Stock Index Futures the Case for Markets in Baskets of Securities

We provide an explanation for the explosive growth in the popularity of Stock Index Futures contracts. In our economy there are three broad classes of traders that place orders with a competitive market maker that sets a bid-ask spread arising from adverse selection. Informed traders trade on the basis of their private information about the value of particular securities. Liquidity traders trade either specific stocks, or wish to trade diversified portfolios. We show that the Stock Index is the efficient trading vehicle for this last class of traders, who abandon the spot securities markets with consequences for the liquidity of individual stocks. The reason is that the costs faced by diversified traders will be lower in the Index market than in markets for individual stocks, because any idiosyncratic information flowing in the Index market is substantially lower than that brought by insiders to the spot market. Stock Index Futures contracts are, therefore, convenient innovations for financial institutions that trade large portfolios of securities to match the liquidity needs of their clients. We predict that the innovation of index contracts adversely affects the liquidity of individual stocks. Trading in the stock market becomes more costly for those traders whose strategies involve the purchase or sale of specific securities. STOCK INDEX FUTURES THE CASE FOR MARKETS IN BASKETS OF SECURITIES Ian Cooper* and Antonio S. Mello**