Understanding volatility dynamics in the EU-ETS market: lessons from the future

In this paper we study the short term price behavior of December 2008 future prices for EU emission allowances. We model returns and volatility dynamics of this price showing that a standard ARMA-GARCH framework is not adequate and that the gaussianity assumption is rejected due to the occurrence of a number of level and volatility outliers. To improve the fitness of the model, we combine the underlying price process with an additive stochastic jump process. The resulting distribution, a mixture of Gaussians, allows for endogenously determined jumps in the process governing the returns, while the mixing law determines the jump probability. The performance of the model is improved by introducing a time varying jump probability explained by two variables. The first one is the daily relative change in the volume of transactions and suggests that sharp increases in volume increase volatility even in the absence of changes in what recent literature considers as market fundamentals. The second one accounts for changes in the jump probability associated to the European Commission's announcements regarding the NAPs for Phase II. We find that announcements concerning the NAPs induce jumps in the process and tend to increase volatility. This result suggests authorities should advocate to increase stability in the regulatory environment which is crucial to allow traders to realize efficient trading strategies and informed investment decisions regarding pollution reduction.