Arbitrage opportunities and feedback trading in emissions and energy markets

• We examine the presence of feedback trading in energy and emission markets.
• We also investigate the extent to which feedback behaviour is linked to arbitrage opportunity.
• We find feedback trading in coal and electricity which becomes prevalent when arbitrage opportunity is high.
• However, we find no evidence of feedback behaviour in emission market.
• Contrary to the popular belief that institutional investors are akin to feedback traders.

This paper extends Sentana and Wadhwani (SW 1992) model to study the presence of feedback trading in emissions and energy markets and the extent to which such behaviour is linked to the level of arbitrage opportunities. Applying our augmented models to the carbon emission and major energy markets in Europe, we find evidence of feedback trading in coal and electricity markets, but not in carbon market where the institutional investors dominate. This finding is consistent with the notion that institutional investors are less susceptible to pursuing feedback-style investment strategies. In further analysis, our results show that the intensity of feedback trading is significantly related to the level of arbitrage opportunities, and that the significance of such relationship depends on the market regimes.