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

50 Pages Posted: 9 Nov 2004

See all articles by Eduardo S. Schwartz

Eduardo S. Schwartz

Simon Fraser University (SFU); University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Richard Roll

California Institute of Technology

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Date Written: August 24, 2005

Abstract

Deviations from no-arbitrage relations should be related to frictions associated with transacting; in particular to market illiquidity, because frictions impede arbitrage. Thus, financial market liquidity may play a key role in moving prices to fair values. At the same time, a wide futures/cash basis may trigger arbitrage trades and thereby affect liquidity. We test these ideas by studying the joint dynamic structure of aggregate NYSE market liquidity and the NYSE Composite index futures basis for a relatively long time-period, over 3000 trading days. We find that liquidity and the basis forecast each other in addition to being contemporaneously correlated. There is evidence of two-way Granger causality between the short-term absolute basis and effective spreads, and quoted and effective spreads Granger-cause longer-term absolute bases.

These results are preserved after including a proxy for arbitrage financing costs, the Federal Funds rate, which bears an independent positive and significant relation with the short-term absolute basis. Impulse response functions indicate that shocks to the absolute basis predict future stock market liquidity. Overall, the evidence suggests that stock market liquidity enhances the efficiency of the futures/cash pricing system.

Keywords: Market efficiency, liquidity, arbitrage

JEL Classification: G12, G14

Suggested Citation

Schwartz, Eduardo S. and Roll, Richard W. and Subrahmanyam, Avanidhar, Liquidity and the Law of One Price: The Case of the Cash/Futures Basis (August 24, 2005). Available at SSRN: https://ssrn.com/abstract=615721 or http://dx.doi.org/10.2139/ssrn.615721

Eduardo S. Schwartz (Contact Author)

Simon Fraser University (SFU) ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1953 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Richard W. Roll

California Institute of Technology ( email )

1200 East California Blvd
Mail Code: 228-77
Pasadena, CA 91125
United States
626-395-3890 (Phone)
310-836-3532 (Fax)

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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