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Spot Market Volatility and Futures Trading: The Pitfalls of Using a Dummy Variable Approach

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  • Martin T. Bohl
  • Jeanne Diesteldorf
  • Christian A. Salm
  • Bernd Wilfling

Abstract

This study challenges the existing literature examining the impact of the introduction of index futures trading on the volatility of its underlying. To overcome econometric shortcomings of previously published work using the dummy variable approach, we employ a Markov‐switching‐GARCH technique. This approach endogenously identifies distinct volatility regimes rather than modeling an exogenously defined one‐step change in the volatility process. We investigate stock market volatility in France, Germany, Japan, the United Kingdom, and the United States. Our empirical results indicate that index futures trading does neither stabilize nor destabilize the underlying spot market. © 2015 Wiley Periodicals, Inc. Jrl Fut Mark 36:30–45, 2016

Suggested Citation

  • Martin T. Bohl & Jeanne Diesteldorf & Christian A. Salm & Bernd Wilfling, 2016. "Spot Market Volatility and Futures Trading: The Pitfalls of Using a Dummy Variable Approach," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 36(1), pages 30-45, January.
    • Handle: RePEc:wly:jfutmk:v:36:y:2016:i:1:p:30-45
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    1. Antoniou, Antonios & Koutmos, Gregory & Pericli, Andreas, 2005. "Index futures and positive feedback trading: evidence from major stock exchanges," Journal of Empirical Finance, Elsevier, vol. 12(2), pages 219-238, March.
    2. B. Wade Brorsen, 1991. "Futures trading, transaction costs, and stock market volatility," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 11(2), pages 153-163, April.
    3. Dueker, Michael J, 1997. "Markov Switching in GARCH Processes and Mean-Reverting Stock-Market Volatility," Journal of Business & Economic Statistics, American Statistical Association, vol. 15(1), pages 26-34, January.
    4. Cox, Charles C, 1976. "Futures Trading and Market Information," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1215-1237, December.
    5. Brad M. Barber & Terrance Odean, 2008. "All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors," The Review of Financial Studies, Society for Financial Studies, vol. 21(2), pages 785-818, April.
    6. Bray, Margaret M, 1981. "Futures Trading, Rational Expectations, and the Efficient Markets Hypothesis," Econometrica, Econometric Society, vol. 49(3), pages 575-596, May.
    7. Brad Baldauf & G. J. Santoni, 1991. "Stock price volatility: Some evidence from an ARCH model," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 11(2), pages 191-200, April.
    8. Cohen, Randolph B. & Gompers, Paul A. & Vuolteenaho, Tuomo, 2002. "Who underreacts to cash-flow news? evidence from trading between individuals and institutions," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 409-462.
    9. Conrad, Jennifer & Kaul, Gautam, 1988. "Time-Variation in Expected Returns," The Journal of Business, University of Chicago Press, vol. 61(4), pages 409-425, October.
    10. Martin T. Bohl & Christian A. Salm & Bernd Wilfling, 2011. "Do individual index futures investors destabilize the underlying spot market?," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 31(1), pages 81-101, January.
    11. Benjamin H. Cohen, 1999. "Derivatives, Volatility and Price Discovery," International Finance, Wiley Blackwell, vol. 2(2), pages 167-202, July.
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    Cited by:

    1. Bohl, Martin T. & Reher, Gerrit & Wilfling, Bernd, 2016. "Short selling constraints and stock returns volatility: Empirical evidence from the German stock market," Economic Modelling, Elsevier, vol. 58(C), pages 159-166.
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    3. Xie, Xiaoyu & Zhu, Heliang, 2021. "The role of gold futures in mitigating the impact of economic uncertainty on spot prices: Evidence from China," Research in International Business and Finance, Elsevier, vol. 56(C).
    4. Lu, Fei & Ma, Feng & Bouri, Elie & Liao, Yin, 2024. "Do commodity futures have a steering effect on the spot stock market in China? New evidence from volatility forecasting," International Review of Financial Analysis, Elsevier, vol. 94(C).
    5. Sui, Cong & Lung, Peter & Yang, Mo, 2021. "Index option trading and equity volatility: Evidence from the SSE 50 and CSI 500 stocks," International Review of Economics & Finance, Elsevier, vol. 73(C), pages 60-75.

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    More about this item

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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