Craig Pirrong's Research Page


This page contains a list of my recent publications, my CV, and abstracts of current working papers. You can download any of the working papers and CV.

Selected Recent Publications and Curriculum Vitae

  • "The Clearinghouse Cure,” Regulation, 2009.
  • "Clearing Up Misconceptions on Clearing," Regulation, 2008.
  • "The Price of Power: The Valuation of Power and Weather Derivatives," Journal of Banking & Finance, 2008.
  • "Detecting Manipulation in Futures Markets: The Ferruzzi Soybean Episode,  American Law and Economics Review, 2004.
  • "Securities Market Macrostructure: Property Rights and the Efficiency of Securities Trading, The Journal of Law, Economics, and Organization, 2002.
  • "New Economy: Implications for the Organization and Structure of Securities Markets, " forthcoming in D. Jones (ed.), The New Economy Handbook. The Academic Press, 2003.
  • " Market Microstructure Issues," forthcoming in R. Sauer (ed.), Electricity Deregulation. The Independent Institute Press, 2003.
  • "Manipulation of Cash-Settled Futures Contracts," Journal of Business 2001.
  • "A Theory of Financial Exchange Organization," Journal of Law and Economics 2000.
  • "The Organization of Financial Exchange Markets: Theory and Evidence, " Journal of Financial Markets 1999.
  • "Valuing Power and Weather Derivatives on a Mesh Using Finite Difference Methods" (with Martin Jermakyan) Energy Modelling and the Management of Uncertainty, Risk Books 1999.
  • "Metallgesellschaft: A Prudent Hedger Ruined or a Wildcatter on NYMEX? " Journal of Futures Markets 1997
  • The Economics, Law and Public Policy of Market Power Manipulation 1996
  • "Market Liquidity and Depth on Computerized and Open Outcry Trading Systems: A Comparison of DTB and LIFFE Bund Contracts," Journal of Futures Markets, 1996
  • "Price Dynamics in Physical Commodity Spot and Futures Markets: Spreads, Spillovers, Volatility and Convergence in Refined Petroleum Products," Journal of Empirical Finance, with Victor Ng, 1996
  • "The Self-Regulation of Commodity Exchanges: The Case of Market Manipulation," The Journal of Law and Economics, 1995
  • "The Welfare Costs of Arkansas Best: the Pareto Inefficiency of Asymmetric Taxation of Hedging Gains and Losses," The Journal of Futures Markets, 1995
  • "Mixed Manipulation Strategies in Commodity Futures Markets," The Journal of Futures Markets, 1995
  • "The Efficient Scope of Private Transactions Cost Reducing Institutions: The Case of Commodity Exchanges," The Journal of Legal Studies, 1995
  • "Commodity Futures Market Regulation: The Inefficiency of the Anti-Manipulation Provisions of the Commodity Exchange Act," Regulation, 1994
  • "Commodity Market Manipulation Law: A (Very) Critical Analysis of the Existing Doctrine and A Proposed Alternative," Washington and Lee University Annual Review of Securities and Comodities Law, 1994
  • "Fundamentals and Volatility: Storage, Spreads, and the Dynamics of Metals Prices," The Journal of Business, with Victor Ng, 1994
  • "Regulation: Futures Trading and Institutional Investors," The American Enterprise, 1994
  • "Manipulation of the Commodity Futures Delivery Process," The Journal of Business 1993

Download my CV

Working Papers

Below are abstracts for my current working papers. You can also download PDF versions of these papers by clicking on the appropriate URL. Any feedback on these papers is appreciated.

 

Papers on Asset Pricing

Momentum in Futures Markets. Momentum has been examined extensively in equity markets, but little studied outside them. I document the existence of momentum and reversals in futures markets including commodity and financial futures contracts traded in the US and overseas. Futures momentum portfolios earn positive average returns even after adjusting for risk using canonical pricing models including the CAPM and Fama-French three factor models. If futures momentum portfolios are formed based on standardized performance, they earn positive average returns even after a momentum factor is included in the Fama-French model, although the momentum factor is statistically significant. Thus, futures momentum is related to, but not subsumed by, equity momentum. Non-parametric risk adjustment reduces momentum returns, but momentum portfolios formed based on standardized historical returns exhibit abnormal performance even allowing for time varying, non-parametric risk adjustment.
Download "Momentum in Futures Markets."

Papers on Financial Exchange Organization and Governance

The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty. New!  Credit derivatives have received intense scrutiny--and criticism--as a major contributor to the ongoing financial crisis.  In response, regulators have proposed requiring the formation of a central clearinghouse to share default risk on these contracts.  A comparative economic analysis of the costs and benefits of alternative default risk sharing mechanisms casts considerable doubt on the advisability of central clearing of credit derivatives.  These products are likely to be subject to severe information asymmetry problems regarding their value, risk, and the creditworthiness of those who trade them, and these information asymmetries are likely to be less severe in bilateral markets than in centrally cleared systems.  Moreover, although regulators have argued that clearing would reduce systemic risk, a more complete analysis demonstrates that clearing could actually increase risks to the broader financial system.  Download The Economics of Clearing. 

The Industrial Organization of Trading, Clearing, and Settlement in Financial Markets.  New!  The execution, clearing, and settlement of financial transactions are all subject to substantial scale and scope economies which make each of these complementary functions a natural monopoly.  Integration of trade, execution, and settlement in an exchange improves efficiency by economizing on transactions costs.  When scope economies in clearing are more extensive than those in execution, integration is more costly, and efficient organization involves a trade-off of scope economies and transactions costs.  A properly organized clearing cooperative can eliminate double marginalization problems and exploit scope economies, but can result in opportunism and underinvestment.  Moreover, a clearing cooperative may exercise market power.  Vertical integration and tying can foreclose entry, but foreclosure can be efficient because market power rents attract excessive entry.  Integration of trading and post-trade services is the modal form of organization in financial markets, which is consistent with the hypothesis that transactional efficiencies explain organizational arrangements in these markets.  Download "The Industrial Organization of Trading, Clearing, and Settlement in Financial Markets." Download the (relatively) Journal Friendly version of "The Industrial Organization of Trading, Clearing, and Settlement in Financial Markets."

Rocket Science, Default Risk and the Organization of Derivatives Markets.  Financial derivatives are traded on OTC markets and organized exchanges.  Default risks are partially shared--``mutualized"--on exchanges through a clearinghouse.  Default risks typically are not shared on OTC derivative markets.  In the absence of private information and moral hazard, mutualization improves welfare by reducing the expected cost of default by exploiting scale economies scale economies.  Although moral hazard and asymmetric information problems exist in both exchange and OTC markets, private information is more important in OTC transactions because valuation of OTC derivatives often requires the use of  specialized, proprietary mathematical models.  The lack of default risk mutualization in OTC derivatives markets and its presence for exchange derivatives is consistent with the greater importance of private information on OTC markets.  Scale economies are exploited in OTC markets by the formation of large dealer firms rather than via mutualization.  Moreover, private information and netting create scope economies that can make it economical to eschew mutualization of default risks even for standardized OTC products.   Download "Rocket Science, Default Risk and the Organization of Derivatives Markets."

Bund for Glory, or, It's a Long Way to Tip a Market. (REVISED!) Theory predicts that liquidity considerations make financial markets ``tippy." In 1998, trading on Bund futures tipped from LIFFE (an open outcry exchange) to Eurex (an electronic market). Measures of spreads on LIFFE and Eurex did not change markedly in the eighteen month period over which Eurex achieved dominance in Bund futures trading, but a measure of market depth did worsen on LIFFE as tipping proceeded. The evidence suggests that trading fee differentials and operational efficiencies were the key factors in precipitating the shift in volume. The ``sponsorship" of the Eurex platform by German banks narrowed liquidity cost differences sufficiently to permit Eurex to charge lower fees and thereby undercut total trading costs on LIFFE. Download "Bund for Glory"

Upstairs, Downstairs: Electronic vs. Open Outcry Markets. Computerized trading has made great inroads in equity and derivatives markets, especially in Europe and Asia, but open outcry markets remain dominant in the United States despite predictions of the imminent demise of floor trading. This article identifies three factors that influence the relative liquidity of computerized and open outcry markets: the sizes of upstairs and downstairs liquidity pools, the magnitude of the risk that upstairs traders face in being ``picked off" when trading via limit order in an open outcry market, and the quality of information available to floor and upstairs traders. Although liquidity differences certainly influence the choice of trading technology, network effects and coordination costs may allow the less liquid trading method to prevail. In the presence of coordination costs, the existence of mechanisms for coordinating the trading choices of investors and hedgers, agency costs, and the organization and governance structures of exchanges also influence whether open outcry or computerized trading will dominate.
Download "Upstairs, Downstairs"

The Macrostructure of Electronic Financial Markets.  Investor-owned, for-profit electronic exchanges differ in many ways from traditional intermediary-owned, non-profit exchanges, but both are subject to the centripetal force of liquidity. Due to the nature of liquidity, competition between investor-owned electronic exchanges that offer different functionalities is of the winner take all variety if traders uniformly prefer one system over the other, with the winner being the firm that offers the preferred functionality obtaining a natural monopoly. The prices and profits of the winning firm are determined by the value traders place on the superior functionality. Switching costs also influence the profitability of the winning exchange. Whereas traditional intermediary-owned exchanges enhance member profits by restricting the number of intermediary-members, thereby restricting the supply of liquidity, the investor-owned electronic exchange has an incentive to maximize liquidity supply in order to maximize derived demand for its services.
Download "The Macrostructure of Electronic Financial Markets"

Securities Market Macrostructure: Property Rights and the Efficiency of Securities Trading. This article derives securities market macrostructure from microstructural foundations under a variety of assumptions regarding property rights. Because liquidity effectively makes securities trading a network industry, intermediaries can exercise market power by restricting access to the trading mechanism. Fragmentation, cream skimming and free riding reduce the inefficiency that results from this market power, but welfare would be improved further by requiring open access to all trading venues. Implementing open access in practice must confront a trade-off between reducing market power and potentially impairing the incentives of the operators of trading systems to reduce cost and improve quality. Other network industries, notably telecoms and electricity transmission, have faced similar dilemmas, and the path to the creation of a more efficient property rights structure in financial markets could benefit from the experiences of other network markets.
Download " Securities Market Macrostructure"

Third Markets and the Second Best. The costs and benefits of third markets for financial instruments are widely debated. Contrary to claims that it is inefficient for third markets to free ride off of a primary exchange's price discovery, this article presents a model that implies that (1) third markets actually improve welfare, and (2) the increase is often greatest when third markets free ride. The microstructure of financial trading allows exchanges (primary markets) to restrict inefficiently the supply of liquidity and risk bearing services. Third markets mitigate this source of inefficiency, and sometimes do so most effectively when they free ride. Thus, although free entry to the exchange would maximize welfare, encouragement of a third market (by making price information a public good, for instance) may be a second-best response to exchange market power.
Download "Third Markets and the Second Best"

Technological Change, For-Profit Exchanges, and the Self-Regulation of Financial Markets. Financial exchanges historically have been organized as mutual non-profit firms. In recent months, many exchanges have proposed to convert to for-profit, investor owned firms. Financial regulators have expressed concerns that for-profit exchanges would reduce expenditures on self-regulatory activities to increase the cash available to pay to shareholders. Non-profit organization can indeed lead to production of greater quantities of non-observable or non-contractible product characteristics, but it is unlikely that these considerations are relevant to financial exchanges. Most exchange self-regulatory outputs are observable. Various contractual arrangements can provide exchanges with an incentive to produce regulations for which observability is more problematic. Moreover, the non-distribution constraint inherent in the non-profit form cannot provide an effective incentive for an exchange to improve unobservable quality because its owners (for-profit firms) benefit from reductions in exchange regulatory expenditures. For-profit exchanges may not engage in first best regulations because they do not internalize fully the costs and benefits of rules and rule enforcement. In this respect they do not differ fundamentally from non-profit exchanges. Since or-profit exchanges are likely to be electronic, whereas non-profit exchanges are likely to be traditional open outcry markets, differences in competition and enforcement costs across trading environment, rather than ownership form per se, will determine the efficiency of self-regulation by for-profit and non-profit exchanges.
Download "Technological Change, For-Profit Exchanges, and the Self-Regulation of Financial Markets"

The Organization of Financial Exchange Markets. This article presents theory and evidence regarding the organization of financial exchange markets. It derives conditions under which (1) a member-owned exchange has a monopoly over the trade of a particular financial contract and its close substitutes, and (2) exchange members earn economic rents. Specifically, if the identified conditions hold, low cost suppliers of financial services can form an exchange which is large enough to deter entry by competing exchanges but which is smaller than optimal. However, exchanges trading differentiated products may not merge to exploit all scope economies; maintaining separate exchanges reduces competition between suppliers of trading services. Furthermore, exchanges that offer a variety of products may allow some members to trade only a subset of these products in order to preserve member rents. The evidence is broadly consistent with these predictions. Exchanges typically monopolize trade in a particular financial contract. Exchange q ratios are well above 1, indicating economic rents. Exchanges limit the number of members, and frequently create membership classes with limited trading rights. The analysis has implications for the optimal regulation of financial exchanges.
Download "Organization of Financial Exchange Markets"

A Positive Theory of Financial Exchange Organization. Although there has been extensive research on the economic functions of financial exchanges and the properties of prices determined on exchanges, there has been little research on the organizational structure and governance of these exchanges. This article demonstrates that the heterogeneity of the suppliers of financial services who are members of financial exchanges explains salient features of exchange organization. Specifically, when suppliers of financial services are heterogeneous, one expects to observe exchanges organized as not-for-profit firms, especially if an exchange can enforce collusive agreements. Moreover, heterogeneity can lead to conflicts between members over rents, which necessitates the creation of formal governance mechanisms. Finally, if exchanges exercise market power or are protected from competitive entry (as is plausible), exchanges may adopt inefficient rules; the efficiency of exchange rules depends in part upon the distributive consequences of these rules (which depends in turn on membership heterogeneity) and the ability of exchange governance structures to enforce wealth-enhancing bargains among members with disparate interests.
Download "A Positive Theory of Financial Exchange Organization"

Papers on Electricity Derivatives Pricing

The Valuation of Power Options in a Pirrong-Jermakyan Model (NEW!)  This article uses a Pirrong-Jermakyan framework to value options on electricity, including daily strike, monthly strike, and spark spread options.  This framework posits that power prices depend on two state variables--load and fuel prices.  Although variations in load explain a large fraction of variations in power spot prices, power options do not vary strongly with load except very close to the expiry of daily strike and spark spread options due to the strong mean reversion in load.  Load mean reversion also affects time decay, and the evolution of implied volatilities over time.  I also discuss how to modify the model to take into account the impact of  factors other than load and fuel prices (e.g., outages) that affect power prices; I show that a relatively simple modification can capture the effect of these factors on value if they are not very persistent and not priced in equilibrium.  Download "Valuation of Power Options"

The Price of Power. (REVISED!) Pricing contingent claims on power presents numerous challenges due to (1) the nonlinearity of power price processes, and (2) the seasonal and intraday variations in prices. We propose and implement an equilibrium model in which the spot price of power is a function of two state variables: demand (load or temperature) and fuel price. In this model, any power derivative price must satisfy a PDE with boundary conditions that reflect capacity limits and the non-linear relation between load and the spot price of power. Moreover, since power is non-storable and load (or temperature) is not a traded asset, the power derivative price involves a market price of risk. Using inverse problem techniques and power forward prices from the PJM market, we solve for this market price of risk function. The market price of risk represents a substantial fraction (as much as one-third) of power forward prices for delivery during peak demand summer months. This is plausibly due to the extreme right skewness of power prices; this induces left skewness in the payoff to short forward positions, and a large risk premium is required to induce traders to sell power forwards. The existence of this huge risk premium suggests that the power derivatives market is not fully integrated with the broader financial markets.
Download "The Price of Power"

Valuing Power and Weather Derivatives on a Mesh Using Finite Difference Methods. This contains a chapter from a forthcoming chapter in a Risk Publications book titled Managing and Modelling Uncertainty. This chapter also shows how power price, power volume, and weather contingent claims can be valued and hedged in a unified framework.
Download "Valuing Power and Weather Derivatives"

Papers on Storable Commodity Price Dynamics

Searching for the Missing Link: High Frequency Price Dynamics and Autocorrelations For Seasonally Produced Commodities. Recent research on the behavior of commodity prices demonstrates that storage alone is insufficient to induce price autocorrelations of the magnitude observed in empirical data. Researchers have posited a high autocorrelation in commodity demand to remedy this deficiency. However, a traditional storage model with a high demand autocorrelation cannot explain salient features of commodity futures prices for seasonally produced goods, specifically the high correlation between old crop and new crop futures prices and the responsiveness of old crop prices to news about the expected harvest. Incorporating intertemporal substitution in consumption can explain these features of commodity futures prices. Intertemporal substitution provides an additional linkage between old crop and new crop prices that overcomes the deficiencies in the standard storage model which assumes no such substitution effect.
Download "Searching for the Missing Link"

Price Dynamics and Derivatives Prices For Continuously Produced, Storable Commodities. Commodity price dynamics, the economics of commodity storage, and commodity options pricing models have been the subject numerous recent studies, but the research in these areas has been largely disjoint. This is unfortunate, because this article demonstrates that these subjects are inextricably linked. Solution of a dynamic recursive model of the market for a storable, continuously produced commodity demonstrates that the economics of storage and production exert a decisive influence on the short-term dynamics of commodity prices. When marginal costs are convex and increasing and demand is stochastic, commodity prices exhibit complex dynamics characterized by spot price variances that vary significantly and systematically with demand conditions and the amount of inventory on hand. In brief, the prices of storable, continuously produced commodities are highly volatile when demand and supply conditions are tight but exhibit little volatility when supply is abundant. Moreover, when there are both transitory and persistent demand shocks, spot-forward price correlations also vary systematically with market conditions. These results have important implications for derivatives pricing. Traditional commodity options pricing models do not incorporate state-dependent volatilities and correlations. In the storage economy simulated herein, constant volatility models generate large options mispricings. The direction of the mispricings varies with market conditions. The constant volatility benchmark model grossly underprices options when demand is high and/or inventories are very short; this occurs when the commodity price is high. When demand is low or inventories are abundant, however, the benchmark model overprices commodity options. This analysis also implies that options prices for a storable commodity with stochastic demand and convex increasing marginal costs should exhibit volatility skews.
Download "Price Dynamics and Derivatives Prices"

Papers on Market Manipulation

Squeeze Play: The Dynamics of the Manipulation End Game. NEW! Corners and squeezes are, and have always been, regular features of derivatives markets.  The received bare-bones models of the delivery end game cannot capture the richness and complexity of trading as a contract nears expiration.  Herein I show that asymmetric information can greatly affect the dynamics of trading in derivatives contracts that are vulnerable to a squeeze.  The most important results relate to the effect of private information concerning the cornerer's position.  The deadweight losses and wealth transfers that occur during the delivery end game provide a motive for longs and shorts to liquidate prior to expiration and avoid the losses associated with playing the end game. If shorts do not know the cornering long's precise position, however, the information asymmetry can impede these mutually beneficial trades.  When all shorts are atomistic, the results are stark: free rider and coordination problems preclude the consummation of any mutually beneficial trades.  The presence of a large short can mitigate these problems, however.  The large short is always willing to bid a price to liquidate his positions that is sufficiently high to induce some longs that would otherwise corner the market in the end game to sell contracts prior to the end of trading. 

The model predicts that some longs sell their cornering interests prior to the end game; that some longs do not and instead play the end game despite the costs associated therewith; that some longs sell part of their positions, but still retain sufficient market power to squeeze during the end game, though the resulting squeezes are less severe than what would occur in the absence of the pre-delivery partial liquidation.  The model also predicts the pre-expiration liquidation of large long positions at supercompetitive prices, and that prices in pre-delivery trading fluctuate (exhibiting continuations up, continuations down, and reversals) even in the absence of the arrival of fundamental supply and demand information.  The model also implies that the structure of the short side of the market--the sizes and concentration of short positions--influences the nature and efficiency of trading during a corner, and that the presence of large shorts actually make a cornering long better off.

Private information on the supply side can also shed light on other noted features of corners and squeezes.  For instance, private information on delivery costs can explain why some corners result in huge deliveries that impose large losses on the cornerer.  Private information about delivery costs, and heterogeneity of these costs between shorts, may also motivate the otherwise puzzling use of ``step up" orders near expiration as a means of price discrimination,  although it should be noted that the actual use of such orders in manipulations is not uniformly consistent with the predictions of these price discrimination models.  Download "Squeeze Play."

Cornered: Market Power Manipulation by a Large Speculator.  NEW!  Manipulation—the exercise of market power in a derivatives contract—has plagued derivatives markets since their birth in the 19th century up to the present day.  Moreover, most of the regulatory apparatus in derivative markets is intended to reduce the frequency and severity of manipulation.  Despite the importance of manipulation to the operation and regulation of futures markets, there is a paucity of formal models examining how a large trader can obtain market power by contracting with the shorts who will be its ultimate victims.  This paper presents a straightforward adaptation of the standard Anderson-Danthine hedging model.  In the model, a large speculator corners the market with positive probability even though his trading is observed.  The frequency and severity of manipulation varies with structural factors, most notably with the size of the short hedging interest.  The model predicts that some policies intended to reduce manipulation, such as position limits, can actually reduce welfare by constraining efficient speculation as well as opportunistic speculation.  It also implies that certain legal doctrines related to intent and the concept of a “natural squeeze” are misguided.  Thus, the model provides positive predictions regarding the factors that influence the likelihood and severity of manipulation, and welfare implications regarding the efficiency of alternative regulatory policies.  Download "Cornered"

Manipulation of Cash-Settled Futures Contracts. Replacement of delivery settlement of futures contracts with cash settlement is frequently proposed to reduce the frequency of market manipulation. This article shows that it is always possible to design a delivery-settled futures contract that is less susceptible to cornering by a large long than any given cash-settled contract. Such a contract is more susceptible to manipulation by large shorts, however. Therefore, cash settlement does not uniformly dominate cash settlement as a means of reducing the frequency of market power manipulations in derivatives markets. The efficient choice of settlement mechanism depends on whether supply and demand conditions favor short or long manipulation.
Download "Manipulation of Cash-Settled Futures Contracts"

Detecting Manipulation in Futures Markets: The Ferruzzi Soybean Episode. Market manipulation--the exercise of market power in a futures market--is a felony under US commodity law, but recent court and regulatory decisions have made conviction of a manipulator problematic at best. Instead, regulators attempt to prevent manipulation through various means. Deterrence is more efficient than prevention if manipulations can be detected ex post with high probability. This article examines a particular episode of attempted manipulation--the Ferruzzi soybean episode of 1989--to demonstrate how to test for the exercise of market power in a commodity market. The analysis demonstrates that it is highly unlikely that the price and quantity relations observed in May and July 1989 were the result of competition; they are instead reflective of market power. The article also shows that the proposed statistical tests are very powerful, and can detect virtually all manipulations of even modest size even if a high burden of proof is established. More information is available after the end of a manipulation, moreover, so deterrence is more powerful than prevention. Since the probability of detection ex post is near one, deterrence through the imposition of harm based sanctions is the efficient means of curbing market power in futures markets. This implies that the existing legal regime in US commodity markets is inefficient.
Download "Detecting Manipulation in Futures Markets: The Ferruzzi Soybean Episode"

Manipulation of Power Markets. The deregulation of wholesale power markets has sparked trading in power derivatives. Power markets are susceptible to manipulation by both large longs and large shorts when derivatives are traded. The non-storability of electricity implies that manipulation of power markets differs in many ways from manipulation of markets for traditional storable commodities such as copper. Because of non-storability, manipulators of power markets must be vertically integrated producers and sellers of power, so speculative corners are not possible. Moreover, a manipulator must have market power in generation. Unlike storables markets, power markets are simultaneously vulnerable to short and long manipulation. Manipulation is most likely when power output nears system capacity and can have dramatic effects on prices. The differences between manipulation in power and storables markets implies that different regulatory structures are required to reduce manipulation efficiently. Vertical disintegration is probably the most efficacious and efficient way to reduce manipulation in power markets.
Download "Manipulation of Power Markets"