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

This paper 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 identifes distinct volatility regimes rather than modelling an exogenously defined one-step change in the volatility process. We investigate stock market volatility in France, Germany, Japan, the UK and the US. Our empirical results indicate that index futures trading does neither stabilize nor destabilize the underlying spot market.