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Liquidity and the Law of One Price: The Case of the Futures‐Cash Basis
Author(s) -
ROLL RICHARD,
SCHWARTZ EDUARDO,
SUBRAHMANYAM AVANIDHAR
Publication year - 2007
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2007.01273.x
Subject(s) - market liquidity , liquidity risk , liquidity premium , liquidity crisis , economics , financial economics , arbitrage , futures contract , accounting liquidity , market maker , monetary economics , cash , granger causality , index arbitrage , stock market , econometrics , risk arbitrage , arbitrage pricing theory , capital asset pricing model , finance , paleontology , horse , biology
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.