This is the third and final post in a series which draws on research undertaken in collaboration with the Department of Accountancy and Finance at the University of Otago. In the first post, we looked at evidence for premia in electricity futures prices. In the second post we found some surprising drivers of premia observed in futures prices. In this post we look at liquidity in the futures market, how it has evolved, and what developments or events caused it to change.
By Greg Sise, 13 October 2016
The research was undertaken by Finance Masters student Fergus Bevin-McCrimmon and Senior Lecturer Ivan Diaz-Rainey, in collaboration with me and assisted by Mark Nelson, Senior Consultant at Energy Link. The project looked at whether there are premia in electricity futures prices and at whether futures market liquidity has changed over time. The working paper can be found at Research Gate*.
Liquidity in a financial market is one of those concepts that can be hard to pin down in a succinct and easily measurable fashion. A market is generally considered to be liquid if it meets three criteria:
• prices of recent trades are readily available to any person wishing to trade on the market; and
• trades can be made readily and easily by any person wishing to trade; and, most importantly
• individual trades do not significantly move the market
A financial market that meets the three criteria above is transparent and accessible, and anyone trading it can be confident that they can observe the market price at any instant in time, and trade arbitrarily large volumes at or near that price.
Researchers have proposed and applied various measures of liquidity in the form of a simple formula which expresses liquidity in a single number, and thus allows comparisons over time or between markets. In our case, we chose a measure of ‘illiquidity’ developed by Amihud in 2002, expressed as the daily absolute return divided by the daily volume, calculated for any given day. This measure was chosen because it gives consistent results across a range of markets.
The market’s daily return rt on day t is the absolute value of the natural log of the ratio of today and yesterday’s closing futures prices:
where Ft is the closing futures price on day t.
If there is no change in price over the course of a trading day, the return is ln(1) = 0. When the price increases or decreases over the course of a trading day, then the value of rt increases accordingly.
Amihud’s illiquidity measure is then given by the absolute value of the daily return divided by the daily volume Vt
and can be thought of as the “percentage price change per dollar of daily trading volume, or the daily price impact of the order flow” (Amihud 2002, p34).
If the volume is high, then illiquidity could be low even if the daily return is relatively large: in this case a large daily return could be achieved by many trades which each move the market by just a small amount. However, if volume is low then a large daily return suggests that a small number of trades have each moved the market significantly, violating our third criteria for liquidity.
We also looked at the trading volumes as an indicator of liquidity because it has been shown that volume is an increasing function of a market’s liquidity – monthly traded volume and the open interest at the end of each month of the quarterly futures contracts at Benmore and Otahuhu to July 2016 are shown in the chart below in GWh, and a marked step up in volume can be observed late in 2011.
As the chart above shows, volumes were initially low, but the Electricity Authority and the ASX worked with the four largest electricity market participants to introduce market making in January 2010 with a maximum bid-ask spread of 10% and in October 2011 the bid-ask spread was reduced to 5%. The market makers put up offers to buy and sell on all the quarterly contracts, and the bid-ask spread is the maximum difference allowed between the bid and offer (asking) prices.
There was no statistically significant change in liquidity around the introduction of market making, but the reduction in the bid-ask spread was significant and achieved the policy objective of increasing liquidity. However, the change was only observed in the front end contracts (contracts expiring with the earliest dates) and further out there was no significant change.
The chart below shows the illiquidity ratio for the front contract (contract with earliest expiry) at Benmore, on days that the front contract actually traded, along with the 60 day moving average: the moving average shows how the illiquidity fell sharply after October 2011 when the bid-ask spread reduced to 5%.
Based on the results above, it would be tempting to conclude that a further reduction in the maximum bid-ask spread would cause illiquidity to reduce further in the front contracts – but no such conclusion can be made. Our research does not provide a function which could quantify the change in illiquidity for any given reduction and in any case, a further reduction could impose costs and risks on market makers out of proportion to any benefits gained.
* The working paper ‘Liquidity and Risk Premia in the New Zealand Electricity Futures Market’ (by Bevin-McCrimmon, F, Diaz-Rainey, I & Sise, G, 2016) can be found at ResearchGate.