Effect of Stock Basket Trading on the Liquidity of Underlying Stocks : Evidence from a Market with Short-Sale Constraints

The “adverse selection” hypothesis expects that the introduction of index futures trading will decrease the liquidity of index component stocks as liquidity-motivated traders migrate to futures trading. Conversely, the “index arbitrage” hypothesis predicts that index arbitrage activity could enhance the liquidity of component stocks. Using the difference-in-difference approach with carefully matched stocks, we find both the bid-ask spread and the Amihud illiquidity of the VN30’s component stocks increase after the introduction of index futures trading. The probability of informed trading of VN30 stocks jumps after the introduction, consistent with the “adverse selection” hypothesis. The prevalence of futures under-pricing indicates the lack of index arbitrage due to short-sale prohibition in the Vietnamese stock market