Financial Innovation in Derivatives: Understanding the Use and Properties of Volatility and Dairy Derivatives

Gafiatullina, Ilnara
Frijns, Bart
Tourani‐Rad, Alireza
Fernandez‐Perez, Adrian
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Doctor of Philosophy
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Auckland University of Technology

Derivative products are undoubtedly among the most important financial innovations in modern history. Since the beginning of the 1970s, derivative markets have seen an expansion in the variety and complexity of products. There is a degree of consensus that derivatives bring significant benefits to the financial system. However, if not properly understood and applied, they can bear significant risks. Therefore, it is important to understand the use and properties of new derivative products. Among different uses, a large body of theoretical and empirical literature recognises derivatives for their informational role, contribution to price discovery, and risk management. This thesis aims to address these important functions with a focus on two recently introduced derivative products on volatility and dairy.

The first product class we investigate are volatility exchange-traded notes (ETNs), introduced in 2009. The most two successful volatility ETNs are the VXX and XIV. Broadly, the VXX allows taking a long position in the US stock market volatility, and the XIV a short position. Historically, the VXX delivers negative long-term returns and, despite that, attracts a tremendous trading volume. This observation might lead to the conclusion that trading in the VXX is dominated by noisy traders, and thus the VXX prices poorly reflect information about volatility. The XIV has a similar dynamic to the VXX but inverted. At times when the XIV increases, the VXX decreases. Informed traders can either switch between these two products, or stay in one market and take either a short or long position, depending on the information they have about future volatility. Understanding which product is more informative and at what times is an important question.

In the first essay, we investigate the informational leadership between the VXX and XIV using high-frequency data and attempt to answer what the key determinants of informational leadership are. Results show that the contribution to price discovery between these two competing markets is time-varying. This time variation is explained by three factors: trading costs, market liquidity, and market conditions. These findings contribute to a better understanding of these relatively new products. Time-variation in price leadership means that both ETNs can quickly react to new information about the future value of volatility and reflect it in their prices.

The second product class we investigate are dairy futures and options introduced by the New Zealand Stock Exchange (NZX) in 2010. Exports of dairy commodities play an important role for the New Zealand economy, dominated by exports in Whole Milk Powder (WMP). Currently, there are eight different dairy derivatives traded on the NZX. Futures and options contracts on WMP are amongst the most popular ones. WMP is one of the most volatile commodities globally. This high volatility affects the decision-making of all supply chain participants, including dairy processors and farmers. The high volatility of dairy commodities translates into a high milk price risk for dairy farmers, which adversely affects the financial strength of farmers and potentially stability of the New Zealand banking sector. Given the importance of the dairy sector to the New Zealand economy, in the next two essays we investigate the benefits these derivatives offer.

In the second essay, we investigate the information content of the dairy derivatives market. We develop a dairy-implied volatility index, termed the DVIX, from option prices on WMP futures. As for the properties of the DVIX, we document the asymmetric return-implied volatility effect. Additionally, we find that the DVIX contains significant information about future volatility, and outperforms the volatility forecast based on historical averages or the GARCH-type forecast. Overall, we find that the relatively new dairy derivatives market contains important information that can be used by market participants.

In the third essay, we evaluate WMP futures from a risk management perspective. We develop a profit margin hedging strategy which aims to protect New Zealand dairy farms from the downside risk of low liquid milk prices. We conduct the analysis both for a representative farm and for a sample of New Zealand farms. The results show that the profit margin hedging strategy decreases the risk, reduces the likelihood of financial distress and improves the returns, even after controlling for commissions and different levels of basis risk. This study demonstrates that WMP futures are useful for a cross-hedging of milk price risk, despite the presence of the basis risk. Overall, our finding means that WMP futures can benefit New Zealand farms and improve the stability of the New Zealand banking sector, as high indebtedness of the dairy farm sector makes it vulnerable to low dairy prices.

All in all, our findings shed light on some properties and uses of relatively new derivative products, which were introduced in the last ten years - volatility and dairy derivatives. We document that both volatility ETNs can efficiently incorporate new information about the future value of volatility. We find that dairy options gained some level of informational efficiency, and information contained in their prices can be used to obtain insights about dynamics of the physical market. Additionally, we document that dairy futures are suitable for one of the most traditional purpose of futures, that is protecting against unfavourable moves in the physical market.

Derivatives , Price discovery , Implied volatility , Profit margin hedging
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