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.

Single Stock Futures (SSF) is a financial derivative which derives its value from its underlying stocks. According to the popular wisdom in the sphere of financial markets, the derivatives markets would have important consequences for the liquidity, among other things, of the underlying stocks. On the one hand, the existence of derivative might make the market a more complete one, and allows for greater information transmission among investors regarding the true value of the underlying security. Given this, one would expect that introduction of SSF would lead to more precise pricing of the underlying stocks and narrower spreads resulting in greater liquidity. Hence, investors with better information will be attracted to derivatives markets so as to make use of the leverages of derivatives. As informed traders migrate to the futures markets, market makers in the spot market can reduce the spread on the underlying stock. On the other hand, presence of derivatives might destabilize the spot market due to the activities of speculators. Under this hypothesis, spreads may widen on introduction of futures contract as market makers respond to greater volatility of the underlying stock induced by futures trading.

Liquidity in the context of financial markets refers to the easiness with which trading can be executed. A liquid market exhibits features like tightness, immediacy, depth, breadth and resiliency. If the transaction cost in a market is minimum like narrow bid-ask spread, such a market is said to be tight, while immediacy involves time factor whereby a transaction can be done as fast as possible. Similarly, depth of a market is measured based on the availability of abundant investment orders according to the investment plans of investors. Breadth of a market is manifested in the large enough number and volume of orders without any impact on the price at which the security is currently traded. The instantaneous arrival of fresh orders to the market, according to the movement of security prices, enabling the correction of the discrepancies in the determination of equilibrium prices, is termed as resiliency. Thus, all these features together constitute the overall efficiency of the operation of capital market.

Applied Economics Journal, Single Stock Futures, SSF, Financial Markets, National Stock Exchange, NSE, Derivatives Markets, Capital Market, Research Methodology, Financial Markets, Liquidity Effect, Logarithmic Form, Capital Resources.