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Liquidity and Arbitrage

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  • Roll, Richard
  • Schwartz, Eduardo S
  • Subrahmanyam, Avanidhar

Abstract

Since arbitrage involves trading, it is potentially impeded by market frictions and costs. We study whether stock market liquidity is related to the efficacy of arbitrage. Specifically, we examine the joint time-series of the NYSE Composite index futures basis and aggregate liquidity on the NYSE for a relatively long time-period, over 3000 trading days, and find that the basis and liquidity are jointly determined. Contemporaneous innovations in the absolute basis and in bid-ask spreads are positively correlated. There is also evidence of two-way Granger causality between short-term absolute bases and effective spreads. Impulse response functions indicate that shocks to the absolute basis are significantly informative in predicting spreads.

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Bibliographic Info

Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt9492m2t1.

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Date of creation: 08 Nov 2004
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Handle: RePEc:cdl:anderf:qt9492m2t1

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  1. Brennan, Michael J & Schwartz, Eduardo S, 1990. "Arbitrage in Stock Index Futures," The Journal of Business, University of Chicago Press, vol. 63(1), pages S7-31, January.
  2. Bakshi, Gurdip & Cao, Charles & Chen, Zhiwu, 2000. "Do Call Prices and the Underlying Stock Always Move in the Same Direction?," Review of Financial Studies, Society for Financial Studies, vol. 13(3), pages 549-84.
  3. Benston, George J. & Hagerman, Robert L., 1974. "Determinants of bid-asked spreads in the over-the-counter market," Journal of Financial Economics, Elsevier, vol. 1(4), pages 353-364, December.
  4. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
  5. Clifford A. Ball, 2001. "True Spreads and Equilibrium Prices," Journal of Finance, American Finance Association, vol. 56(5), pages 1801-1835, October.
  6. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
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