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Upcoming paper in JFR.


Ali F. Darrat
Louisiana Tech University

Shafiqur Rahman
Portland State University

Maosen Zhong
University of Texas - Brownsville


We examine the role of index futures trading in spot
market volatility. We use the exponential generalized
auto-regressive conditional heteroskedasticity
(EGARCH) approach to measure volatility, analyze
causality and feedback relations between volatilities in
the spot and futures markets, and test various
hypotheses in the context of a multivariate model that
incorporates other macrostate variables. Our
empirical results suggest index futures trading may not
be blamed for the observed volatility in the spot
market. Rather, we find stronger and more consistent
support for the alternative posture that volatility in the
futures market is an outgrowth of a turbulent cash
market. We use the regret (cognitive dissonance)
theory to explain our results.

In the aftermath of the 1987 "crash" a number of studies clearly pointed out that volatility was induced in the cash market through derivative trading. In the past 5 years, several papers have shown the opposite effect - volatility is induced in the indexes primarily through the cash market.

I think there is a good explanation for these conflicting results - the time periods studied. In 1980, the registered fund industry owned less than 20% of US equity market capitalization. In the past two decades ( the last data I saw was for 12/31/2000) that number has risen and is now approaching 40%. This change in the underlying capitalization structure is most likely the reason for the conflicting viewpoints on the underlying causes of market volatility..Clearly, the more recent studies (including this one) are showing that volatility is induced in the cash market. My thesis is difficult to prove because of non-stationarity and sample size issues, but I think that the underlying volatility is most likely due to the trading originating from the open end mutual fund industry. I base this on quick observations of two trends: the large increase in capitalization of that industry in the past 20 years, and the trend to higher turnover ratios in that industry compared to the past.


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