Beyond Basis Basics: Liquidity Demand and Deviations from the Law of One Price

Abstract

We argue that deviations from the law of one price between futures and spot prices, known as futures-cash bases, capture important information about liquidity demand for equity market exposure in global markets. We show that bases (1) co-move with dealer and investor futures positions, (2) are contemporaneously positively correlated with spot and futures returns with the same sign, and (3) negatively predict futures and spot market returns with the same sign. These findings are consistent with a model where the futures-cash basis reflects liquidity demand that is common to futures and cash equity markets. We show persistent supply-demand imbalances for equity index exposure reflected in bases, where compensation for meeting that liquidity demand is large (5-6% annual premium).

JEL Classification: G12, G13, G14, G15, G20