The asymmetric spillover effect of the Markov switching mechanism from the futures market to the spot market

Abstract

This article develops a multichain Markov switching dynamic conditional correlation ARCH model with idiosyncratic jump dynamics to investigate whether the state of the crude oil futures market can asymmetrically affect the state of the crude oil spot market. The asymmetric spillover effects are investigated after controlling the dependence structure on idiosyncratic jumps. The empirical findings show an asymmetric spillover effect from the futures market to the spot market. Moreover, the transition probabilities depend highly on the volatility of the futures market, showing the leading role of the futures market. The jump components play a relatively more important role in explaining the conditional variances than do the ARCH and regime-switching effects. Finally, both the contribution of idiosyncratic jumps on total variance and the correlation coefficient between the futures and spot returns rely on the volatility state of the futures and spot returns. The second and fourth moments of the conditional correlation coefficients will be underestimated when the common jumps and/or independent transition mechanisms are ignored. The findings of this paper have important implications for investors in accurately evaluating riskiness, hedgers in improving hedging performance, as well as market participants and government authorities in understanding the lead-lag relationship between crude oil spot and futures markets.