Spot market power and future market trading

Publication Date
Financial Markets Group Discussion Papers DP 531
Publication Authors

When a spot market monopolist participates in the futures market, he has an incentive to adjust spot prices to make his futures market position more profitable. Rational futures market makers take this into account when they set prices. Spot market power thus creates a moral hazard problem which parallels the adverse selection problem in models with inside information. This moral hazard not only reduces the optimal amount of hedging for those with and without market power, but also makes complete hedging impossible. When market makers cannot distinguish orders placed by those with and without market power, market power provides a venue for strategic trading and market manipulation. The monopolist will strategically randomize his futures market position and then use his market power to make this position profitable. Furthermore, traders without market power can manipulate futures prices by hiding their orders behind the monopolist's strategic trades.