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

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.