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Una de las fallas del modelo Black-Scholes de valoración es asumir que las actividades de negociación de los agentes no tienen efecto sobre los precios, supuesto que solo puede cumplirse en mercados perfectamente líquidos, lo que hace que el modelo sea muy restrictivo. Este elemento ya ha sido considerado en algunos trabajos que incorporan el efecto de las actividades de negociación de los agentes asumiendo un proceso continuo para la dinámica de los precios, sin embargo, los mercados financieros muestran que una mejor descripción de la dinámica de los precios de activos riesgosos debe incorporar saltos aleatorios. La contribución de este documento es considerar el problema de la valoración de derivados en mercados ilíquidos en donde el precio del activo subyacente sigue un proceso de difusión con saltos. Se presenta la ecuación diferencial parcial no lineal de valoración correspondiente y se describe la estrategia de negociación que minimiza la varianza de la cobertura. One failure of the Black-Scholes valuation model is to assume that the trading activities of agents have no effect on prices, an assumption that it can only be fulfilled in perfectly liquid markets, making the model very restrictive. This element has already been considered in some studies that incorporate the effect of agents’ trading activities assuming a continuous process for price dynamics, however, financial markets show that a better description of the price dynamics of Risky assets must incorporate random jumps. The contribution of this document is to consider the problem of the valuation of derivatives in illiquid markets where the price of the underlying asset follows a diffusion process with jumps. The corresponding non-linear partial differential equation of valuation is presented and the trading strategy that minimizes the variance of the hedge is described.

We examine persistence and cross-market liquidity spillovers in the Chicago Mercantile Exchange soybean complex futures markets. A multidimensional liquidity measure is derived from the limit-order-book, and a Vector Heterogeneous Autoregressive model estimates high-resoluted liquidity from 30 s to one trading day. We find traders' order placement influenced by the liquidity of related markets. Liquidity persistence and positive liquidity spillovers mainly occur within 30 s, whereas spillovers for longer horizons are mostly negative. Findings are important for hedgers that hedge the crush and traders who wish to capitalize on the short-term deviation of price relationships.

Conservatism in the CAPM and L-CAPM standards often emphasizes systematic risk to explain the phenomenon of the risk-return relationship and ignores idiosyncratic risk with the assumption that the risk can be diversified. The effect of the Covid-19 outbreak raises the question of whether the idiosyncratic risk can still be ignored considering that the risk has a close relationship to firm-specific risk. This study sets a portfolio consisting of 177 active public firms in the Indonesia Stock Exchange before and after the Covid-19 pandemic. On portfolio set, idiosyncratic risk is estimated by the standard CAPM and L-CAPM in the observation range from January 2, 2019, to June 30, 2021. The results of the analysis show that L-CAPM and CAPM produce significantly different idiosyncratic risks. Empirical evidence shows that the highest firm-specific risk is in the third period and has a stable condition since the fourth period. This condition is confirmed by regression results that idiosyncratic risk together with systematic risk positively affects stock returns in the fourth period as suggested by the efficient market hypothesis. Uniquely, both systematic risk and idiosyncratic risk based on L-CAPM do not show a significant effect on stock returns in the fifth period, so it is a strong indication that liquidity is an important factor that must be considered in making investments. © Winston Pontoh, Novi Swandari Budiarso, 2021

Elevated government debt in the wake of unprecedented stimulus packages increasingly raise concerns about a looming return of inflation, as governments may be tempted to monetize debt. In this paper, we examine optimal debt management in the presence of inflation concerns in a setting where i) the government can issue long-term nominal and real (TIPS) bonds, ii) the monetary authority sets short-term interest rates according to a Taylor rule, and iii) inflation has real costs as prices are sticky. Nominal debt can be inflated away, but bond prices reflect elevated inflation expectations. Real bond prices are higher, but such debt constitutes a real commitment ex post. We show that the optimal government debt portfolio includes a substantial allocation to real bonds, which lowers inflation levels, inflation volatility, and inflation persistence in equilibrium. The associated lower inflation risk premia are reflected in welfare gains through real debt management. Quantitatively, our results are stronger i) the higher the initial debt level, and ii) the longer debt maturity. Our results hold up when accounting for frictions in the TIPS market, such as illiquidity. Our findings suggest that TIPS should be an important tool for debt management in the presence of looming inflation.

The Fama-French (FF) five-factor model is cast into a dynamic setting to capture the impact of illiquidity over the phases of the business cycle on the returns of the passive FF twelve sector portfolios. We use two dynamic approaches, Kalman filtering and a recursive/rolling robust instrumental variables (IV) algorithm cast into a GMM framework, to determine time-varying alpha and beta estimates. Our principal result is that the Kalman filter approach supports the hypothesis that illiquidity is an important risk factor in a dynamic context. However, the only factor found to matter in the dynamic GMM approach is the market risk premium. Nevertheless, illiquidity may be prescient with respect to financial crises. Keywords: Illiquidity, Fama-French five-factor model, Kalman filter, Robust IV algorithm, JEL Classification: C58, G12

Underlying idiosyncratic and illiquidity risks are suppressed in infrequently reported indexes of house prices and rents. Idiosyncratic risks result from bid–ask spreads for prices and rents. Time series autocovariances generate a distribution of prices and rents. Capital gains and rent-price ratios are transforms of these distributions, generating cross-sectional idiosyncratic volatility. Housing data are infrequent and usually made available every month. The monthly–quarterly volatility ratios of house prices and rents and their spreads estimate unobserved daily fluctuations and illiquidity risks. Including idiosyncratic and illiquidity risks, a U.S. house has a standard deviation in returns of 8.7% annually for three decades after 1990. With a mean excess return of 3.7%, the Sharpe ratio of 0.42 is comparable to the S&P 500. Excluding spreads, the house Sharpe ratio is 0.69. House returns respond to liquidity. A 1% increase in volume raises returns by 0.8%.

This study investigates the structural relationship between illiquidity and ex-ante returns in the German stock market over time. In line with other authors, we show that illiquidity is still a significant factor, but has had a weakened impact in more recent times. When considering structural breaks, illiquidity is not priced during times of financial turmoil, which explains the weakened relationship between illiquidity and returns in the recent past. Incorporating structural breaks in portfolio decisions results in significantly better portfolio returns explained by increasing illiquidity premia. The results are robust to different variations of Amihud’s illiquidity measures and when controlled for Fama-French factors.

The Covid-19 crisis is unique in several respects. This devastating recession does not have an economic origin, will dance largely to the tune of non-economic factors, and is truly global. The policy response has been equally unique, in terms of speed, size and scope, eliciting an unprecedented concerted effort combining monetary, fiscal and prudential policies. This has contained the fallout. At the time of writing, financial markets have rebounded to the point of looking exuberant, but it all feels more like a truce than a peace treaty. The crisis is transitioning from the liquidity to the solvency phase in a context of limited and shrinking room for policy manoeuvre. All this raises difficult near- and longer-term challenges. Rebuilding policy buffers in all policy areas is likely to be the policy challenge of the decade ahead.

The work is devoted to the elaboration and demonstration of a method for measuring the cost of illiquidity in the delta hedging of futures-style options on the Moscow Exchange. Illiquidity is usually measured per unit of asset or money. However, given the specifics of futures, this article proposes to use the total volume of the initial margin and the state of the limit order book. In this case, it becomes possible to compare the cost of illiquidity for various futures. The most liquid futures that are traded on the Moscow Exchange are analyzed and the cost of liquidity is compared.

We provide a theoretical rationale for dealer objections to ex post transparency in over-the-counter markets. Disclosure of the terms of a transaction conveys information possessed by the dealer about the asset quality and reduces the dealer’s rents when she disposes of the inventory in a second transaction. We show that costly signaling in a transparent market benefits investors through lower spreads and higher volume. Dealers may also gain from transparency despite lower spreads when potential gains from trade are small or adverse selection is high, because in those circumstances higher volume offsets smaller spreads for dealer profits.

Most recent studies on conference calls focus on the costs for firms that can arise from the calls' open nature. We study the benefits of conference calls and hypothesize that firms could use the balanced scorecard concept as a framework for presenting the information (i.e. balanced information composition) in conference calls to lower the cost of capital. Our results show a negative association between a more balanced information composition in conference calls and a firm's cost of capital. Additional tests substantiate that the effect of such a balanced information composition on the cost of capital is driven by a reduction in information asymmetry. Overall, the findings suggest that firms can benefit from the balanced scorecard concept by using it as a framework for preparing their conference calls.

This paper employs four established market microstructure measures on information-based trade in financial markets. A set of German mid and small caps is used to analyze potential differential information content in real estate stocks compared to other asset classes. After linking substantially lower amounts of information-based trade in real estate stocks to higher liquidity premia, it is found that the evolution of the information content in real estate and other assets follows similar trends. Consequently, interdependence is tested for rolling time windows, revealing strong informational links between real estate and other assets. Particularly, small caps, financials, as well as companies offering consumer goods and services show a close relationship to real estate. Depending on the choice of the measure of information-based trade, up to 75% of the variation in the information content in real estate shares is related to other asset classes, pointing to the notion of high dependence.

Market illiquidity and investor sentiment show a significant role in Malaysian capital market, the variation of average stock returns left unexplained by capital asset pricing model is covered effectively by illiquidity and sentiment risks. Our investor sentiment measure consists of six market proxies. This study tests pricing implications using Size, Liquidity and BM ranked portfolios. It finds that small and illiquid stocks are exposed more to sentiment risk. Illiquidity and sentiment factors jointly explain the variations explained by size and value effects. Furthermore, quantile regressions reveal an asymmetric influence of investor sentiment, a large (small) effect is observed on stocks with high (low) returns. A three factor model directed at capturing illiquidity and investor sentiment risks is apparently persuasive in this market.

This paper argues that in Euro-area economies, where the ECB cannot bail-out …nancially distressed governments, the …scal multiplier is adversely affected by the amount of public debt. A regression model on a panel of 26 EU countries over the period 1996-2011 shows that a 10 percentage point increase in the debt-to-GDP ratio is connected to a slowdown in annual growth rates of 0.28 percentage point. Furthermore, the e¤ectiveness of …scal spending is adversely affected by the amount of public debt; for a debt-to-GDP ratio above 150% the impact on growth of the …scal stimulus turns negative.

This paper contributes to the general understanding of how sovereign CDS prices are formed by studying the information content of pricing errors generated by a non-arbitrage model. We implement a price-discrepancy measure in the spirit of the noise measure introduced by Hu et al. (2013) in the Treasury Bond market, and analyze its main determinants in panel data analysis. The main results show that sovereign CDS pricing errors are systematically related to higher bid-ask spreads. The evidence in this paper also suggests that exits of capital arbitrage during distressed periods, as measured by changes in net offsetting, can be associated to larger pricing errors in sovereign CDS from advanced economies, thereby supporting the main claims of the limit-to-arbitrage theories. These findings are robust for the most common CDS pricing models employed in the industry and different estimation techniques. Antonio Rubia acknowledges financial support from the Spanish Ministry of Economy and Competitiveness (MEC) grant ECO2012-33619 and ECO2014-58434-P. Pedro Serrano acknowledges financial support from MEC grant ECO2012-34268 and from Junta de Andalucía project P12-SEJ-1733.

The new Insolvency Act sets down the presupposition identified with insolvency. The apparent conceptual homogeneity of such conceals a split associated with the mode in which proceedings are brought (involuntary and voluntary bankruptcy). This study explores the relationship between insolvency and its warning signs, highlighting the difficulty concerning probative evidence as well as the application of both notions for the interested parties and the judge. La nueva Ley Concursal impone formalmente la unidad de presupuesto objetivo, identificado con la insolvencia. Tras la aparente homogeneidad conceptual de dicho presupuesto se oculta un desdoblamiento ligado al modo de instar el procedimiento (concurso necesario y voluntario). El trabajo establece las relaciones entre la insolvencia y sus indicios reveladores, poniendo de relieve las dificultades probatorias y de aplicación de ambas nociones, tanto para los interesados como para el juez.

This paper investigates the risk-return relations in Chinese equity markets. Based on a TARCH-M model, evidence shows that stock returns are positively correlated with predictable volatility, supporting the risk-return relation in both aggregate and sectoral markets. Evidence finds a positive relation between stock return and intertemporal downside risk, while controlling for sentiment and liquidity. This study suggests that the U.S. stress risk or the world downside risk should be priced into the Chinese stocks. The paper concludes that the risk-return tradeoff is present in the GARCH-in-mean, local downside risk-return, and global risk-return relations.

‘Liquidity’ is highly significant to representations of the crisis that gripped financial markets from the summer of 2007. A wide-ranging ‘liquidity crisis’ is typically traced to the collapse of prices in markets for assets backed by or derived from the repayments of American subprime mortgagors, while public authorities are said to have responded by ‘restoring liquidity’ to markets in these now ‘distressed’ and ‘toxic assets’. Here the category of performativity is developed to enable a critical investigation of liquidity. The performance of liquidity in booming subprime markets is shown to have turned on the affirmation and exemplification of wider norms present in wholesale asset markets, and upon specific calculative and emotional valuations of risk through underwriting procedures, bond rating and hedging. However, the performance of liquidity contained its other, illiquidity, and this surfaced in subprime markets because asset prices symbolised risk valuations which could not capture incalculable future uncertainties. As the crisis broke, talk of liquidity and illiquidity licensed particular policy responses and closed down wider political debate.

The paper explores illiquidity of the Serbian financial market for the period of 2005-2009. The financial market in Serbia is, by its type, a frontier market. We used daily data from the BELEXline index, as well as all stocks within this index in examined timeframe, provided by the Belgrade Stock Exchange. Results of this paper suggest that level of market liquidity is low and persistent in Serbia. Additionally, results confirm that time-varying illiquidity and its volatility is highly unstable in this market. This is the first paper that analyses liquidity issues in case of Serbia. It identifies different periods and shows that, in most cases, ups and downs in foreign investors' participation leads to dramatic falls and rises in market illiquidity and its volatility.

This paper examines the impact of illiquidity and liquidity risk on expected asset returns in the Serbian stock market. For this market we estimate the conditional Liquidity-adjusted Capital Asset Pricing Model (LCAPM) of Acharya and Pedersen (2005). We use daily data for the period from 2005-2009. While the method developed is applicable in other markets this is the first paper that tests the LCAPM model in the case of Serbia. Liquidity risks are allowed to be timevarying. We find that for the Serbian market as a frontier market illiquidity and liquidity risk significantly impact price formation. For such a market the LCAPM may indeed be a good tool for realistic assessment of the expected asset returns.

This article analyzes the role of liquidity in the sovereign credit default swap (CDS) market. We employ a continuous-time specification to incorporate illiquidity as an additional pricing factor of default swap contracts for the most developed economies. The illiquidity discount process is identified as compensation to investors for the risk of unwinding their positions when trading in the less liquid part of the curve, and the information about illiquidity is directly extracted from the term structure of sovereign CDS spreads. Our empirical findings reveal that a positive time-varying illiquidity premium is embedded in sovereign default swaps. These risk premia exhibit substantial comovement across countries. Only unidirectional causality from default to liquidity is detected for the overall market. We are exceptionally grateful to Jonatan Groba for his valuable comments and suggestions. J.A. Lafuente acknowledges financial support from the Spanish Ministry of Economy and Competitiveness through grant ECO2012-31941, the Generalitat Valenciana through grant PrometeoII/2013/015 and the University Jaume I through grant P1.1A2012-09. P. Serrano acknowl- edges financial support from the Spanish Ministry of Economy and Competitiveness through grant ECO2012-34268 and from Junta de Andalucía project P12-SEJ-1733.

We construct a monetary economy with heterogeneity in discounting and consumption risk. Agents can insure against this risk with money and nominal government bonds, but all trades must be monetary. We demonstrate that a deflationary policy a la Friedman cannot sustain the constrained-efficient allocation as no-arbitrage imposes too stringent a bound on the return money can pay. The constrained-efficient allocation can be sustained when bonds have positive yields and, under certain conditions, only if they are illiquid. Illiquidity, meaning that bonds cannot be transformed into consumption as easily as cash, is necessary to eliminate arbitrage opportunities due to disparities in shadow interest rates.

This article analyzes the role of liquidity in the sovereign credit default swap (CDS) market. We employ a continuous-time specification to incorporate illiquidity as an additional pricing factor of default swap contracts for the most developed economies. The illiquidity discount process is identified as compensation to investors for the risk of unwinding their positions when trading in the less liquid part of the curve, and the information about illiquidity is directly extracted from the term structure of sovereign CDS spreads. Our empirical findings reveal that a positive time-varying illiquidity premium is embedded in sovereign default swaps. These risk premia exhibit substantial comovement across countries. Only unidirectional causality from default toliquidity is detected for the overall market

We examine the financial conditions of dealers that participated in two of the Federal Reserve’s lender-of-last-resort (LOLR) facilities--the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF)--that provided liquidity against a range of assets during 2008-09. Dealers with lower equity returns and greater leverage prior to borrowing from the facilities were more likely to participate in the programs, borrow more, and--in the case of the TSLF--at higher bidding rates. Dealers with less liquid collateral on their balance sheets before the facilities were introduced also tended to borrow more. There also appear to be some interaction effects between financial performance and balance sheet liquidity in explaining dealer behavior. The results suggest that both financial performance and balance sheet liquidity play a role in LOLR utilization.

I show theoretically and empirically that cash holdings can help rationalize the low returns to distressed equity. In my model, levered firms with financing constraints optimally choose their cash holdings to eliminate liquidity risk and optimally default when insolvent. Using data on solvency, liquidity, and returns for US firms, I find evidence consistent with the model’s predictions: (1) In all solvency levels, the average firm holds enough liquid assets to cover its short-term liabilities; less solvent firms have (2) a higher fraction of their total assets in liquid assets and therefore (3) lower conditional betas and (4) lower returns; (5) the profits of long-short solvency strategies are highest among firms with low liquidity; and (6) the profits of long-short liquidity strategies are highest among firms with low solvency.

This article analyzes the role of liquidity in the sovereign credit default swap (CDS) market. We employ a continuous-time specification to incorporate illiquidity as an additional pricing factor of default swap contracts for the most developed economies. The illiquidity discount process is identified as compensation to investors for the risk of unwinding their positions when trading in the less liquid part of the curve, and the information about illiquidity is directly extracted from the term structure of sovereign CDS spreads. Our empirical findings reveal that a positive time-varying illiquidity premium is embedded in sovereign default swaps. These risk premia exhibit substantial comovement across countries. Only unidirectional causality from default toliquidity is detected for the overall market J. Groba acknowledges financial support from the Spanish Government project ECO2011-28134. J.A. Lafuente acknowledges financial support from the Ramon Areces Foundation, the Spanish Ministry of Education through grant ECO2012-31941, the Generalitat Valenciana through grant Prometeo II/2013/015 and the University Jaume I through grant P1.1A2012-09. P. Serrano acknowledges financial support from the Ministry of Economics and Competitiveness through grant ECO2012-34268

This paper examines the effect of return dispersion on the dynamics of stock market liquidity, risk and return. Moreover, the importance of return dispersion in forecasting aggregate economic activity is rediscovered in the context of a regime switching model that accounts for stock market fluctuations and their association with the state of the economy. We find that there is a bidirectional, Granger-causal association between illiquidity and return dispersion in the U.S. stock market. The empirical results show that stock returns can help us predict both realized volatility as well as return dispersion. We report that there is a significant relation between economic conditions and the risk measures (return dispersion and realized volatility).

While the global financial crisis was centered in the United States, it led to a surprising appreciation in the dollar, suggesting global dollar illiquidity. In response, the Federal Reserve partnered with other central banks to inject dollars into the international financial system. Empirical studies of the success of these efforts have yielded mixed results, in part because their timing is likely to be endogenous. In this paper, we examine the cross-sectional impact of these interventions. Theory consistent with dollar appreciation in the crisis suggests that their impact should be greater for countries that have greater exposure to the United States through trade and financial channels, less transparent holdings of dollar assets, and greater illiquidity difficulties. We examine these predictions for observed cross-sectional changes in CDS spreads, using a new proxy for innovations in perceived changes in sovereign risk based upon Google-search data. We find robust evidence that auctions of dollar assets by foreign central banks disproportionately benefited countries that were more exposed to the United States through either trade linkages or asset exposure. We obtain weaker results for differences in asset transparency or illiquidity. However, several of the important announcements concerning the international swap programs disproportionately benefited countries exhibiting greater asset opaqueness.

A lack of commonly accepted benchmarks for hedge fund performance has permitted hedge fund managers to attribute to skill returns that may actually accrue from market risk factors and illiquidity. Recent innovations in hedge fund replication permits us to estimate the extent of this misattribution. Using an option-based model, we find evidence that the value of liquidity options that investors implicitly grant managers when they invest may account for part or even all hedge fund returns. Coupled with the competition from hedge fund replication vehicles, this finding may motivate hedge fund investors to demand less restrictive investment terms in the future.

Fire sales that occur during crises beg the question of why sufficient outside capital does not move in quickly to take advantage of fire sales, or in other words, why outside capital is so slow-moving. We propose an answer to this puzzle in the context of an equilibrium model of capital allocation. Keeping capital in liquid form in anticipation of possible fire sales entails costs in terms of foregone profitable investments. Set against this, those same profitable investments are rendered illiquid in future due to agency problems embedded with expertise. We show that a robust consequence of this trade-off between making investments today and waiting for arbitrage opportunities in future is the combination of occasional fire sales and limited stand-by capital that moves in only if fire-sale discounts are sufficiently deep. An extension of our model to several types of investments gives rise to a novel channel for contagion where sufficiently adverse shocks to one type can induce fire sales in other types that are fundamentally unrelated, provided arbitrage activity in these investments is sourced from a common pool of capital.

This paper studies how financial development affects the relation between average growth and growth volatility through liquidity crises. We .first establish in a micro model that imperfect enforceability creates a short term bias in contracts financing long term investments. This can generate maturity mismatches between firms' assets and liabilities and lead to liquidity crises. Then with this mechanism, we show in a macro framework that the relation between average growth and growth volatility is more likely to be negative in developing countries, but more likely to be positive in developed economies. Finally we provide empirical evidence which supports the prediction of the model.

This paper utilizes a very simple model to study the timing and determinants of speculationagainst a fixed exchange rate regime when investors are heterogeneous because of locationaldifferences. Location matters because resident players may incur smaller costs when takinga short-position, are less exposed to exchange rate risk, possess better information quality,have more knowledge about each others information sets, due to asymmetries in tax treatment,or because of the presence of government guarantees. Our model clarifies the respective rolesplayed by local and international investors during episodes of capital flight as well as theresulting room of maneuver for policymakers in emerging markets.

This paper aims to empirically investigate holding periods, illiquidity and disposition effect in Karachi Stock Exchange (KSE). KSE 100 Index Companies daily data were collected for a period of five year i.e. 2003-2007. Daily returns, holding periods, illiquidity and volatility were calculated through this data. These variables were regressed in models used by Visaltanachoti et al. (2007) to calculate annual holding periods, illiquidity and disposition effect. The results have revealed that there exists disposition effect in KSE. Holding periods were found positively related to illiquidity and negatively associated with stock returns. Further, holding periods were long for illiquid stocks and short for less illiquid stocks. The study is significant in the sense that it’s perhaps the first study conducted in a developing country like Pakistan.

We investigate the cross-sectional variation in the credit default swap (CDS)-bond bases and test explanations for the violation of the arbitrage relation between cash bond and CDS contract, which states that the basis should be zero in normal conditions. The evidence is consistent with "limits to arbitrage" theories in that deviations are larger for bonds with higher frictions as measured by trading liquidity, funding cost, counterparty risk, and collateral quality. Surprisingly, we find the basis to be more negative when bond lending fee is higher suggesting that arbitrageurs are unwilling to engage in a negative basis trade when short interest on the bond is high.

In this paper, the results of an investigation into the relationship between the illiquidity and realized volatility of the time series of stocks listed on the Warsaw Stock Exchange (WSE) and Vienna Stock Exchange (VSE) are presented. The first measure of illiquidity is the well-known Amihud ratio (Amihud, 2002) called AMI, and the second is a transformation of the Liquidity Index (Danyliv et al., 2014) called ILLIX. In the study, the results of the detection of the structural breaks (and their removal), the calculation of long memory, and finally the dependence structure of the illiquidity and realized volatility by the copulas are also demonstrated. Both types of series exhibit structural breaks and long-memory properties. Despite the similarities in the illiquidity measures, their associations with the realized volatility is different. The dependence structures described by the copulas for the AMI-realized volatility pairs show a dependence in the upper tails; i.e., the high values of illiquidity are related to the high volatility. However, in the case of the ILLIX-realized volatility pairs, the dependence was detected in the lower tail; i.e., the low ILLIX is accompanied by the low realized volatility.

We develop a model of illiquidity transmission from spot to futures markets that formalizes the derivative hedge theory of Cho and Engle (1999). The model shows that spot market illiquidity does not translate one to one to the futures market but, rather, interacts with price risk, liquidity risk, and the risk aversion of the market maker. The model's predictions are tested empirically with data from the stock market and markets for single-stock futures and index futures. The results support our model and show that the derivative hedge theory provides an explanation for the liquidity link between spot and futures markets. Revised Version