Hedging pressure and oil volatility: Insurance versus liquidity demands

• Published date: 01 February 2024
• Author: Christina Sklibosios Nikitopoulos,Alice Carole Thomas,Jianxin Wang
• Date: 01 February 2024
• DOI: http://doi.org/10.1002/fut.22470

Received: 15 April 2023

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Accepted: 18 October 2023

DOI: 10.1002/fut.22470

RESEARCH ARTICLE

Hedging pressure and oil volatility: Insurance versus

liquidity demands

Christina Sklibosios Nikitopoulos|Alice Carole Thomas|Jianxin Wang

Finance Department, UTS Business

School, University of Technology Sydney,

Broadway, New South Wales, Australia

Correspondence

Christina Sklibosios Nikitopoulos,

Finance Department, UTS Business

School, University of Technology Sydney,

PO Box 123, Broadway, NSW 2007,

Australia.

Email: christina.nikitopoulos@uts.edu.au

Abstract

This study evaluates the dual role of hedging pressure (HP) in oil futures markets

and analyses its effects on weekly oil volatility. We find that HP driven by hedgers'

insurance demands is negatively related to volatility, while HP driven by

speculators' short‐term liquidity demands is positively related to volatility. Oil

volatility tends to be more responsive to speculators' short‐term liquidity demands

than variations induced by hedgers' insurance demands. These channels are also

significant determinants of volatility in inverted and normal markets, with the

effects being more pronounced in inverted markets. Under low financial and

business‐cycle risk environments, the two HP channels typically have a

measurable impact on volatility. These opposing effects of HP on weekly volatility

provide empirical support on the significance of the dual role of hedgers in oil

markets, as price insurance seekers and as short‐term liquidity providers.

KEYWORDS

hedgers, hedging pressure, liquidity provision, oil volatility, speculators

JEL CLASSIFICATION

C58, G10, Q40

1|INTRODUCTION

It is widely acceptable in industry and academia that hedging pressure (HP) is a key determinant of oil volatility and

risk premia.

1

The notion of two risk premiums (associated with the traditional hedgers' insurance demands and the

short‐term liquidity demands from speculators) captured by two distinct measures of HP as established by Kang,

Rouwenhorst et al. (2020), mandates the re‐examination of the relationship between HP and volatility. These findings

also revive discussions on controversial debates on how hedgers and speculators are classified,

2

and who is responsible

for the volatility in oil markets: the (perceived) speculation or hedging?

J Futures Markets. 2024;44:252–280.252

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wileyonlinelibrary.com/journal/fut

This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial‐NoDerivs License, which permits use and distribution in any

medium, provided the original work is properly cited, the use is non‐commercial and no modifications or adaptations are made.

© 2023 The Authors. The Journal of Futures Markets published by Wiley Periodicals LLC.

1

A representative list of related works includes Symeonidis et al. (2012), Basu and Miffre (2013), Szymanowska et al. (2014), and Kang,

Nikitopoulos et al. (2020).

2

Following the customary classification in the literature (e.g., Gorton et al., 2013), commercial traders are hereafter defined as hedgers, while

noncommercial traders represent speculators.

This study provides empirical evidence to support the distinct and differential impact of two HP channels in

determining oil volatility. Using the weekly reports on hedgers' positions, published by the Commodity Futures

Trading Commission (CFTC), we disentangle the impact of these two HP measures and assess the effect of these two

channels on determining weekly oil volatility. We control for the impact of important determinants of weekly volatility,

including past volatility, returns, and weekly information on inventory (Bianchi, 2021; Gorton et al., 2013; Kilian &

Murphy, 2014). We find that a 1% increase in the long‐term component of HP driven by hedgers' insurance demands

reduces volatility by 16%, while a 1% increase in the short‐term component of HP driven by speculators' liquidity

demands increases volatility by 68%. Further, oil volatility tends to be more responsive to speculators' liquidity

demands (thus the hedgers' short‐term liquidity provision) than to variations induced by speculators' liquidity

provisions enforced by hedgers' insurance demands.

Motivated by the findings of Büyükşahin and Harris (2011) and Kang, Rouwenhorst et al. (2020), we also investigate

the interaction between asymmetric volatility effects and the impact of HP channels on oil volatility. We find that the

two HP measures exert opposite effects on weekly oil volatility, independent of the asymmetric effects in the oil market

and the interaction of positive and negative return shocks. Furthermore, speculators tend to provide liquidity in both

rising and falling oil markets for hedgers to insure their positions, whereas hedgers engage in short‐term liquidity

provision to fulfill speculators' liquidity demands only in bull oil markets.

Crudeoilmarketshaveexperiencedsubstantial variation in recent years linked to supply inelasticity and the global

economic slowdown, which has been reflected in the shape of the futures curve. The impact of volatility on the shape of the

futures curve has been established, and positive spreads tendtobemoreresponsivetovolatilityshocks(Nikitopoulos

et al., 2017;Symeonidisetal.,2012). Since normal and inverted markets respond differently to volatility shocks, we assess the

impact of the HP channels on volatility under these market conditions. First, we confirm the V‐shaped relationship between

the slope of the futures curve and the two market states (inverted and normal), increasing volatility by the same magnitude

(Haugom et al., 2014; Nikitopoulos et al., 2017). The aggregate effects on volatility are negative for HP by hedgers' insurance

demands and positive for HP by speculators' liquidity demands, with the effects being more pronounced in inverted markets.

We also examine the responsiveness of the HP measures (in determining oil volatility) to macroeconomic conditions

associated with financial market and business‐cycle risks. Cheng et al. (2015) assert a convective risk flow from speculators to

hedgers during periods of financial distress.

3

We find that independent of the level of market risk, the aggregate effect of HP

by hedgers' insurance demands on volatility is negative. However, the reduction in volatility is greater in low‐market‐risk

conditionsthaninhigh‐market‐risk conditions, potentially because speculators are reluctant to provide liquidity in high‐

market‐risk conditions. Inversely, the aggregate effect of the HP by speculators' short‐term liquidity demands on volatility is

positive in both high‐and low‐market‐risk environments. However, HP by speculators' short‐term liquidity demands tends

to increase volatility substantially in low‐risk conditions as hedgers are inclined to facilitate liquidity provision in low rather

than in high‐market‐risk conditions. Business cycles are likely to influence the demand for hedging via liquidity provision by

speculators (Baumeister & Kilian, 2016;Lang&Auer,2020), while business cycles have a profound effect on the relation of

HP with commodity risk premiums (Bianchi, 2021). We demonstrate that the aggregate effects of the two HP channels on

oil volatility remain the same, irrespective of economic boom or downturn signals.

This study offers novel insights into the role of speculators and, for the first time in the literature, the role of hedgers

as liquidity providers in determining weekly oil market volatility. We establish the dual role of hedgers in oil markets,

which have a statistically and economically significant impact and opposite effects on oil price volatility. The hedgers'

dual role as insurance seekers and short‐term liquidity providers may provide a justification for references regarding

hedgers' excessive trading, addressed by Cheng and Wei (2014) and Kang, Rouwenhorst et al. (2020). Indeed, Kang,

Rouwenhorst et al. (2020) observe that hedgers, acting as liquidity providers for momentum speculators in the short

term, earn comparatively higher returns (premiums). Their findings show that a considerable portion of speculators'

trading is orthogonal to momentum and that the benefits to hedgers of ‘immediate' liquidity provision are higher than

losses from facilitating momentum trading.

4

Although many studies, including those of De Roon et al. (2000), Basu and

Miffre (2013), and Bosch and Smimou (2022), acknowledge that hedgers' insurance demand is highly influenced by the

3

As a result, increased trading activity from speculators, which is beyond the standard trading associated with responding to hedger's insurance needs

(HP), may have adverse effects on commodity prices. An increase in speculators' trading positions in response to HP tends to decrease prices, while

an increase in speculators' trading positions in high volatility index (VIX) conditions, may increase prices.

4

Kang, Rouwenhorst et al. (2020) assess the profit/loss potential of three components of hedger's activities, namely, insurance demand, liquidity

provision, and momentum trading. They find that the speculator's losses generated by their short‐term momentum trading partly offset the insurance

premium earned, while hedgers benefit more from liquidity provision than momentum trading.

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