Question

2a. Explain the role of arbitrage and the efficient market hypothesis in the oil market. Provide relevant examples to explain 2.b. Related to perfect competition, how will it affect oil market price? 2.c. The NYMEX price has risen by $1.10 per barrel and that of ICE has decreased by $1.39. What profit or loss has been made by the trader? In answering the question you need to: justify the trading strategies in the midst of changing oil prices between NYMEX and ICE why differentials between NYMEX and ICE will relate to perfect information and how it affects price Justify what trading platform you will follow and why.

Answer 1

2. A) in an efficient market the asset prices will reflect all the information’s available. There will be symmetry of information. Thus the calculation of intrinsic value of an asset should be unbiased. That does not mean you may predict the exact value in which the asset is traded instead the occurrence of error will be random. Thus the possibility of arbitrage is not possible. Because all the market participants are trading on the same information’s and so if somebody is making any gain that is because of only pure luck. On the other hand information asymmetry or inefficiency of market led to arbitrage opportunity.

E.g.: Now let’s talk about a practical situation, say for example in the recent future, the price of oil is going to increase. And that information is known by some traders only not the entire market. What they will do is, they will make a bulk purchase now and will sell it when the price ups. So this is purely arbitrage, and the reason is severe information asymmetry in the market.

Related to perfect competition, how will it affect oil market price?

2. B) in a perfect competition the level of price will be the same across all homogeneous product categories. Here if the oil market is perfect then the prices of similar oil commodities will be equal. But the tendency of inefficiency in the market lead to information asymmetry and unequaled the price. The prices of similar oil commodities will be different and people will trade on this difference in order to gain.

2. C since the “ICE” price has been decreased by 1.39 USD per barrel, the traders will purchase it and sell it in “NYMEX”, where the price actually increased by 1.10 USD per barrel. So the trader will gain 1.39 USD per barrel from “ICE” and 1.10 USD per barrel from “NYMEX”. That means 2.49 USD per barrel. This will continue till the prices are equalizing significantly in both market. That kind of an equlibriyam will end this arbitrage process. So this is an arbitrage technique.

Some time there will be a prior information leakage in the market says for example some of the traders in “ICE” have realized that the price is going to fall in advance before the occurrence. So they may sell and come out of the possible loss if they are still holding the stock. But the other traders may loss since they do not have the information.

This can also happen that the traders in “NYMEX” got the information of price increment in advance. So the traders will purchase the asset know and sell it when the price increases the gain they will make then will be 1.10 per barrel. This is again because of severe information asymmetry and lead to arbitrage opportunity. Here you are trading on information and of course it can be the so-called “insider trading”. The insider information really led to such an arbitrage opportunity. And of course legally trading on information is permitted with “High frequency algorithmic trading platforms”. There you will use algorithms to make predictions and investment and for advanced information it is possible via “ultra high frequency trading platforms”. So these are the platforms you will legally trade on information and in reality the decisions coming out of algorithms can go wrong some time.