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Allan Hodgsona, A. Mansur M. Masihb,*, Rumi Masihc

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Futures trading volume as a determinant of prices in different momentum phases

School of Accounting, Banking and Finance, Griffith University, Nathan, Brisbane 4111, Australia b Department of Finance and Economics, King Fahd University of Petroleum and Minerals, KFUPM P.O. Box 1764, Dhahran 31261, Saudi Arabia c Global Economic Research, Goldman, Sachs & Co., New York, NY 10004, USA

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Abstract

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JEL classification: G15; C52 Keywords: Futures trading volume; Stock and futures prices; Multivariate causality; Price momentum phases

Recent studies contend that trading volume has predictive power for ex ante stock prices, particularly small stocks that do not react quickly to macroeconomic information. This study postulates that a significant amount of macro-information that flows on to stock markets is derived from derivative markets. We examine the impact of short-term futures trading volume and prices on cash stock prices using a case study of 15-min data from the Australian stock index futures market which reports actual trading volume. After applying vector error correction modelling (VECM), variance decomposition and impulse functions, we conclude that futures prices provide a short-term information lead to stock prices that dominates trading volume effects. We also observe asymmetric changes in the impact of trading volume between bull and bear price momentum phases and after large trading volume shocks. These results suggest that, in future, studies on trading volume should control for the cross-correlation impact from derivative prices and the differential impact of trading phases. D 2004 Published by Elsevier Inc.

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* Corresponding author. Tel.: +966 3 860 2135; fax: +966 3 860 2585. E-mail address: masih@kfupm.edu.sa (A.M.M. Masih). 1057-5219/$ - see front matter D 2004 Published by Elsevier Inc. doi:10.1016/j.irfa.2004.10.014

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1. Introduction The objective of this paper is to investigate the role of index futures trading volume in terms of the information it contains about ex ante futures and stock prices. More specifically, we are interested in the power of trading volume, over and above own and cross-price autocorrelations in predicting ex ante prices during different bull and bear price momentum phases. The paper is primarily motivated by claims that trading volume is a primary vehicle for predicting ex ante stock prices. Secondary motivations are provided by concerns posed by the dramatic increase in trading volume in futures markets,1 whether trading volume has additional information for prices, whether different price momentums affect the impact of trading volume, and in extending previous research in futures that has concentrated on the relationship between trading volume and price volatility (see Bessembinder & Seguin, 1992, 1993; Karpoff, 1987; Locke & Sayers, 1993; Rutledge, 1986). This research is important with an obvious advantage the ability of investors to profit from such research. More generally, exchange organisation, regulation, portfolio and investment risk management could all be improved by knowledge of the factors that influence price formation, hedging activities and information transfer. Finally, a better understanding of these determinants should increase investor confidence in financial markets and thereby enhance the efficacy of corporate resource allocation (Chordia, Roll, & Subrahmanyam, 2001, p. 501). Previous research concerned with predicting prices has concentrated on stock markets and has uncovered persistent cross-autocorrelation patterns in prices. Explanations vary but mainly encompass (i) time varying expected returns, (ii) microstructure bias such as thin trading, and (iii) the tendency of prices to adjust more slowly to economy wide information (the speed of adjustment hypothesis). More recent research has determined trading volume is also a significant determinant of the cross-autocorrelation patterns in price returns and the volume of trading plays a significant role in the dissemination of market wide information. Moreover, the fundamental importance of trading volume is exemplified by the specific relationship between liquidity, trading volume and the corporate costs of capital (the liquidity hypothesesAdmati & Pfleiderer, 1988; Chordia et al., 2001); learning information by jointly observing past prices and trading volume metrics (the information hypothesisBlume, Easley, & OHara, 1994; Chordia & Swaminathan, 2000); and the impact of speculative trading on prices (the speculative hypothesisGrossman, 1977).2 The above indicates a number of competing hypotheses for the impact of trading volume on prices. For example, Chordia and Swaminathan (2000) find that high trading volume portfolio returns significantly predict low trading volume portfolio returns and this is caused by the tendency of low volume stocks to respond more slowly to
1

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For example, in Australia in 1980 less than 3% of contracts traded on the Sydney futures exchange (SFE) were financial derivatives. By 2000, over 99% of annual futures trading volume were in financial futures or options. At the same time, total trading volume on the SFE increased from 617,800 contracts to over 31 million (in 2000), and in the SPI from 180,000 (1983) to 3.8 million (in 2000). 2 Embedded within the speculative hypothesis is the volume price momentum hypothesis (Jegadeesh & Titman, 1993) and the volume overreaction hypothesis (Lee & Swaminathan, 2000).

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marketwide information. In a similar vein, Gervais, Kaniel, and Mingelgrin (2001) find that unusually high trading volume stocks outperform low trading volume stocks in the short term. They attribute this to trading volume causing higher market visibility for the stock, thus leading to subsequent price increases caused by: (i) a larger set of potential buyers compared to sellers being limited to current shareholders, (ii) short selling constraints, and (iii) the arrival of additional analysts and traders who reduce estimation risk, facilitate risk sharing and increasing information flow (see also Merton, 1987; Miller, 1977). These authors basically argue information or structural theories for the impact of trading volume. On the other hand, others argue that high trading volume indicates the presence of speculative trading, psychological factors or market inefficiency. Cooper (1999) concludes that periods of high trading volume indicate the presence of speculative trading, Hong and Steins (1999) behavioural model states that increased trading by one class of agents produces momentum in stock prices, and Gervais et al. (2001) observe that knowledge of trading volume metrics leads to positive economic returns of 11% per annum. Additionally, Lee and Swaminathan (2000) state that abnormal trading volume causes divergence from fundamental value and partly reconciles the long-term underand over-reaction price effects. They further conclude that initial price momentums observed by others3 is caused by abnormal trading volume and past trading volume predicts the magnitude, persistence and reversion coefficients of ex ante prices.4 In turn, related to market misperceptions of future earning prospects with analysts providing over (under) optimistic earnings forecasts for high (low) volume stocks. In this paper, we pose two main incremental refinements to the above research. First, we postulate that part of the high trading volume premium is related to macroeconomic information obtained from futures prices. Second, we examine the impact of trading volume in different momentum phases. The first extension is manifestly important because of the theoretical role that futures markets play in disseminating information and in providing liquidity to spot cash markets. It is well established that futures prices provide an information lead to stock prices (Abhyankar, 1995; Chan, 1992; Cheung & Ng, 1990; Garbade & Silber, 1983; Kawaller, Koch, & Koch, 1987; Stoll & Whaley, 1990).5 Theoretically, this information externality is a result of lower transaction costs (Brorson, 1991), incentives to collect and first trade macroeconomic information in futures markets, increased financial leverage, and higher liquidity in futures markets (Grossman, 1977; Subrahmanyam, 1991). These features, in theory, attract new and differentially informed investors to futures markets. The resulting increase in trading activity, together with the inextricable arbitrage linkage between stock and futures markets, implies an increase in

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Jegadeesh and Titman (1993) and Gervais et al. (2001) reported a short-term volume return premium stocks that experience unusually high (low) trading volume outperform (are outperformed by) stocks that have normal trading volume. 4 High (low) volume winners (losers) experience faster momentum reversals and lower (higher) future returns (see also Datar, Naik, & Radcliffe, 1998). 5 Garbade and Silber (1983) concluded that approximately 75% of new information first affected futures prices and then flows to stock prices and Chan (1992) found that futures prices consistently led cash price movements by 10 to 45 min, with cash stock prices rarely leading futures by more than 1 min.

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The Australian financial press has reported that the ranks of private security traders have swelled as technology and market access has become cheaper, more sophisticated and accessible. The bulk of private traders are seen to be information traders who take advantage of short-term opportunities offered by futures markets. 7 The role of futures market trading has been the focus of substantial recent attention in the US, including studies by the New York Stock Exchange, the Commodity Futures Trading Commission, the Securities and Exchange Commission, the United States General Accounting Office and a Presidential Task Force (the Brady Commission). In Australia, the Australian Securities Commission released a report on over the counter derivative trading in May 1994 with a major focus being the impact of derivative trading volume on price setting in futures and cash markets. 8 A reported example of asymmetric behaviour is that institutions act as momentum traders when they enter markets and act as contrarian traders when they exit (Badrinath & Wahal, 2002).

market information (Stephan & Whaley, 1990).6 Conversely, individual stocks of the cash market are more likely to react only to firm specific information, which in turn, reduces market wide transparency and inhibits trading. Hence, if futures prices are a reflection of macroeconomic data and the underlying asset is an index of stocks, then the use of derivative prices (partially) controls for the impact of macroeconomic data. In addition, the mixture of distributions hypothesis (MDH) of Epps and Epps (1976), hypothesises that trading volume provides a lead to absolute price changes and in the sequential information model (SIC), the arrival of new information to the market generates both trading volume and price movements, leading to positive leadlags between prices and volume in either direction (Jennings, Starks, & Fellingham, 1981). Moreover, Roll (1984) empirically observed that informed futures investors brought own private information into the market through their trading volume. We thus add futures trading volume as a potential metric that reveals macrodata. Within this context, our paper is in the spirit of Chordia et al. (2001) who analyse the time series behaviour of trading volume across the aggregate market and Blume et al. (1994) who argue prices and trading volume are jointly determined by the same market dynamics. Consequently, we analyse the impact of macroeconomic data through the cross-correlations of both futures prices and trading volume. Additionally, concern has been expressed that futures trading is based upon speculation and driven by psychological factors. For example, Grammatikos and Saunders (1986) argue that most trading in futures is speculative in nature and that interval-to-interval variations in trading volume may be a proxy for interval-to-interval variations in speculative activity (see also Garbade & Silber, 1983; Rutledge, 1986; Schwarz & Laatsch, 1991).7 Previous trading volume research has concentrated on examining the total volume of trading or extracting an abnormal volume metric. We provide a different focus by examining the impact of trading volume (also abnormal trading volume) on prices during bull and bear trading phases. Evidence that trading volume has differential effects during each phase may suggest a psychological explanation or that the information impact of prices declines in different phases (Fabozzi, Ma, & Linkstey, 1988).8 Finally, for technical analysts who favour the psychological approach, the volume/price relationship may be used to extract the current dmoodT of the market. The inclusion of futures market metrics also provides us with the opportunity to control for some other structural problems raised by previous studies. For example, there are no

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asymmetries in the ability of futures traders to short sell and the pool of potential traders is not confined by current share ownership. Hence, there should be no behavioural trading distinctions such as a steeper demand curve for dbullsT compared to dbearsT as hypothesised by Epps (1975). Additionally, previous studies on intraday futures trading (for example Chan, 1992) used recorded number of transactions as a proxy for actual trading volume because of the unavailability of intraday futures trading volume in the US. This problem is controlled by the use of actual intraday futures trading volume obtained from the Australian futures market. We also check for long- and short-term Granger causality by the application of cointegration and vector error correction techniques (VECM). The findings in this paper confirm that futures price cross-correlations have a statistically significant and substantial predictive impact on the underlying stock market. We also observe subtle changes in the explanatory power of trading volume with a stronger influence in bear markets and opposite impacts from sudden jumps in trading volume during the bull and bear momentum phases. The paper now proceeds as follows. We concentrate on short-term futures trading volume as an explanatory metric and apply a 15min intraday data set from the Sydney futures exchange as a case study illustration. The next section describes the data, Section 3 outlines the methodology, Section 4 reports the results and the paper is concluded in Section 5.

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2. Data

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The data used consists of a case study of 15-min interval dsnapshotT derived from an online service of Australian all ordinaries (AOI) and share price futures index (SPI) prices and SPI futures trading volume over a 1-year period from 1 April 1992 to 30 March 1993. This data was further checked for integrity against 15-min intraday price data on the AOI in hard copy form and tick-by-tick data on the SPI, obtained from the stock and futures exchanges. The nearest traded SPI futures contract was used to match against the AOI. In Australia, the SPI trades from 0950 to 1610 each day (with a break for lunch from 1230 to 1400), and the shares which constitute the AOI trade continuously from 1000 to 1600. The observations for the first and last 10 min of trading were excluded for the SPI and the lunch time trades from 1245 to 1345 excluded for the AOI. Three days were deleted from the sample3 August 1992 because no trading data could be obtained for the SPI, 24 August 1992 because there was no trading on the stock market during the morning, and 9 February 1993 because prices were extremely erratic and deemed to be aberrant. This gave 20 matched intraday observations for 249 complete trading days with a total of 4980 observations over the research period. Raw 15-min data was transformed by taking natural logarithms and the rate of change (or first difference) in prices was calculated as:

where X t is the observed variable at time t , X t 1 is the previous periods price or futures trading volume and ln is the natural logarithm.

DXt lnXt lnXt1 171 170 172

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The data displayed two distinct bull and bear phases. The bear phase coincided with the first half of the data set from 1 April 1992 to 30 September 1992 when the value of the AOI index consistently declined by some 6.3% from 1584.4 to 1485. During this period, 57.8% of intraday price changes were negative, which represented 37% more price decreases than increases. The bull period equated with the second half of the data set when the AOI increased by 12.3% to close at 1667.4 on 31 March 1993. During this phase, the ratio of relative intraday price changes was reversed with price increases outnumbering price decreases by 33%. The application of intraday futures data from the Australian market also allows the opportunity to examine the contentions that the pricevolume relation is strongest in markets in which price volatility is highest9 (Karpoff, 1987). Further, if trading volume is a proxy for information flow, then its value would be stronger in markets driven by thin trading (Conrad, Hameed, & Niden, 1994). The Australian market employs a continuous trading mechanism which when combined with thin trading theoretically implies (i) the depth of the market will be further reduced, and (ii) that differential forms of information (such as trading volume) may have greater impact.

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3.1. Cointegration and vector error-correction modelling (VECM) Two or more variables are cointegrated if they exhibit long-run equilibrium relationship(s) that is they share common trend(s) (Engle & Granger, 1987). As long as two variables have a common trend, causality in the Granger sense, must exist in at least one direction either unidirectional or bidirectional. Evidence of cointegration among variables also rules out the possibility that the estimated relationship is dspuriousT. However, although cointegration indicates the presence or absence of Granger-causality, it does not indicate the direction of causality between variables. The direction of Granger causality can be detected through the vector error correction model (VECM) derived from the longrun cointegrating vectors. Engle and Granger (1987) demonstrated that once a number of variables (say, x t and y t ) are cointegrated, there always exists a corresponding error-correction representation (ECM). This in turn implies that changes in the dependent variable are a function of the level of disequilibrium in the cointegrating relationship as well as changes in other explanatory variables. A consequence of ECM is that either Dx t or Dy t or both must be caused by E t 1 (the equilibrium error) which is itself a function of x t 1, y t 1. Intuitively, if y t and x t have a common trend, then the current change in x t (say the dependent variable) is partly the result of x t moving into alignment with the trend value of y t (the independent variable). The Granger-causality (or endogeneity of the dependent variable) can be evidenced either through the statistical significance of the t -test of the lagged error-correction term(s) and/or the F -test applied to the joint significance of the sum of the lags of each explanatory variable.
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In the data set used in this study, the relative SPI/AOI price variance ratio was 2.96. This ratio was consistent across the trading day.

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3.2. Variance decompositions (VDCs) and causal relativities The VECM, F - and t -tests may be interpreted as within-sample causality tests. They can indicate only the Granger-exogeneity or endogeneity of the dependent variable. They do not provide an indication of the dynamic properties of the system, nor do they allow us to gauge the relative strength of the Granger-causal chain or degree of exogeneity amongst the variables beyond the sample period. VDCs by partitioning the variance of the forecast error of a variable into proportions attributable to innovations (or shocks) in each variable in the system including its own, can provide an indication of these relativities. Alternatively, VDCs provide a literal breakdown of the change in the value of the variable in a given period arising from changes in the same variable in addition to the changes in other variables in previous periods. A variable that is optimally forecast from its own lagged values will have all its forecast error variance accounted for by its own disturbances (Sims, 1982).10

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In addition to indicating the direction of causality amongst variables, the VECM approach allows the researcher to distinguish between dshort-runT and dlong-runT forms of Granger-causality. When the variables are cointegrated, then in the short-term deviations from the long-run equilibrium will feed back on the changes in the dependent variable in order to force the movement back towards long-run equilibrium. If the dependent variable is driven directly by this long-run equilibrium error then it is responding to this feedback. If not, it is responding only to short-term shocks to the stochastic environment. The F -tests of the ddifferencedT explanatory variables provide an indication of the dshort-termT causal effects (i.e. the joint cross-autocorrelations) whereas the dlong-runT causal relationship is implied through the significance or otherwise of the t -test(s) of the lagged error-correction term(s). This point is important. If the variables are cointegrated, then causality tests which incorporate differenced variables will be misspecified unless the lagged error-correction term is included (Toda & Phillips, 1993). Second, standard tests that establish stationarity by mechanically differencing variables eliminate the long-run information embodied in the original level form of the variables. The VECM derived from the cointegrating equation(s) overcomes these problems by including the lagged error-correction term that reintroduces the long-run information lost through the differencing procedure and opens up an additional channel of Granger causality. This is an important statistical innovation given that it accounts for short-term dynamics whilst still preserving the long-run structural relationship inferred by the arbitrage cost-of-carry model.

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The results based on VARs and VDCs are generally found to be sensitive to the lag length used and the ordering of the variables. A considerable time was spent in selecting the lag structure by using FPE criterion. FPE is based on an explicit optimality criterion of minimising the mean squared prediction error. The criterion tries to balance the risk due to bias when a low order is selected, and the risk due to the increase in the variance when a higher order is selected. By construction, the errors in any equation in a VAR are usually serially uncorrelated. However, there could be contemporaneous correlations across errors of different equations. These errors were orthogonalised through Choleski decomposition with a pre-determined triangular ordering in the following order: [SPI, CSH, VOL]. The results were not sensitive to alternative ordering of the variables.

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8 t1.1 A. Hodgson et al. / International Review of Financial Analysis xx (2004) xxxxxx Table 1 Tests of the unit root hypothesis Aug DickeyFuller sl Bear market period Levels SPI 0.03 CSH 1.13 VOL 1.99 First differences (D) SPI 2.87*** CSH 4.11* VOL 3.33** Bull market period Levels SPI 0.21 CSH 1.51 VOL 1.65 First differences (D) SPI 4.87* CSH 4.11* VOL 3.33** ss Z (a ) Z (t a ) PhillipsPerron Z (U 1) Z ( a *) Z (t a *) Z (U 2) Z ( U 3)

t1.24

3.3. Response to unanticipated shocks: impulse response functions (IRFs) The information contained in the VDCs may also be equivalently represented by IRFs, as both are obtained from the moving average (MA) representation of the original VAR model. IRFs essentially map out the dynamic response path of a variable (say, the cash stock prices) due to a one-period standard deviation shock to another variable (say, futures trading volume). The impulse response functions like the variance decompositions were also obtained from the unrestricted VAR form of the model, although they could be computed via a dynamic multiplier analysis of VAR systems with cointegration constraints (see Lutkepohl & Reimers, 1992). To trace the dynamic effects of various shocks, the estimated VECM was reparameterised to its equivalent formulation in levels. With this reparameterisation, the error-correction terms were incorporated into the first period lagged terms of the autoregression. The model was then inverted to obtain the impulse response functions that capture the effects of deviations from long-run equilibrium on the dynamic paths followed by a variable in response to initial shocks. Intuitively, IRFs trace the response over time of a variable, due to a unit shock given to another variable.

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The optimal lag used for conducting the Augmented DickeyFuller test statistic was selected based on an optimal criteria (Akaikes Final Prediction Error), using a range of lags. The truncation lag parameter l used for the PhillipsPerron tests was selected using a window choice of w (s ,l )=1[s /(l +1)] where the order is the highest significant lag from either the autocorrelation or partial autocorrelation function of the first differenced series. The symbols *** , ** and * indicate significance at the 10%, 5% and 1% levels, respectively.

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t1.15 t1.16 t1.17 t1.18 t1.19 t1.20 t1.21 t1.22 t1.23

0.11 0.25 1.25 6.22* 5.42* 4.26*

1.58 1.87 3.03 12.10* 24.19* 32.28*

1.25 1.35 1.88 10.84* 10.28* 9.87*

0.60 1.54 2.97 57.21* 24.31* 31.02*

1.22 3.34 3.54

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1.98 1.65 1.85 13.20* 12.57* 11.98*

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3.21 2.27 1.27 25.67* 35.74* 35.01* 4.41 2.98 1.95 52.41* 45.88* 45.61* 31.10* 25.41* 24.74*

t1.14

t1.2 t1.3 t1.4 t1.5 t1.6 t1.7 t1.8 t1.9 t1.10 t1.11 t1.12 t1.13

2.18 1.37 2.00 4.71* 4.21* 3.49*

0.11 1.93 4.28 25.47* 24.14* 24.19*

1.06 1.15 2.00 11.78* 11.51* 10.71*

1.20 1.66 3.18 69.02* 66.16* 57.32*

1.43 4.55 7.73 22.37* 25.52* 32.17*

2.55 1.44 2.09 11.87* 11.57* 10.73*

3.41 1.42 2.55 46.69* 44.51* 38.32*

5.87*** 1.14 2.66

F
70.04* 66.77* 57.48*

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4. Results 4.1. Prerequisites for cointegration: unit root tests A necessary but not sufficient condition for cointegration is that each of the variables should be integrated of the same order (more than zero) or that all series should contain a deterministic trend. A wide range of unit root tests was applied in order to test the order of integration of the variables and the results appear in Table 1. Basically, if a time series is trend-stationary and no account is made of this fact when implementing the testing procedure, this may lead to high probabilities of making a type II error (see Taylor, 1993).11 The results in Table 1 indicate that for all variables concerned, the variables were nonstationary at the dlevelT form but stationary after dfirst-differencingT I(1). The results were robust to both the bull and bear market samples. 4.2. JohansenJuselius (JJ) maximum likelihood multivariate tests for cointegration We apply the JJ procedure (Johansen & Juselius, 1990) to test for cointegration.12 The results based on the JJ multivariate cointegration tests are presented in Table 2 and indicate that these three variables are bound together by two separate long-run equilibrium relationships (i.e. r =2). Note that both maximum eigenvalue (K ) and trace statistics reject the null of r V1 in favour of r N1, but cannot reject the null of r V2 at the 95% critical values. These results mean that there is a unique common long-term trend which binds together AOI cash prices, SPI futures prices and SPI trading volume. Economically, it is expected that AOI and SPI prices would be related in a long-term trend because of the nature of the arbitrage relation between cash and futures markets. However, what is more interesting is the cointegration of futures trading volume and cash and futures prices. This means that as price levels increase so does the level of trading volume. This could be related to a richer information environment or a result of factors unrelated to information, such as an increased demand for risk transfer trading supplied by hedging and insurance strategies. Having established the two cointegrating vectors, the Johansen and Juselius procedure allows us to test several hypotheses on the coefficients by way of imposing restrictions
11 The following sequence was applied with details of test equations appearing in Appendix A1: (i) apply Z (t a *), Z (U 2) and Z (U 3), respectively, and if the unit root hypothesis is rejected then the procedure should be halted at this point; (ii) if the unit root hypothesis cannot be rejected then the greatest power may be obtained by estimating equations associated with the PhillipsPerron transformations of the relevant t - and F -statistics, Z (t a *), and Z (U 1). Due to the fact that these two tests are not invariant to the constant term, this is only valid if the drift term (l *) used in test equations applied in (i) was zero. In this respect, these two tests should only be used if Z (U 2) cannot be rejected. 12 The JJ procedure has several advantages: (i) it explicitly tests for the number of cointegrating relationships; (ii) it assumes all variables to be endogenous; (iii) the JJ procedure avoids the arbitrary choice of the dependent variable used in the EngleGranger approach, and is insensitive to the variable being normalised; (iv) it establishes on a unified framework for estimating and testing cointegrating relations; and (v) JJ provide the appropriate statistics and the point distributions to test hypothesis for the number of cointegrating vectors and tests of restrictions upon the coefficients of the vectors.

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10 t2.1 A. Hodgson et al. / International Review of Financial Analysis xx (2004) xxxxxx Table 2 Johansen and Juselius tests for multiple cointegrating vectors Long-run cointegrating vector Bear market period H0: r=0 r V1 rV 2 H1: r N0 r N1 r =3 Max eigenvalue (K ) 271.386** 24.816** 0.037 Trace 306.239** 34.853** 0.037 Hypotheses Test statistics

t2.2 t2.3 t2.4 t2.5 t2.6 t2.7 t2.8

t2.9

t2.15

t2.16 t2.17 t2.18 t2.19 t2.20

t2.21

Bull market period H0 : r=0 r V1 r V2 H1: r N0 r N1 r =3

Max eigenvalue (K ) 185.251** 38.407** 3.508

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Trace 227.161** 41.915** 3.508

t2.11 t2.12 t2.13 t2.14

SPI CSH VOL

1.000 0.8466 0.0211

1.000 0.9390 0.0009

51.371* 49.911* 71.284*

t2.22 t2.23 t2.24 t2.25 t2.26

Coefficients of normalised cointegrating vector and tests of restrictions Vector 1 SPI CSH VOL 1.000 0.896 0.048 Vector 2 Chi-square test [v 2] 37.001* 36.970* 81.507*

and likelihood ratio tests which are, asymptotically, chi-square distributed with one degree of freedom. Further, the scrutinising of the cointegration vector in each model provides us with a measure of the relative importance of each component in terms of its relative weight in comparison to the remaining components. Estimates of these tests are also presented in Table 2 for the bull and bear samples. Results indicate each of these restrictions are rejected, at conventional levels, which in turn implies that each of the variables enters into the cointegrating vectors at a statistically significant level. 4.3. Temporal causality and vector error-correction modelling The presence of a two cointegrating vector(s) in each of the bull and bear threedimensional VARs used in the JJ cointegration tests provides us with two errorcorrection term(s) for constructing models. In order to determine the direction of

t2.27

The optimal lag structure for each of the VAR models was selected by minimising the Akaikes FPE criteria. Critical values are sourced from Johansen and Juselius (1990). The test statistic under the null is distributed as chi-square with two degrees of freedom, ** indicates rejection at the 95% critical values and * indicates rejection of zero restriction at least at the 1% level of significance.

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1.000 0.957 0.0002

Vector 1

Vector 2

Chi-square test [v 2]

F
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t2.10

Coefficients of normalised cointegrating vector and tests of restrictions

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t3.1

t3.2 t3.3 t3.4 t3.5 t3.6 t3.7 t3.8

t3.9

Table 3 Summary results of multivariate temporal causality among SPI, CSH and VOL, based on vector error-correction model (VECM) Dep variable Bear market period DSPI DCSH DVOL Bull market period DSPI DCSH DVOL DSPI DCSH DVOL ECT1[n i ,t 1] t -statistics 1.109 0.731 1.099 1.010 2.921* 2.796* 6.584* 0.450 2.334** 0.450 ECT2[n i ,t 1] F -statistics

t3.14

t3.10 t3.11 t3.12 t3.13

4.997* 0.768

4.279* 1.107

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causality, we now turn to the results based on the VECM formulation presented in Table 3. As previously discussed, the long-run equilibrium is driven by the theoretical cost-ofcarry arbitrage relationship between cash AOI and SPI futures prices and long-term levels in trading volume. When the error correction term (ECT) term is significant, this implies that this term contains information over and above that implied by only shortterm lagged changes in the explanatory variables and has a significant feedback effect on the changes in the dependent variable. In futures markets, if futures prices lead cash prices then this is taken as evidence that futures are used by informed traders to reestablish fundamental values. If stock prices lead futures prices then this suggests that futures are used to hedge cash prices. With respect to the ECT for the bear market period, the results indicate at least one ECT is significant for each of the equations in the VECM. In econometric terms, this indicates that when there is a deviation from any long-term equilibrium cointegrating relationship, each variable endogenously adjusts to clear the disequilibrium. In terms of a leadlag, it means that no individual variable leads or lags in the long-term and that neither information nor hedging activities dominate in the long term. During the bull market period, the situation is different. The ECT term in the trading volume equation is significant at the 1% level together with weaker evidence of significance in futures prices. In contrast to the bear period, the ECT is no longer significant for the cash AOI index equation. Econometrically, this means that after an exogenous shock to the long-term equilibrium, trading volume and futures prices adjust back to long-term equilibrium. This indicates that the AOI is the leading long-term

302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322 323

0.865 0.826

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1.205 0.291 6.275*

The ECTs (n it 1 for i =1) for each model were derived by normalising the cointegrating vectors on SPI resulting in r number of residuals. Optimal lag structures for each model were selected by minimising Akaikes FPE criteria. This procedure filters out the infrequent trading component in the AOI and bid-ask bounce in the SPI. Figures that appear in the final column are estimated t -statistics testing the null that each lagged-ECT is statistically insignificant. All other estimates are asymptotic Granger F -statistics. The residuals used in constructing the ECTs (from each JJ VAR) were also checked for stationarity by way of unit-root testing procedures applied earlier and inspection of their autocorrelation functions, respectively. The VECM was estimated using an optimally determined criteria (Akaikes FPE) lag structure for all lagged difference terms and a constant. The symbols ***, **, and * indicate significance at the 10%, 5% and 1% levels.

F
1.772*** 0.203 0.699

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4.4. Variance decompositions (VDCs) and causal relativities In order to gauge the relative strength of prices and raw trading volume or to dquantify our temporal causality resultsT, the system of financial variables is now shocked and the forecast error variance of each of the variables is partitioned. The decomposition results are presented in Table 4 for both bear and bull periods for five alternative accumulative 15-min periods. Those results pertaining to 40 periods (2 days trading) after the shock are only discussed. By observing the main diagonal, we can ascertain the extent to which each variable is exogenous since the diagonal represents how much of a variables own variance is being explained by movements in its own shock over the forecast horizon.
13

variable providing the anchor price for arbitrage purposes with futures prices being used more often as a long-run hedging vehicle. Having filtered out the longer-term leadlag relationships, we are now able to determine, in a more rigorous statistical manner, the short-term leadlag effects by referring to the asymptotic Granger F -statistic. Reading down the columns in Table 3 shows that the lagged terms for the DSPI have a significant short-term impact on the DCSH but not on DVOL. Short-term movements in cash prices and futures trading volume do not exert any influence. These equations strongly indicate that futures prices provide the short-term lead to the cash stock index and that the results are robust across both bull and bear markets. To summarise our results in terms of leadlag relations. During the bear market period, there is no long-term leadlag relationship from any variable. In the short term, futures prices exert a strong leading impact on cash prices with short-term futures trading volume not statistically significant. During the bull market, cash AOI prices provide the long-term lead, but are still strongly affected in the short term by changes in futures prices. These observations are consistent with the results of Chan (1992) and reinforce that SPI prices consistently provide a short-term information lead to the AOI regardless of the psychological state of the market. In terms of the aim of this paper, the results confirm that short-term cross-autocorrelations in futures prices are significant explanators of cash stock prices. Further, after controlling for price cross-correlations results show that trading volume does not significantly affect futures or cash prices. There may, however, be a potential research design flaw because raw trading volume is applied and not unexpected trading volume. As a test of the robustness of our results, and given the emphasis on differentiating the effects of anticipated and unanticipated information on prices, measures of expected trading volume based on the day of the week and time of the day were constructed by fitting polynomial functions to intraday trading volume. We then analysed the impact of surprises from expected trading volume in the VECM model. Results were not qualitatively different from those obtained from raw volume.13 Consequently, at first pass, raw and unexpected futures trading volume appear to be exogenous and provide very little incremental predictive or information to prices.

324 325 326 327 328 329 330 331 332 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 349 350 351 352 353 354 355 356 357 358 359 360 361 362 363 364

Results can be obtained from the authors on request.

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A. Hodgson et al. / International Review of Financial Analysis xx (2004) xxxxxx t4.1 Table 4 Decomposition of variance Percentage of forecast variance explained by innovations in: DSPI Bear market period Periods 1 4 8 20 40 Periods 1 4 8 20 40 Periods 1 4 8 20 40 Bull market period Periods 1 4 8 20 40 Periods 1 4 8 20 40 Periods 1 4 8 20 40 Relative variance in: DSPI DCSH DVOL 13

t4.2 t4.3 t4.4 t4.5 t4.6 t4.7 t4.8 t4.9 t4.10 t4.11 t4.12 t4.13 t4.14 t4.15 t4.16 t4.17 t4.18 t4.19 t4.20 t4.21 t4.22 t4.23
t4.24

Relative variance in: DCSH

Relative variance in: DVOL

t4.44

t4.25 t4.26 t4.27 t4.28 t4.29 t4.30 t4.31 t4.32 t4.33 t4.34 t4.35 t4.36 t4.37 t4.38 t4.39 t4.40 t4.41 t4.42 t4.43

Relative variance in: DCSH

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Relative variance in: DSPI

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100.00 99.00 98.27 97.20 96.01 58.62 59.87 59.46 59.24 58.61 0.00 0.39 0.75 1.48 2.10

0.08 0.17 0.34 0.47 1.18

PR
0.01 0.07 0.15 0.47 0.86 0.00 0.96 1.13 1.46 2.15 41.38 40.10 40.17 39.57 39.54 0.01 0.05 0.26 1.20 1.58

59.09 60.99 60.12 59.57 58.77

40.91 35.20 34.54 34.23 34.25

Relative variance in: DVOL

Figures in the first column refer to horizons (i.e. number of 15-min intervals). All other figures are estimates rounded to two decimal placesrounding errors may prevent a perfect percentage decomposition in some cases. Several alternative orderings of these variables were also triedsuch alterations, however, did not alter the results to any substantial degree. This is possibly due to the variancecovariance matrix of residuals being near diagonal, arrived at through Choleski decomposition in order to orthogonalise the innovations across equations.

F
0.00 3.81 5.35 6.20 6.98 99.91 99.76 99.51 99.06 97.96 0.00 0.03 0.59 1.32 1.85 0.00 0.03 0.37 1.19 1.86 99.99 99.57 98.99 97.32 96.32

100.00 97.57 96.24 95.69 94.07

0.00 0.22 0.37 0.62 1.29

0.00 0.21 3.39 4.07 4.64

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4.5. Impulse response analysis

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What is clearly highlighted in Table 4 is the relative endogeneity of the cash AOI prices and the impact of futures prices. For example, after 2 days trading following the shock, about 58.77(58.61)% of the shock to the cash index is explained by innovations in the futures prices for the bear (bull) market periods. That is, cash stock prices become more dependent on futures prices as the time frame is increased. This result further confirms the importance of futures prices in explaining and predicting ex ante stock prices. In contrast, both futures prices and trading volume are exogenous in the short run. Trading volume has minor impacts on futures and cash stock prices and we attribute this to the fact that we have controlled for the cross-autocorrelations in own and related market prices. However, there are some subtle changes. In bear (bull) market phases, the importance of trading volume is higher (lower) in predicting subsequent price movements. For example, in the bear phase 4.6% (7%) of the variance in futures (cash share) prices is explained by trading volume with the proportion much lower in the bull phase. Decomposition analysis also serves as a tool to assess the behaviour of the relative information dynamics of this system across bull and bear markets. For example, during the bull market the cash AOI index appears to be slightly more exogenous compared to the bear market, since in the former 39.54% of the own shock is explained as compared to 34.25% explained in the case in the bear market. This suggests stock markets generate increased internal information in bull markets which may be related to heightened analyst interest.

365 366 367 368 369 370 371 372 373 374 375 376 377 378 379 380 381 382 383 384 385 386 387 388 389 390 391 392 393 394 395 396 397 398 399 400 401 402 403 404 405 406 407

In this section, we utilise impulse response analysis which outlines the dynamic response of each variable to innovations from other individual variables in the system. Impulse response functions indicate the extent that a shock of one variable is transitory (or persistent) in terms of its effect on other variables. From our system of three variables, we could construct illustrations of up to nine possible scenarios (for each of the bull and bear market periods) of impulse response paths. However, we wish to further explore the asymmetric volume theories which suggest that trading volume will have differential information effects in bear and bull markets. To this end, reliance is placed on the empirical observations of Bessembinder and Seguin (1993) who documented that positive shocks in futures trading volume were associated with 76% greater price volatility. We therefore analyse the response paths of cash AOI and SPI futures prices to a large (one standard deviation) shock in increased futures trading volume in the separate bear and bull periods. Impulse response paths illustrating these scenarios are presented in Figs. 1 and 2 and demonstrate the difference in the dynamic response paths of the cash and futures prices across bear and bull periods. During the bear market, a large shock to futures trading volume has a negative transitory path dependent effect. The increased trading volume has the effect of initially lowering price volatility with cash and futures prices reverting back to their pre-shock level within about 15 periods. Of further interest is that the impulse response paths appear to have a cyclical effect with the path repeating itself after 1 day (20 lags), albeit with a reduced impact. In contrast, during the bull market a

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Fig. 2. Impulse responses of CSH and SPI from a one-standard deviation shock to VOL during bull period.

sudden increase in futures trading volume is associated with higher initial price volatility which lasts about 11 periods. Similarly, the bull market impulse response paths also appear to have a decaying 1-day memory lag with price volatility again increasing at 20 periods after the volume shock. A further observation is that there is a greater absolute volatility reaction in futures prices compared to cash AOI prices, but they generally follow similar response paths. These results both confirm and modify previous theoretical predictions and observations. Large increases in futures trading volume have an asymmetric information impact across bear and bull days and a memory lag of 1 day which is not related to current trading volume. In bull markets, sudden increases in trading volume may provide information content that is associated with or indicates further speculative activity (per Rutledge, 1986), with the subsequent higher price volatility a reflection of the increased uncertainty induced by noise trading. During bear periods, the information of increased trading volume may be perceived as positive reinforcement

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Fig. 1. Impulse responses of CSH and SPI from a one-standard deviation shock to VOL during bear period.

O
408 409 410 411 412 413 414 415 416 417 418 419 420 421

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with traders interpreting this as signalling greater confidence. This in turn results in an inverse feedback relationship with the dgood newsT of increased trading interpreted as less uncertainty and reflected in lower price volatility. The above conjectures may be contentious but offer the possibility of further research into the information importance of futures trading volume.

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5. Summary and conclusions This paper places the empirically controversial issue of the predictive relationship causality between cash share prices, SPI futures prices and futures trading volume within a multivariate cointegrated Granger-causal framework. This is done by analysing the ddynamicT Granger-causal chain or leadlag relationship amongst the three variables using 15-min data, with an additional focus on the impact that bear and bull momentum phases have on the dynamics of the system. Overall, our case study results support the contention that macroeconomic information flows from futures prices and they, in turn, are a statistically significant predictor of ex ante share prices. On the other hand, futures trading volume was statistically exogenous in the short term and was dominated by futures prices. That is, when jointly estimated, futures trading volume added very little predictive power to that already impounded in prices. There are, however, some qualifications. The predictive power of trading volume increased during the bear phase and large increases in trading volume induced lower (higher) initial price volatility during the bear (bull) phase. Overall, this research adds to previous short-term research in the stock market which attributes excess trading volume as the provider of incremental macro-information. The results confirm that substantial macro-information flows in from futures price changes and predict subsequent movements in stock prices. Second, we also uncovered asymmetric impacts from trading volume to prices during different price momentum phases and this signals subtle changes in the predictive and information value of trading volume. We suggest that researchers control for cross-autocorrelation effects from related markets (especially derivatives markets) and market psychology when analysing the predictive power of trading volume.

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6. Uncited references

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Chan & Chung, 1993 Hong, 2000

Acknowledgments We gratefully acknowledge Robert Brooks, Robert Faff and Pradeep Yadav for insightful comments. The views contained in this paper do not necessarily reflect those of Goldman, Sachs and Co. or any of its affiliated offices.

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