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

Richard Roll, Eduardo S. Schwartz, Avanidhar Subrahmanyam

The Journal of Finance · 2007 · 205 citations · 58 references

TL;DR

Deviations from no‑arbitrage relations are linked to market liquidity, as liquidity facilitates arbitrage, and a wide futures‑cash basis can trigger arbitrage trades that in turn influence liquidity. The study tests the relationship between stock market liquidity and the index futures basis. The authors analyze the dynamic interaction between stock market liquidity and the index futures basis. The study finds two‑way Granger causality between short‑term absolute basis and liquidity, with liquidity also Granger‑causing longer‑term bases, and shows that shocks to the absolute basis predict future liquidity, indicating that liquidity improves the efficiency of the futures‑cash pricing system.

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.