The dynamics of the relationship between spot and futures markets under high and low variance regimes

This investigation is one of the first studies to examine the dynamics of the relationship between spot and futures markets using the Markov‐switching vector error correction model. Three mature stock markets including the U.S. S&P500, the U.K. FTSE100 and the German DAX 30, and two emerging markets including the Brazil Bovespa and the Hungary BSI, are used to test the model, and the differences between the two sets of markets are examined. The empirical findings of this study are consistent with the following notions. First, after filtering out the high variance regime, the futures price is shown to lead the spot price in the price discovery process, as demonstrated by prior studies; conversely, the spot market is more informationally efficient than the futures market under the high variance condition. Second, the price adjustment process triggered by arbitrage trading between spot and futures markets during a high variance state is greater in scale than that based on a low variance state, and the degree of the co‐movement between spot and futures markets is significantly reduced during the high variance state. Third, a crisis condition involved in the high variance state is defined for the two emerging markets, whereas an unusual condition is presented for the three mature markets. Last, the lagged spot–futures price deviations perform as an information variable for the variance‐turning process. However, the portion of the variance‐switching process accounted for by this signal variable is statistically marginal for the three mature markets selected for this study. Copyright © 2008 John Wiley & Sons, Ltd.