International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 14 (2008)

© EuroJournals Publishing, Inc. 2008
http://www.eurojournals.com/finance.htm

Asymmetric Causal Relationship between

Spot and Futures in Taiwan

Chiung Chiao Chang

Associate Professor, Department of Finance, Vanung University

Yen Hsien Lee

Instructor, Department of Finance, Vanung University
E-mail: yenhsien@msa.vnu.edu.tw
Tel: 886-3-451-5811 ext: 779; Fax: 886-3-4528633

Abstract

This paper employed the threshold error-correction model (TECM) to investigate

the asymmetric causal relationship between spot and futures in Taiwan by using the
intraday data running from Jan, 2001 to May, 2005. Empirical results found the existence
of threshold co-integration and a bidirectional feedback causality relationship between spot
and futures markets from the Granger-Causality tests based on the corresponding TECM.
Our empirical results showed that the negative deviations have a significant effect on the
dynamic relationship between spot and futures prices, indicating the effect of arbitrage
activity on the basis. However, the fact that a positive deviation has no significant effect on
the spot price implies that the presence of short selling constraints limits reverse arbitrage.
Finally, we found that our empirical results were consistent with the asymmetric error-
correction model (symmetric error-correction model) in the spot (futures) market, and
might contribute to there being no short selling constraints in the futures market.

Keywords: Threshold Error-Correction Model, Asymmetric Causality, Stock and Futures

Markets
JEL Classification Codes: C32, G10

1. Introduction
The dynamic relationships between spot and futures have been extensively examined and analyzed by
academics and practitioners over the past three decades. According to the cost of the carry model stock
and futures have been cointegration. (e.g. Wahab and Lashgari, 1993; Ghosh, 1993; Brenner and
Kroner, 1995)1. The lead-lag short-run dynamic and long-run equilibrium relationships between these
two financial assets can provide possible arbitrage opportunity for investors and speculators.
Many empirical studies have adopted the vector auto regression model (VAR) or cointegration
method proposed by Engle and Granger (1987) and Johanson (1988) to investigate the dynamic
relationships between spot and futures. Empirical research has produced mixed results, (a)futures
prices tend to influence spot prices (e.g. see, Kawaller et al., 1987; Stoll and Whaley, 1990; Chan, 1992
1
The cost of the carry model is well known, and the relationship between index and index futures can be described by the cost of the carry model. This
model can be stated as Ft St exp[(r q )(T t )] , where Ft is the futures price at time t for a contract which matures at time T, S t is the
spot index price, r is the risk-free rate, and q is the dividend yield on the index. The natural logarithms equation can be rewritten as
f t st (r q )(T t ) .
114 International Research Journal of Finance and Economics - Issue 14 (2008)

and Abhyankar, 1998), (b) spot prices tend to lead futures prices (Subrahmanyam,1991; Moosa,1996;
Shyy, et al., 1996), and (c) a bidirectional feedback relationship exists between spot and futures prices
(Abhyankar, 1995; Silvapulle and Moosa, 1999 and Hasan, 2005).
A large number of empirical studies have shown that most economic variables exhibit an
asymmetric adjustment process2. Some recent literature suggested that the dynamic relationship
between spot and futures prices may be characterized by a nonlinear equilibrium correction model due
to factors such as non-zero transaction costs, infrequent trading, etc. Balke and Fomby (1997) point out
that the presence of a transaction cost may prevent economic agents from adjusting continuously. Only
when the deviation from the equilibrium exceeds the cost, i.e., the threshold value, the agents act to
move toward the equilibrium. Balke and Fomby (1997) and Abhyankar (1998) examined the dynamic
interrelationship between spot and futures, and their results suggested a nonlinear relationship between
spot and futures. Moreover, the cointegration and its corresponding error correction model assume that
the tendency to move toward a long-run equilibrium is always present. However, it is possible that an
adjustment towards equilibrium need not occur in every period. Pippenger and Goering (1993), Balke
and Fomby (1997), Enders and Granger (1998) and Enders and Siklos (2001) all show that traditional
cointegration tests have low power in the presence of asymmetric adjustment. Enders and Granger
(1998) extended the Dickey- Fuller (1979) procedure to construct the unit root test under asymmetric
adjustment, and Enders and Siklos (2001) developed the cointegration test capable of capturing the
asymmetric adjustment processes.
As there are constraints for selling short in many spot markets, this may affect the dynamic
relationship between spot and futures prices in Taiwanese stock marekt. This paper employs the
threshold error-correction model (TECM) elaborated by Enders and Granger (1998), and the
asymmetric cointegration test developed by Enders and Siklos (2001) to investigate the price
transmissions between spot and futures in Taiwan for the period between Jan, 2001 and May, 2005 by
using the intraday data. The results from the Granger-Causality tests, based on the corresponding
TECM clearly indicate a bidirectional feedback causality relationship between the spot and futures
markets. Asymmetric price transmissions between these two markets are also found in the long run.
The remainder of this study is organized as follows. Section 2 describes the methodologies
employed. Section 3 shows the data and the empirical results, and in Section 4 we provide a summary
of our findings and draw our conclusions.

2. Methodologies
2.1. Threshold Cointegration Tests
We applied the methodology of the threshold cointegration test of Enders and Granger (1998). The
completion of the threshold autoregressive (TAR) model requires two steps. Assuming variables xt
and yt are I(1) process, the first regression takes the form
yt xt t , (1)
where t is the stochastic disturbance term. A regression with the form
l

t It 1 t 1 (1 I t ) 2 t 1 i t i t
i 1 , (2)
is then carried out, where { t } contains the regression residuals from Eqn.(1), t is an i.i.d.
disturbance with zero mean, and I t is the Heaviside indicator such that
1 if t 1 0 1 if t 1
It or I t , (3)
0 if t 1 0 0 if t 1

2
Pippenger and Goering(1993); Balke and Fomby (1997); Enders and Granger(1998); Enders and Siklos (2001) all point out that if there is an
asymmetric adjustment, then the traditional test for unit root and cointegration might result in low power.
International Research Journal of Finance and Economics - Issue 14 (2008) 115

where is the threshold value.

l
When t 1 > , Eqn.(3) becomes t It 1 t 1 i t i t , otherwise
i 1
l

t 2 t 1 i t i t is used. This representation not only captures the asymmetric effect, but
i 1

can also test the long term relationship between xt and yt . For any value of , Petrucelli and
Woolford (1984) demonstrated that the sufficient and necessary conditions for t to be stationary are
1 0 , and (1 1 )(1 2 ) 1 3.
0, 2
Enders and Granger (1998) and Caner and Hansen (1998) claim that it is also possible to allow
the Heaviside indicator to depend on the change in t 1 (namely, t 1 ) rather than on the level of t 1,

the Momentum-Threshold Autoregressive (M-TAR) model. The Heaviside indicator of Eqn.(3) then
becomes,
1 if t 1 0 1 if t 1
It or I t . (4)
0 if t 1 0 0 if t 1

The M-TAR model implies that the adjustment mechanism of t is dynamic, since the
momentum of the series is greater in one direction than in the other. Thus, for any large and smooth
change, the M-TAR model can explain the series in a more efficient manner.
This study adopts the method of Chan (1993) to obtain a consistent estimate of the threshold
used by Enders and Siklos (2001). The consistent threshold estimate can be estimated by ordering the
{ t } sequence in ascending order such that 1 2 T , where T is the number of usable
observations. There is runcating the upper and lower 15%, leaves 70%. Substituting this 70% into the
model, the estimated threshold yielding the lowest residual sum squares (RSS) is the consistent
estimate of the threshold. The same method can also be applied to the MTAR model4.

2.2. Granger-Causality Tests Based on the Threshold Error-Correction Model

The threshold cointegration results further suggest that the underlying adjustment dynamics of x1t in
response to the changes in x 2t can be captured by a threshold error-correction model. The TECM can
be expressed as follows (Enders and Granger, 1998; Enders and Siklos, 2001):
k1 k2
x i ,t 1Zt 1 2Zt 1 i x1,t i i x 2 ,t i vt (5)
i 1 i 1

where ( x1 , x 2 ) ( Spot , Futures ) , Z t 1 I t uˆ t 1 , Z t 1 (1 I t )uˆ t 1 such that I t 1 if ut 1 , It 0 if

ut 1 and vt is a white-noise disturbance. The long-run adjustment of xi ,t is determined by the
parameters, 1 and 2 . The short-run adjustment of xt , which is governed by the parameters, i and
i , may come either from its own history of lagged dynamics or from the lagged effects of y t . A

priori, we expect the coefficients of Z and Z to be negative for the spot market and positive for the
futures market. Because, when the shocks are positive Z , then this means that the spot prices are
overvalued, the investors will engage in reverse cash and carry arbitrage, and then the spot prices will

3
We can test the null hypothesis of 1 2 0 for the cointegration relationship, and the rejection of this null implies the existence of
cointegration between variables. Enders and Siklos (2001) applied Chan’s methodology to a Monte Carlo study to obtain the F-statistic for the null
hypothesis of 1 2 0 where the threshold is estimated using Chan’s procedure. The critical values of this non-standard F-statistic for
testing the null hypothesis of 1 2 0 are also tabulated in their paper. If the null hypothesis is rejected, it is worthwhile to further test for
symmetric adjustment (i.e., 1 2 ) by using a standard F-test. Rejecting both the null hypotheses of 1 2 0 and 1 2 implies the
existence of threshold cointegration and asymmetric adjustment.
4
Since there is generally no presumption on whether to use the TAR or M-TAR specification, it is recommended to choose the appropriate adjustment
mechanism via various model selection criteria, such as the Akaike Information Criteria(AIC) or the Schwartz Bayesian Criteria(SBC).
116 International Research Journal of Finance and Economics - Issue 14 (2008)

reverse to their fundamental value and and then the futures prices rise. So, the Z are negatively
correlated with the spot prices, but positively correlated with the futures prices. On the other hand,
when the shocks are negative Z , it means that the spot prices are undervalued, investors engage in
cash and carry arbitrage, and then futures prices reverse to their fundamental value and the spot prices
rise, the Z are negatively correlated with the spot prices, but positively correlated with the futures
prices. The Granger-Causality tests from the system are examined by testing whether all the
coefficients of x1,t i or x 2,t i are jointly statistically different from zero based on a standard F-test,
and/or whether the j coefficients of the error-correction are also significant5.

3. Empirical analysis
3.1 Data and Summary Statistics
The data analyzed consists of five-minute intraday recorded prices of the TW index and TX index
futures contracts from Jan 2001 through May 2005. Daily trading begins at 9:00 M for the stock
market and at 8:45 AM for the futures market and ends at 1:30 PM for the stock market and at 1:45 PM
for the futures market. In the Taiwan futures market, five contracts with different maturity can be listed
at the same time. Because the futures trading begins 15 minutes earlier and ends 15 minutes later than
the spot market, we deleted the first and last 15 minutes of the data of the futures trading to reconcile
the number of observations for both the futures and the spot markets.
The descriptive statistics for the data are reported in Table 1. The means of the spot market are
greater than those for the futures market. The futures volatility (standard deviation) is greater than that
of the spot market volatility. The distribution of the daily prices is negatively skewed and has excess
kurtosis relative to a normal distribution. In figure 1, we show the return series for the spot and the
futures market.

Table 1: Summary Statistics of Returns

Iterms Spot Futures

Mean 0.000371 0.000350
SD 0.207176 0.209798
Skewness -0.606075 -1.209574
Kurtosis 86.45924*** 103.2501***
Jarque-Bera Test 18967134*** 27376875***
Notes: 1. SD denotes standard error.
2. The standard errors of the skewness and kurtosis are (6 / T ) 0.5 and (24 / T ) 0.5 , respectively.
3. Jarque-Bera Test denotes the Jarque-Bera normality test.
4. *,** and *** denotes rejection of the hypothesis at the 10%, 5% and 1% level

Figure 1: Up liner is return of spot. Down liner is return of futures

8

8 0

4 -4

0 -8

-4

-8
1 0 0 0 0 2 0 0 0 0 3 0 0 0 0 4 0 0 0 0 5 0 0 0 0 6 0 0 0 0

5
Since the Granger-Causality tests are very sensitive to the selection of the lag length, we used the AIC criterion to determine the appropriate lag
lengths and found both lag lengths of k1 k 2 8 .
International Research Journal of Finance and Economics - Issue 14 (2008) 117

3.2 The threshold co-integration test

Pippenger and Goering (1993), Balke and Fomby (1997), Enders and Granger (1998) and Enders and
Siklos (2001) all showed that traditional cointegration tests have low power in the presence of
asymmetric adjustment. Hence, we employed two asymmetric models in the analysis. Table 2 reports
the various results of the threshold cointegration test under the constraints of 0 and 0 . Chan’s
(1993) methodology was therefore employed to determine the consistent estimates of the threshold, as
reported in figs. 2 and 3, and were 0.0059 and -0.0053. Both the null of no cointegration ( 1 2 0)
and the symmetric adjustment ( 1 2 ) are rejected for the TAR and the MTAR models, implying the
existence of a threshold cointegration between the spot and the futures in Taiwan. Furthermore, both
the AIC and the SBC suggest that the most preferable model for our adjustment mechanism is the TAR
model with the threshold value of 0.

Table 2: The Threshold Cointegration Test

Items TAR MTAR

Threshold value 0 0.0059 0 -0.0053
F -2.0895** -1.8386* -5.7566*** -8.7901***
T 1649.2621*** 1648.7445*** 621.3606*** 643.8325***
AIC -117501.5440 -117500.5584 -115516.3059 -115560.3973
SBC -117483.3693 -117482.3837 -115498.1312 -115542.2226
Notes: 1. Critical values are from Enders and Siklos(2001).
2. The F and T, are the sample F statistics respectively for the null hypothesis of 1 2 0 , i.e., there is no cointegration; and for the null
hypothesis of 1 2 , i.e., the adjustment is symmetric.
3. *,** and *** denotes rejection of the hypothesis at the 10%, 5% and 1% level

Figure 2: The estimated threshold for the TAR model

λ­·¼«¿´Í«³
­±ºÍ¯«¿®»­
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óðòððê óðòððì óðòððî ðòððð ðòððî ðòððì ðòððê ðòððè
̸®»­¸±́¼

Figure 3: The estimated threshold for the MTAR model

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3.3 The Granger-Causality Tests Based on ECM and TECM

Table 3 presents the results of asymmetric and symmetric ECM. Focusing on the error correction term
( 0 or 1 2 0 ) in the symmetric error-correction model or the threshold error-correction model.
118 International Research Journal of Finance and Economics - Issue 14 (2008)

First, we found significant a long-run equilibrium relationship between spot and the futures markets for
symmetric error-correction model or the threshold error-correction model. Second, the F-statistic
indicates that the null hypothesis of 1 2 (the coefficients of Z and Z are equal) was rejected in
the spot market, but not rejected in the futures market. We further found difference which is
asymmetric long-run equilibrium adjustment terms between the spot and the futures markets, implying
econometric model have difference between spot and futures markets. Finally, this study selects the
threshold error-correction model (the symmetric error-correction model) in the spot (futures) market
according to AIC and SBC and F-statistic of 1 2.
The point estimates of the adjustment coefficients indicated that, within an intraday, the speed
of the long-run adjustment in the spot price was approximately -2.0912 for restoring to the equilibrium
level when the error correction is below 0. On the other hand, only -0.2702 of the deviation could be
restored to the equilibrium level in the spot prices when the error correction was above 0. The standard
error for Z t 1 and Z t 1 indicated that the spot prices responded strongly to negative shocks, but that
positive shocks in the margin were allowed to persist. That is, when Z t 1 spot price – futures price
<0 was large enough, investors engaged in cash-and-carry arbitrage, i.e., buy spot and sell the index
futures contract, which induced the spot price to rise and Z t 1 to decrease.
International Research Journal of Finance and Economics - Issue 14 (2008) 119
Table 3: Asymmetric and Symmetric Error-Correction Models

Panel A Estimates of the Error-Correction Models

Asymmetric Error-Correction Models Symmetric Error-Correction Models
Items
Spot Futures Spot Futures
-0.0038(0.0012) *** 0.0004(0.0012) 0.0003(0.0007) 0.0003(0.0008)
1 -0.1912(0.0057) *** -0.0094(0.0060) -0.1921(0.0057) *** -0.0094(0.0060)
2 -0.2281(0.0057) *** -0.0249(0.0061) *** -0.2289(0.0057) *** -0.0249(0.0061) ***
3 -0.1497(0.0059) *** -0.0295(0.0062) *** -0.1504(0.0059) *** -0.0295(0.0062) ***
4
-0.0960(0.0059) *** -0.0037(0.0063) -0.0967(0.0059) *** -0.0036(0.0063)
5 -0.0584(0.0059) *** -0.0191(0.0063) *** -0.059(0.0059) *** -0.0191(0.0063) ***
6
-0.0420(0.0058) *** -0.0140(0.0062) ** -0.0426(0.0058) *** -0.0140(0.0062) **
7 -0.0465(0.0057) *** -0.0191(0.0060) ** -0.047(0.0057) *** -0.0191(0.0060)
8 -0.0214(0.0053) *** -0.0067(0.0056) -0.0218(0.0053) *** -0.0067(0.0056) **
1 0.3521(0.0053) *** 0.0113(0.0057) ** 0.353(0.0053) *** 0.0113(0.0057) **
2 0.1760(0.0057) *** 0.0001(0.0060) 0.1766(0.0057) *** 0.0001(0.0060)
3 0.1203(0.0058) *** 0.0030(0.0061) 0.1208(0.0058) *** 0.0030(0.0061)
4 0.0795(0.0058) *** 0.0298(0.0061) *** 0.0800(0.0058) *** 0.0298(0.0061) ***
5 0.0952(0.0058) *** 0.0297(0.0061) *** 0.0957(0.0058) *** 0.0297(0.0061) ***
6 0.0434(0.0057) *** 0.0050(0.0061) 0.0438(0.0057) *** 0.0050(0.0061)
7
0.0380(0.0057) *** 0.0161(0.0060) *** 0.0384(0.0057) *** 0.0161(0.0060) ***
8 0.0256(0.0054) *** 0.0091(0.0058) 0.0259(0.0054) *** 0.0091(0.0058)
1
-0.2702(0.2162) 0.6935(0.2298) ***
2 -2.0912(0.2718) *** 0.7261(0.2890) **
-1.0331(0.1317) *** 0.7071(0.1400) ***
Panel B Asymmetric Test
H0 : 1 2 0 40.6508[0.0000] 12.7490[0.0000]
H0 : 1 2 19.8030[0.0000] 0.0056[0.9402]
Panel C: Asymmetric and Symmetric Granger-Causal Relationship
H0 : i 0 576.6043[0.0000]
H0 : i 0 6.5681[0.0000]
H0 : i 1 0 520.3471[0.0000]
H0 : i 2 0 547.0958[0.0000]
H0 : i 1 0 5.4796[0.0000]
H0 : i 2 0 5.1078[0.0000]
Panel D: Diagnostic
Likelihood 13448.7588 9448.27345 13438.8559 9448.2706
AIC 512078.43187 520079.40268 512096.2377 520077.40830
SBC 512251.08909 520252.05989 512259.8077 520240.97829
Q(4) 0.1464 0.0120 0.1589 0.0120
Notes: 1. *, **, and *** denote significance at the 1%, 5%, and 10% levels, respectively.
2.Standard error and P value are in ( ) and [ ].
k1 k2
3. Asymmetric Error-Correction Models: xi,t 1Zt 1 2Zt 1 i x1,t i i x2,t i vt .
i 1 i 1
k1 k2
4. Symmetric Error-Correction Models: xi,t Zt 1 i x1,t i i x2,t i vt .
i 1 i 1

However, although the speeds of the adjustments in the lower region were faster in the spot
markets, the non-significant coefficient of Z t 1 contributed to the short-selling constraint in Taiwan.
Hence, arbitrage couldn’t engage in reverse cash-and-carry arbitrage, i.e., buy the index futures
120 International Research Journal of Finance and Economics - Issue 14 (2008)

contract and sell the spot index. For the futures market, the empirical results were consistent with the
symmetric error-correction model, which contributed to the fact that there were no short-selling
contracts in the futures market. Hence, the futures prices did not significantly respond in a different
fashion to negative or positive change. However, from the magnitude of the adjustment, we should still
argue that the price transmissions are asymmetric in the spot markets and symmetric in the futures
markets.
Finally, the results of the tests for the Granger-causality are summarized in Table 3 panel C. We
reject the null hypothesis of none the Granger-causality from the spot prices to the futures prices, and
from the futures prices to the spot prices. The F statistics were all statistically significant and suggested
bi-directional causality within an intraday.

4. Conclusion
Employing the threshold error-correction model, we investigated the asymmetric causal relationship
between spot and futures in Taiwan using both the intraday data from Jan 2001 to May 2004.
The results from the Granger-Causality tests based on the corresponding TECM clearly
indicated a bidirectional feedback causality relationship between the spot and the futures markets, both
in the short-run. We found that the most preferable model for our adjustment mechanism was the TAR
model which implied the existence of threshold cointegration between spot and futures in Taiwan. We
selected the threshold error-correction model (the symmetric error-correction model) in the spot
(futures) market by various methods. When Z t 1 was large enough, investors engaged in cash-and-
carry arbitrage, i.e., buy spot and sell the index futures contract, which induced the spot price to rise
and Z t 1 to decrease. The non-significant coefficient of Z t 1 contributed to the short-selling of
contracts in Taiwan. Hence, arbitrage couldn’t engage in reverse cash-and-carry arbitrage, i.e., buy the
index futures contract and sell the spot index. For the futures market, the empirical results were
consistent with the symmetric error-correction model, which may contribute to the fact that there were
no short-selling contracts in the futures market. Hence, futures prices did not significantly respond
differently to negative or positive change.
These findings should be made available to individual investors and financial institutions
holding long-term investment portfolios in these two asset markets because of their likely implications.
International Research Journal of Finance and Economics - Issue 14 (2008) 121

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