A theory of trading in stock index futures

It is demonstrated that markets in stock index futures or, moregenerally, in baskets of securities, provide a preferred tradingmedium for uniformed liquidity traders who wish to trade portfolios,because adverse selection costs are typically lower in thesemarkets than in markets for individual securities. Thus, anexplanation is provided for the immense liquidity and popularityof markets in stock index futures. Implications are also developedfor the effect of the introduction of a basket on market liquidityand the informativeness and variability of component securityprices, and for the price relationship between the basket andits underlying portfolio.