It is demonstrated that markets in stock index futures or, more
generally, in baskets of securities, provide a preferred trading medium
for uninformed liquidity traders who wish to trade portfolios, because
adverse selection costs are typically lower in these markets than in
markets for individual securities. Thus, an explanation is provided for
the immense liquidity and popularity of markets in stock index futures.
Implications are also developed for the effect of the introduction of a
basket on market liquidity and the informativeness and variability of
component security prices, and for the price relationship between the
basket and its underlying portfolio. Article published by Oxford University Press on behalf of the Society for Financial Studies
in its journal, The Review of Financial Studies.