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Beyond Basis Basics: Liquidity Demand and Deviations from the Law of One Price

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  • Todd M. Hazelkorn
  • Tobias J. Moskowitz
  • Kaushik Vasudevan

Abstract

We argue that deviations from the law of one price between futures and spot prices, known as bases, capture important information about liquidity demand for equity market exposure in global equity index futures markets. We show that bases (1) co-move with dealer and investor futures positions, (2) are contemporaneously positively correlated with spot and futures markets with the same sign, and (3) negatively predict futures and spot market returns with the same sign. These findings are uniquely consistent with our liquidity demand model and distinct from other explanations for bases, such as arbitrage opportunities or intermediary balance sheet costs. We show persistent supply-demand imbalances for equity index exposure reflected in bases, where compensation for meeting liquidity demand for that exposure is large (5-6% annual premium).

Suggested Citation

  • Todd M. Hazelkorn & Tobias J. Moskowitz & Kaushik Vasudevan, 2020. "Beyond Basis Basics: Liquidity Demand and Deviations from the Law of One Price," NBER Working Papers 26773, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:26773
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    Cited by:

    1. van Binsbergen, Jules H. & Diamond, William F. & Grotteria, Marco, 2022. "Risk-free interest rates," Journal of Financial Economics, Elsevier, vol. 143(1), pages 1-29.
    2. Jappelli, Ruggero & Lucke, Konrad & Pelizzon, Loriana, 2022. "Price and liquidity discovery in European sovereign bonds and futures," SAFE Working Paper Series 350, Leibniz Institute for Financial Research SAFE.
    3. Patrick Augustin & Mikhail Chernov & Lukas Schmid & Dongho Song, 2024. "The Term Structure of Covered Interest Rate Parity Violations," Journal of Finance, American Finance Association, vol. 79(3), pages 2077-2114, June.
    4. Gino Cenedese & Pasquale Della Corte & Tianyu Wang, 2021. "Currency Mispricing and Dealer Balance Sheets," Journal of Finance, American Finance Association, vol. 76(6), pages 2763-2803, December.

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    More about this item

    JEL classification:

    • F3 - International Economics - - International Finance
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F65 - International Economics - - Economic Impacts of Globalization - - - Finance
    • G1 - Financial Economics - - General Financial Markets
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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