The impact of energy derivatives on the crude oil market

We examine the effects of energy derivatives trading on the crude oil marke t. There is a common public and regulatory perception that derivative secur ities increase volatility and can have a destabilizing effect on the underl ying market. Consistent with this view, we find an abnormal increase in vol atility for three consecutive weeks following the introduction of NYMEX cru de oil futures. While there is also evidence of a longer-term volatility in crease, this is likely due to exogenous factors, such as the continuing der egulation of the energy markets. Subsequent introductions of crude oil opti ons and derivatives on other energy commodities have no effect on crude oil volatility. We also examine the effects of derivatives trading on the dept h and liquidity of the crude oil market. This analysis reveals a strong inv erse relation between the open interest in crude oil futures and spot marke t volatility. Specifically, when open interest is greater, the volatility s hock associated with a given unexpected increase in volume is much smaller. (C) 1999 Elsevier Science B.V. All rights reserved. JEL classification: G1 3.