Understanding Causality: What came first the Chicken or the Egg?

Abstract

The question of association as opposed to causation is an important issue in many scientific fields, including finance. Much of the empirical research in finance deals with the question of causality or stated differently what came first: the chicken or the egg. We are interested, for example, to know the transmission channels through which shocks propagate themselves in financial markets (e.g., how volatility shocks in one stock market affect other markets); or to build superior forecasting models to find out price leadership among similar financial assets traded on different markets (e.g. is it the shares listed on the home market or the host market of a cross-listed firm that first reacts to a corporate event). Hence, being able to correctly infer the direction of causality among financial assets is crucial for accurately understanding relations among those assets. While in practice we can easily observe correlations among financial assets or markets, detecting causal relationship (in other words, who moves first and who reacts) is often not an easy task