages 715-724.
  7. Tarun Chordia, 2001. "Market Liquidity and Trading Activity," Journal of Finance, American Finance Association, vol. 56(2), pages 501-530, 04.
  8. Tarun Chordia & Asani Sarkar & Avanidhar Subrahmanyam, 2003. "An empirical analysis of stock and bond market liquidity," Staff Reports 164, Federal Reserve Bank of New York.
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Cited by:
  1. Cifarelli, Giulio & Paladino, Giovanna, 2011. "Hedging vs. speculative pressures on commodity futures returns," MPRA Paper 28229, University Library of Munich, Germany.

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