The Impacts Of Derivatives On Oil Prices Finance Essay

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In the 20th century energy industry is confronted by enormous threats and uncertainity due to this fact risk management was emerged. In order to cope with uncertaninty in the energy sector financial derivative were introduced in 1982 with the contract of WTI, this factor was introduced to pacify the risk factor emerge as the price variation in the oil sector under the regulation of OPEC. Some owners and director of the oil refinaries have argued that if future exchange in the oil market is introduced then factor of price variation can be control and this would also help to create a proper equilibrium approach in supply and demand of price and quantity. This seem to be the sensitive issue, because most of the developed countries crude oil plays an important role in the economy, its an input for many industries. Another aspect from the industrialist point of view was the cost managemnt of the product, due to price fluctuation in the crude oil has created problem for manufacturing firms to estimate accurate price. After anlayzing all the aspect it has become viable to create a robust strategy and policy to nullify the affect of price fluctuation in the energy industry. Aim of this research paper is to evaluate whether the introduction of various financial instrument have reduce the impact of price fluctuation or not.

Future trading is the most common terminology used in financial market instrument and these contracts are legally obligated. In this contract buyer and seller are bound together to fulfil the desire transaction under these instrument in the specific date and condition. Future trading used in oil market is similar to the financial market derivative instrument in which price is determined by some underlying asset. These contracts include the product quality, price and future date in which transaction will be completed. Future trading markets already exist for different financial instruments such as currencies, bond, stock and equities. But in the case of crude oil exchange; two exchanges are working one is located in New York and other one is in London.

These exchanges provide platform for different oil trader around the world, ranging from a single contract to the lot which allows a trader to deal in buying or selling more than 1000 barrel of oil. Future trading allows the trader to purchase or sale oil for many month or year ahead. The volume of activity in commodity futures markets is typically determined on oil for delivery in the next three months. For the last five year activities has been increased vigorously for the deliveries and it has been identified by different economist that many investor will invest more in future in different commodity index.

Research Aims & Objectives:

The objectives of this project are to explore the impacts of derivatives on oil pricing markets in the world. There are many aspect related for fluctuation in the crude oil market; derivatives are used to transform risk. The basic aim of this research is divided into two parts. The core objective of this research is to analyze those factors which engage in fluctuation in market. After completion of the first objective it will be proceed to second objective in which strategy will be made according to the current fluctuation in the market, this strategy will help to create an opportunity in such scenario.


Now a day's crude oil prices aren't working on supply and demand mechanism, things have been change due to expected energy crisis in future. New mechanism of oil pricing worked under financial market mechanism along with an influential factor made by some top American oil companies. Now a day's more than 65% of crude oil pricing is based on trader's speculation and from financial hedging. This mechanism has no relation with the traditional supply and demand mechanism, all its influence by some oil trader's and price mechanism.

Literature Review:

Price and demand instability has created gravity for different executive of oil market, which might help them to create some possible solution regarding eliminate these uncertainty. Sadorsky and Agnolucci have created a practical model for these uncertainties in their model which has been identified as G.A.R.C.H model (generalised autoregressive conditional heteroskedasticity) (Sadorsky and Agnolucci, 2009). There's not much literature available for the effect of future trade in the crude oil and instability exist in oil sector, while enormous amount of data was available related to the stick exchange and other instrument. Powers has tried to create a bond between the future and spot market, he analyzed in his theory that variation in these market has been decreased as financial instrument has been introduced (Powers, 1970). Moreover, Edwards (1988) has tried to identify the impact of the future exchange in the spot market with different trend analysis has analyzed that variation has been increased but in the short term but this theory doesn't included the long term policy. Darratet has argued in his theory that future trading does not have any positive or negative impact in the current spot market trading (Darratet, 2002). While kasman has used TSE to identify the impact, their theory has analyzed a impact of future trading with the current market it means instability in the current market will affect the future trading as well (Kasman, 2008).

Foster and Antonio have analyzed future and spot trading price of crude oil on weekly basis for the last 8 years, their outcome was seem to be positive in nature because they have analyzed that after market has been introduced by future trading concept along with the financial instrument has reduce the fluctuation in the spot market and stability in prices were observed (Antonio and Foster, 1992). While Flemming and Ostdiek have studied the sane trend like foster but they have experienced increased in instability in the spot market (Flemming and Ostdiek, 1999).

On the other hand one of the Australian theorists Frino have analyzed the future and spot trading on the basis of lag-lead model, has claimed that instability can occur due to the investor knowledge about the market (Frino, 2000). Buckle have analyzed that the impact can directed from future to spot in stock exchange and their term included in the contract for trading (Buckle, 2001). Moosa studied spot and future spot price; analyzed an important impact from spot to future market but these studies have also shown reverse impact from future to spot at some specific time period. Asche have also identify the same outcome for the lag-lead analysis on the basis of monthly price analysis of future and spot trading for the period of 25 years (Asche, 2002). Study made by Dick has identified a strong relationship between the future and spot trading but his study was based on two different period of monthly price analysis.


In this comparsion will be made in order to identify the effect of oil price fluctuation in the future trading along with on spot trading, different analysis has been done through different model along with the price instability model; Analyzing the cost price of per barrel that has been fluctuated from the past 35 years from G.A.R.C.H model (generalised autoregressive conditional heteroskedasticity) and E.G.A.R.C.H (exponential GARCH) analysis have been made on the future and spot trading price for the last 23 years. Starting with the application of the model, future exchage were being assumed and importance of the parameters were tested on those assumption. Preceding with other model, unbalanced price fluctuation model have been implemented on both the market that is future as well as spot in order to analyze the affect of news in the oil market. Third and last hypothesis was based on lag-lead analysis with causal test was conducted to calculate those markets leading in the price fluctuation.


London and New York are consider to be the main hub for crude oil traders and these two cities have a vibrant influence in the price mechanism; they consider to be the main authority for controlling price in the crude oil market, free trade agreement are encourage by these exchange, they also allow future trading facility to the oil trader. Now a new exchange has been emerged in the middle east region by the name of DME (Dubai Mercantile Exchange), this has been considered to be as a sister exchange of other two exchanges because board of director along with its chairman are comprising of American and British citizen who seems to be appointed in other exchanges as well. To estimate the cost of futures and spot trading, Brent is the basic instrument use to estimate value of the oil produced in the global market on daily basis, Brent pricing is published on daily basis in different oil publication magazines. Brent pricing is used by major oil producer to estimate crude oil price. Brent pricing method is use for European market as well as Asian. West Texas Intermediaries has worked enormously in the crude oil market for US but also provide basis for future trading for US in crude oil market it has also created a benchmark of oil production for US.


In this paper, stochastic volatility model will be developed and estimated for crude oil product. This model will try to estimate and develop the different means of persistency, declination and instability exist in the data, this might help to identify the causes of instability in the oil market price, because the introduction of financial derivative aren't synchronized with this model. At the introduction of this model some specific feature related to this model will be described along with some perception related to this model. Later on strategies and their outcome will be defined. In the end analysis will be done whether this model is capable enough to estimate the fluctuation on the basis of time period in the crude oil market.

Simulation by the name of Monte Carlo was applied in some specific model (model that analyze the behaviour of an instrument) in a large randomly selected testing, which was used to attain some future possible outcomes. In order to obtain perfect assumed stock price, the best and most common model seems to be the Geometric Brownian Model (GBM, it assumed that continuous changing is escorted with various shocks. The return period in GBM is normally distributed; the resulting multi-period (for e.g. 15 days) is log normally distributed.

To evaluate the impact of financial derivative use in the crude oil market, sample spot price will be needed before the introduction of future oil trading in the crude oil market. Authentic data related to that era is hard to find because US government has deregulate some policy related to the oil market which might over lapped to the related data. However some industry magazine and other trading magazine have represented the Post Prices before those regulations, but these prices didn't seem to representing the actual spot market. Different data is being used for the price analysis from different sources, price for western Texas intermediary are available on weekly basis this analysis has been done for one year before introduction of future trading market. To analyze the impact of introduction of future trading in the oil market, weekly prices analysis has been done for western Texas intermediary and in order to create persistency, day to day price will be analyzed for WTI just after the introduction of future trading. In order to analyze the relationship between future market price fluctuation and spot market price fluctuation, analysis has been done for entire day by day futures trading and interest rate available in New York oil exchange crude oil contract. These future data has also been observed from different database available in oil marketing firms. B-S-M and Black models have use the same assumption process as it has been used in the previous model; this is known as Geometric Winier Process.

In this process, the probability in the upward movement of price has been equal to the probability of a downward movement over a small increment in the time period. In some of the cases asset can lose 1005 of its value that would be occur if division of price is bounded at zero. This can be assumed that return will be normal if price is distributed normally along with persistent fluctuation, on the other hand unqualified price division would be in context of log-normally. Market mechanism is very crucial for these entire models. Stephen have argued that above all the financial theories, black school theory seems to be valid in real world of securities trading, it has a very broader impact in the real life financial situation. According to Stephen most of the participant in the finance market are well aware of this model and they use this model in their decision making process. Different institution have tested this model in the actual current trading price and conclusion has been made that not each and every factor is included in this model but black's model works outstandingly well in elaborating the observed pricing market. Most commodity option models start with the Black model and modify from there; this also is the case in the commodity option markets, particularly in the oil markets. (Stephen, 1989).


The basic analysis outcome shows that price fluctuation has been augmented due to the introduction of financial derivatives in the sector although variable of future exchange was based on assumption, which was used to manage the effect of the market derivative in the current cost of the oil price it was quite pragmatic and important. Further analysis have been made on the futures and spot trading price for the last 23 years, entail that for both futures and spot market instablity, coefficient of unbalanced price fluctuation model has a inverse affect and important outcome was identify with this model that is negative return will have a broader affect in the price fluctuation as compare to the positve ones.

This paper has identify one of the result that cross co-ordination exist between spot and future market; it means that the financial derivative which are being used as a hedging instrument also augment the uncertanity in price fluctuation for crude oil.


This paper will be used to identify the impact of the financial derivative instrument in the price of the crude oil market. According to this analysis, financial derivative which are being used as a hedging instrument also augment the uncertanity in price fluctuation as well as demand and supply for crude oil. The main objective of future trading in oil market in to eliminate price fluctuation and reduce the impact of uncertainity exist in the crude oil market, it can be concluded that derivative fail to serve the exact purpose. For the last 23 year oil prices are being determined on the basis of future and spot trading. It has been analyzed that both market that is future and spot have high price instablity. unbalanced price fluctuation model has a inverse affect and important outcome was identify with this model that is negative return will have a broader affect in the price fluctuation as compare to the positve ones, this will lead the oil industry to more complex situation rather than giving solution. Furthermore, the third model implies that cross co-ordination exist between spot and future market; it means that the financial derivative which are being used as a hedging instrument also augment the uncertanity in price fluctuation for crude oil. It can be concluded that risk of instablity has been increased due to the introduction of financial instrument in the crude oil market.