Linear and Nonlinear Granger Causality: Evidence from the S & P 500 and the Ft-Se 100 Index Futures Markets

Abstract

Several studies have observed a lead-lag relationship between stock index futures and the cash market returns relying largely on the traditional linear tests for Granger causality. Recent research however suggests evidence of nonlinearities in futures and cash market returns. In this study, matched five minute returns from the S & P 500 and the FT-SE 100 index futures and cash markets are examined for the presence of both linear and nonlinear causality. Tests for nonlinear Granger causality are based on a methodology recently developed by Baek and Brock. The results of the linear causality tests are similar to those reported in the previous literature. However, the nonlinear Granger causality tests suggest strong evidence of a bi-directional nonlinear causation. The results emphasize the utility of the Baek-Brock test in exploring dynamic asset pricing relationships and point toward a possible misspecification of the forward pricing model.

JEL Classification: G13