Hedging pressure and oil volatility: Insurance versus liquidity demands

Abstract

This study evaluates the dual role of hedging pressure (HP) in oil futures markets and analyses its effects on weekly oil volatility. We find that HP driven by hedgers' insurance demands is negatively related to volatility, while HP driven by speculators' short-term liquidity demands is positively related to volatility. Oil volatility tends to be more responsive to speculators' short-term liquidity demands than variations induced by hedgers' insurance demands. These channels are also significant determinants of volatility in inverted and normal markets, with the effects being more pronounced in inverted markets. Under low financial and business-cycle risk environments, the two HP channels typically have a measurable impact on volatility. These opposing effects of HP on weekly volatility provide empirical support on the significance of the dual role of hedgers in oil markets, as price insurance seekers and as short-term liquidity providers.