Analyze the destablizing effects of energy derivatives on the volatility of underlying assets

Abstract

Energy is the focal point of many ongoing geopolitical crises and one of the main points on the agenda of all nations. The criticality of energy products in the growth and development of nations and the scarce nature of these resources make the need for a fair market catering to the energy demands and supplies in a fair manner, controlling the adverse impact of unprecedented events on the same paramount. Derivatives as a tool for such purposes have been used for a long time in other asset categories such as equities, bonds etc. their inception in the energy market has been relatively recent. However, the impact of derivatives on the energy markets has been different from the impact on other asset classes. The cross informational linkages in the energy products is far stronger than in any other asset class and thus fluctuations in one derivative has an impact on other underlying products as well. Hence in our study, we aimed at trying to better understand the impact of derivatives on the volatility of the underlying assets. We looked at historical data for various derivative products and their underlying spot prices. We concentrated mainly on the West Texas Intermediate (WTI). In our study we found that the cross-linkages between the WTI and the derivatives of other underlying products were significantly high. Also, a strong causality relationship existed between the two proving that the volatility in the derivatives price affects the volatility in the spot price of other underlying products as well. However, there isn’t a clear direction of the impact of different derivatives. As a result possibly the cumulative impact of different derivatives actually cancel each other out and tend to decrease the volatility. Empirical data seems to point in this direction; however no clear conclusions could be drawn out of it. However, it was evident that the energy market is far more sensitive than other asset markets as the impact of information and the speed with which new information is factored in the current prices was very high for the energy markets. We traced the history of commodities trading in India and in particular that of energy products. It was noted that the Indian market was not as sophisticated as its counterparts in South-East Asia, Europe and the United States. We believe that if the Indian energy markets were to achieve those levels of sophistication, a variety of avenues would open up for different players in the market to suit their needs. We also listed some of these possibilities for different market participants in the Indian context. In conclusion, we see the energy markets as an exciting field, which will hold a lot of importance not just to companies and institutions, but also nations going forward in the future and the existence of a robust market for the same, which provides its participants with an efficient medium to trade and transact with each other will go a long way in securing the country’s needs for attaining self sufficiency and becoming efficient.