Liquidity and the Law of One Price: The Case of the Futures‐Cash Basis

Richard W. Roll · Eduardo S. Schwartz · Avanidhar Subrahmanyam

191 citations0/0 files storedThe Journal of Finance

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Financial Markets and Investment Strategies Financial Risk and Volatility Modeling Market Dynamics and Volatility

Abstract

ABSTRACT Deviations from no‐arbitrage relations should be related to market liquidity, because liquidity facilitates arbitrage. At the same time, a wide futures‐cash basis may trigger arbitrage trades and, in turn, affect liquidity. We test these ideas by studying the dynamic relation between stock market liquidity and the index futures basis. There is evidence of two‐way Granger causality between the short‐term absolute basis and liquidity, and liquidity Granger‐causes longer‐term absolute bases. Shocks to the absolute basis predict future stock market liquidity. The evidence suggests that liquidity enhances the efficiency of the futures‐cash pricing system.

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References

2002Illiquidity and stock returns: cross-section and time-series effects 1985Continuous Auctions and Insider Trading 1998Generalized impulse response analysis in linear multivariate models 2003Liquidity Risk and Expected Stock Returns 1986Asset pricing and the bid-ask spread 1991Inferring Trade Direction from Intraday Data 1984A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market 1981A new approach to decomposition of economic time series into permanent and transitory components with particular attention to measurement of the ‘business cycle’

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