Endogenous Illiquidity Trading Costs from Risk Sharing

Abstract

In general, index and commodity futures markets are considered to be highly liquid. Yet these markets can quickly become illiquid in periods of high uncertainty. So far, there exists no theoretical explanation as to why liquid futures markets can become illiquid in these periods of high uncertainty. This paper shows how illiquidity creates theoretically an endogenous transaction cost increasing with the variance of the spot price and the volume of trades in the futures market generated by hedging pressures. High uncertainty represented by high volatility in the spot market drives out liquidity in the futures market the larger the trades. This transaction cost comes from the trader's inability to share risk freely with the rest of the futures market. Even in its absence, futures markets will be illiquid if its mechanism allows for multiple prices. This suggests that a single price mechanism increases liquidity in the futures markets by forcing the sharing of risks, abstracting from traditional trading costs that would create effectively a bid-ask spread.