The Effect of Large Hedge Fund and Cta Trading on Futures Market Volatility

Abstract

This study uses a unique data set from the CFTC to investigate the impact of trading by large hedge funds and CTAs in 13 futures markets. Regression results show there is a small but positive relationship between the trading volume of large hedge funds and CTAs and market volatility. However, a positive relationship between hedge fund and CTA trading volume and market volatility is consistent with either a private information or noise trader hypothesis. Three additional tests are conducted to distinguish between the private information hypothesis and the noise trader hypothesis. The first test consists of identifying the noise component exhibited in return variances over different holding periods. The variance ratio tests provide little support for the noise trader hypothesis. The second test examines whether positive feedback trading characterized large hedge fund and CTA trading behavior. These results suggest that trading decisions by large hedge funds and CTAs are influenced only in small part by past price changes. The third test consists of estimating the profits and losses associated with the positions of large hedge funds and CTAs. This test is based on the argument that speculative trading can only be destabilizing if speculators buy when prices are high and sell when prices are low, which in turn, implies that destabilizing speculators lose money. Across all 13 markets, the profit for large hedge funds and CTAs is estimated to be just under $400 million. This suggests that trading decisions are likely based on valuable private information. Overall, the evidence presented in this study indicates that trading by large hedge funds and CTAs is based on private fundamental information.

Keywords: Hedge fund, commodity trading advisor, volatility, market efficiency, futures markets