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.
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.
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
Download "Momentum in Futures Markets."
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.
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
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
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
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
Download "A Positive Theory of Financial Exchange Organization"
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
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"
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"
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
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"