In this paper, we analyze the effect of the reduction of transaction costs on the correlation between the spot index and the index futures returns and on the linkage in the second moments of both markets. Using a bivariate Glosten–Jagannathan–Runkle (GJR) process, that takes into account cross-market interactions, we find that the reduction of the width of the nonarbitrage band leads to a significant increase in the contemporaneous correlation and to a significant increase in the volatility spillovers between the two markets.
There is an extensive literature on the linkage between the spot index and the index futures markets (see, among others, Frino et al., 2000, Gulen & Mayhew, 2000, Min & Najand, 1999 and Tse, 1999). In this context, one of the most studied topics is the efficiency of the index futures market centred on the arbitrage-based cost-of-carry relationship between the two assets. In a perfectly efficient market, profitable arbitrage should not exist as prices adjust instantaneously and fully to new information.
Violations of the cost-of-carry relationship may appear for a variety of reasons (Stoll & Whaley, 1990). The first reason is that the market for individual stocks is not perfectly continuous. The second one is related to time delays in the computation and reporting of the stock index value. The third refers to the lead–lag behavior of stock index and stock index futures that may reflect the greater speed with which investors' views are reflected in the futures markets. The latter reason is based on the effect of the transaction costs that induces noise in the relationship. Our paper is related to this last topic.
The role of the transaction costs in the pricing dynamics of the spot index and futures index and specifically in price discovery has been analyzed in several papers (see, among others, Fleming et al., 1996, Gay & Jung, 1999 and Kim et al., 1999). Nevertheless, the purpose of this paper is somewhat different. We are interested in analyzing the effect of the reduction of the transaction costs on the contemporaneous correlation and on the volatility spillovers between the spot index and the future index markets from an empirical point of view.
As is well known, the existence of transaction costs implies that the price of futures could fluctuate within a band around their theoretical value without representing a potential profit opportunity. When the price of futures deviates from this band, arbitrageurs have incentives to trade in both the spot and the futures markets.1 As a consequence, we expect that a modification of the width of the band may influence the correlation between these markets. Because both markets are linked in their second moments (see, Koutmos & Tucker, 1996), we also expect that this fact may influence the volatility spillover between them.
To answer these questions, a particular event in January 1997 in Spain is studied. The Spanish Equity Derivatives Exchange, MEFF RV, changed the contract size of the Ibex35 futures. The new contract, called “Ibex35 Plus,” was 10 times greater than the old “Ibex35,” but the general fees applicable to the trading of contracts were maintained for market makers.2 We think that this provides a good opportunity to analyze the effects of the reduction of the transaction costs on the linkage between the stock index and the index futures markets. To do this, we use an error correction model with innovations following a bivariate Glosten–Jagannathan–Runkle (GJR) process that takes into account cross-market volatility interactions to describe the joint distribution of spot returns and index futures returns.
The remainder of the paper is organized as follows. Section 2 describes the theoretical framework and the hypotheses to test. Section 3 contains a description of the data used in the paper. Section 4 presents the empirical design and in Section 5 some considerations regarding the results are included. Finally, Section 6 contains the conclusions that can be drawn.
In this paper we have studied the effect of the reduction of the transaction costs in the
Spanish futures market on the correlation between the spot index and the index futures market
and also on the linkage in their second moments.
To do this, we have used an error correction model with innovations following a bivariate
GJR process that takes into account cross-market interactions to describe the joint distribution
of the spot returns and index futures returns.
The results obtained reveal an increase in the cross-correlation between the returns of the
two markets and an increase in the volatility spillovers between them. These results are
consistent with the assumption that the reduction in the transaction costs leads to a reduction
of the width of the band and to an increase in the amount of information that is relevant in
order for arbitrageurs to trade.
Other explanations are analyzed, in particular, the upsizing of the contract (which could
lead to noise traders being driven out), the increase in trading activity (which could reduce the
effects of nonsynchronous trading), or whether it could be due to some macroeconomic news.
However, although it is possible that the second explanation may play a significant
role, the main reason for the results obtained is the reduction of the transaction costs.
Other questions such as the effects of the kind of information on the correlation, volatility
spillover, and lead–lag relationship need to be analyzed in future research.
