Do Birds of a Feather Flock Together? Speculator Herding in Derivatives Markets

Abstract

Much of the responsibility for upheaval in international financial markets has been placed on speculators, particularly hedge funds. Speculative capital has been characterized as hot money, with capital flows driven by herding, flocking, and contagion among players in foreign-exchange, stock, bond, and commodity markets. This paper looks at speculative behavior in one of the largest, and most volatile, international financial markets, petroleum. It utilizes a large, detailed database on individual trader positions in crude-oil and heating-oil futures markets. The paper is exploratory, with focus on measuring and assessing the tendency of speculators to herd (trade in the same direction as a group) and flock (trade in the same direction by subgroups of speculators). Two theories behind rational herding behavior are examined - the asymmetric information view (poorly-informed traders make decisions based on observing well-informed traders, rather than market fundamentals) and the monitoring/incentive view (institutional investors make decisions knowing that their incentives are based on performance relative to a benchmark such as mean returns for a group). The evidence is supportive of the monitoring/incentive theory, but not the asymmetric-information theory.