Welcome to GEFRI
SPECULATION AND HERDING IN DERIVATIVES MARKETS
Status: submitted to Journal of Empirical Finance.
Much of the responsibility for upheaval in international financial markets has been placed on speculators, particularly hedge funds. Speculative capital has been characterized as “hot money,” with capital flows driven by “herding,” “flocking,” and “contagion” among players in foreign-exchange, stock, bond, and commodity markets.
Policies to deal with volatility by weakening, or even disabling speculation, have been based largely on anecdote, convenience (speculators have long served as scapegoats for various problems), and ideology, rather than careful analysis. Part of the problem arises from the secrecy with which speculators operate. Since speculative trading cannot easily be observed, it is difficult to assess speculators’ contribution, if any, to volatility.
This paper looks at speculative behavior in one of the largest, and most volatile, international financial markets, petroleum. It utilizes a large, detailed database on individual trader positions in crude-oil and heating-oil futures markets. The paper is exploratory, with focus on measuring and assessing the tendency of speculators to herd (trade in the same direction as a group) and flock (trade in the same direction by subgroups of speculators).
Two theories behind rational herding behavior are examined – the asymmetric information view (poorly-informed traders make decisions based on observing well-informed traders, rather than market fundamentals) and the monitoring/incentive view (institutional investors make decisions knowing that their incentives are based on performance relative to a benchmark such as mean returns for a group). These theories generate different predictions regarding the types of speculators most likely to flock, allowing the construction of tests designed to distinguish between them.
The evidence does not support the view that herding among speculators as a group is widespread in this market. In contrast, the data are consistent with a moderate degree of flocking among one group of speculators, commodity-fund managers. The evidence supports the monitoring/incentive theory, but not the asymmetric-information theory.