Hedging Pressure Effects in Futures Markets

Abstract

We present a simple model implying that futures risk premia depend on both ownmarket and cross-market hedging pressures. Empirical evidence from 20 futures markets, divided into four groups~financial, agricultural, mineral, and currency! indicates that, after controlling for systematic risk, both the futures own hedging pressure and cross-hedging pressures from within the group significantly affect futures returns. These effects remain significant after controlling for a measure of price pressure. Finally, we show that hedging pressure also contains explanatory power for returns on the underlying asset, as predicted by the model.

The behavior and performance of major types of futures traders

“…However, the superior performance seems to result from hedging pressure effects rather than superior timing ability possessed by speculators. The prevalence of hedging pressure effects in U.S. futures markets is consistent with the literature (e.g., Bessembinder, 1992;De Roon et al, 2000). Analyses of intramonth trading behavior, however, reveal that speculators buy (sell) when the returns in the same month are higher (lower), whereas the opposite is true for hedgers.…”

“…The fact that hedgers consistently get the direction of market movements wrong likely reflects hedging pressure effects, meaning that hedgers who transfer nonmarketable risks are required to pay a risk premium. Evidence from several extant studies is supportive of the existence of hedging pressure effects (e.g., Bessembinder, 1992;De Roon et al, 2000). Therefore, the positive abnormal performance of speculators may suggest that speculators earn a risk premium by assuming nonmarketable risks, and does not necessarily imply that these traders are associated with superior information (see a detailed discussion in the analysis that follows).…”

“…Several extant studies have also suggested that dynamic hedging can cause positive feedback trades (e.g., Gennotte & Leland, 1990;Grossman, 1988). The inverse relation between the behavior and performance of speculators and hedgers could have been deduced from an adding-up constraint-a hedger's selling order most likely coincides with a speculator's purchase order; however, this does not prevent us from drawing the inference that the distinct abnormal performance of hedgers and speculators reflects hedging pressure effects (e.g., Bessembinder, 1992;De Roon et al, 2000;Hirshleifer, 1988Hirshleifer, , 1990.…”

“…Ederington and Lee (2002) study a finer dataset in the heating oil futures market and find that while "noncommercials" represent speculators, the "commercials" group likely includes some traders with no known positions in the cash/forward markets. Nevertheless, this interpretation has been widely used in the literature (e.g., Bessembinder, 1992;Chang et al, 1997;De Roon et al, 2000). It is unclear from the COT reports whether the trading motive of nonreportable position holders is hedging or speculation, and therefore, we exclude these traders from our analysis.…”

Futures Basis, Inventory and Commodity Price Volatility: An Empirical Analysis

“…Finally, later studies allow risk premiums to depend on both systematic risk and the positions of hedgers (Hirshleifer, 1989;Bessembinder, 1992;De Roon et al, 2000) and provide evidence that risk premiums vary with net hedging demand. In general, the existence of risk premiums in futures prices and their determinants has been a debatable issue among academics and practitioners.…”