Effects of Futures Trading on the Spot Market Bid-Ask Spread

Abstract

This paper analyzes how the presence of a futures market gives risk averse dealers in the spot asset opportunities for arbitrage that reduces the spot market bid-ask spread through reducing the dealers risk exposure. In particular, if the spot and futures risks are perfectly correlated then the spot bid-ask spread is zero in equilibrium and all spot dealer risk can be diversified away. The paper also analyzes the equilibrium futures price in this two market scenario. Copyright 1998 by Blackwell Publishers Ltd and The Victoria University of Manchester