Liquidity and resolution of uncertainty in the European carbon futures market

Abstract

We investigate whether liquidity introduces or helps resolve uncertainty in Phase I and the first year of Phase II of the European carbon futures market. We propose a distinction between ‘absolute’ or overall liquidity and that which is ‘relative’ to a benchmark. For this purpose, we suggest volume-weighted duration as a natural measure of trading intensity as a proxy for liquidity, and we model it as a rescaled temporal point process. The new model is called Autoregressive Conditional Weighted Duration (ACWD) and is shown to outperform its discrete modelling counterparts. Liquidity is found to play a dual role, with higher relative liquidity introducing uncertainty and higher absolute liquidity accelerating uncertainty resolution, thus, enhancing market efficiency.