The temporal relationship between derivatives trading and spot market volatility in the UK: Empirical analysis and Monte Carlo evidence

This article examines empirically the dynamic relationship between spot mar ket volatility futures trading, and options trading in the context of a tri variate simultaneous equations model, The empirical analysis provides stron g evidence that significant simultaneity, in addition to feedback, characte rizes the relationship between the proxy for time-varying spot market volat ility and derivative trading. Also, futures trading and options trading are found to affect spot market volatility in opposite directions in the struc tural model proposed, The results, corroborated by Monte Carlo evidence, su ggest that the failure to account for any contemporaneous interaction betwe en the variables under consideration, as well as the omission of any of the two derivatives trading activities examined in this study, may generate se rious misspecification and ultimately produce misleading estimation results and statistical inference. (C) 1999 John Wiley & Sons, Inc.