Liquidity-Induced Dynamics in Futures Markets

Fagan, Stephen and Gencay, Ramazan (2008): Liquidity-Induced Dynamics in Futures Markets.

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Liquidity, Futures Markets, Return Predictability, Volatility, Trader Positions, Directional Realized Volatility, Hedgers, Speculators, Position Bounds
• Subjects: G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing; G - Financial Economics > G1 - General Financial Markets > G10 - General; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General