Arbitrage Opportunities and Feedback Trading in Emissions and Energy Markets

Abstract

This paper extends Sentana and Wadhwani (SW 1992) model to study the presence of feedback trading in emissions and energy markets and the extent to which such behaviour is linked to the level of arbitrage opportunities. Applying our augmented model to the carbon emission and four major energy markets in Europe, we find evidence of feedback trading in coal and electricity markets, but not in carbon market where institutional investors dominate. This finding is consistent with the notion that institutional investors are less susceptible to pursuing feedback-style investment strategies. In further analysis, our results show that the intensity of feedback trading is significantly related to the level of arbitrage opportunities, and that the significance of such relationship depends on the market regimes.

Keywords: Feedback trading; Arbitrage opportunities; Emissions and energy markets; Conditional volatility

JEL Classification: G1, G12, G17