Fat Tails and Futures Markets Illiquidity: Theory and Evidence from Crude Oil and Natural Gas
Daniel P. Ahn
Columbia University; Citigroup
November 15, 2007
This paper demonstrates how the presence of "fat" tails in the distribution of price innovations for deliverable goods can lead to unwillingness of risk-averse or capital-supervised speculators and loss-averse producers to provide supply in futures markets at longer horizons. In particular, the thickness of the tail must be greater than the order of risk aversion for these markets to fail. Then an empirical section demonstrates how the model's predictions match the empirically observed hump-shaped trading at short horizons and sparse trading at long horizons for NYMEX crude oil and natural gas futures. New mathematical techniques from majorization theory help solve the model in analytic closed form.
Keywords: Operational Risk, Energy Trading, Futures Contracts, Power Laws, Fat Tails, Market Failure
JEL Classification: G00, G10, G13, G20, G32working papers series
Date posted: January 17, 2008
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