Impact of Liquidity on the Futures-Cash Basis: Evidence from the Indian Market

Abstract

Arbitragers' activities are constrained by market liquidity. In turn, arbitrage activity may trigger order imbalances adversely affecting liquidity. We examine this issue by analyzing the link between the futures-cash basis and bid-ask spreads using intraday data on single stock futures (SSFs) contracts on Indian stocks. In contrast to other countries, the SSF market in India is very active due to retail investors' prior experience with the badla system, a form of forward markets. The analysis reveals two-way Granger causality between the basis and spreads in both the futures and cash markets. Evidence for spreads Granger-causing basis is stronger for stocks with higher volume and SSFs that are relatively more active than underlying stocks. © 2012 Wiley Periodicals, Inc.