Liquidity Effect of Single Stock Futures on the Underlying Stocks : A Case of NSE

This paper examines the bid-ask spread of underlying stocks around the introduction of Single Stock Futures (SSF) in the National Stock Exchange (NSE), in order to ascertain whether SSF trading has any liquidity effect on the underlying stocks. Using both high frequency and daily data from January 1, 2001 to December 31, 2002 on a dataset consisting of 28 stocks on which stocks futures were traded from November 9, 2001 in the NSE, the study shows that the liquidity of underlying stocks has increased as there is considerable decline in both spread and return variance in the post-futures period. This decline in spread may be attributed to the SSF trading, as existence of futures market prompts informed traders to migrate to futures market so as to capitalize on the trading flexibilities available there. Consequently, the dealers in the spot market reduce spread as they need not incur any adverse selection cost for trading with informed traders. Besides, with shift of well-informed traders to futures markets, better information is incorporated into the prices. This leads to reduction in volatility of spot market. This decline in volatility helps dealers to reduce spread as inventory risk associated with maintaining balanced inventory decreases. Thus, it can be concluded that introduction of SSF in the NSE has resulted in improvement of liquidity in the cash market