Liquidity supply and volatility: Futures market evidence

This article examines the provision of liquidity in futures markets as pric e volatility changes. We find that customer trading costs do not increase w ith volatility. However, for three of the four contracts studied, the natur e of liquidity supply changes with volatility. Specifically, For relatively inactive contracts, customers as a group trade more with each other and le ss with market makers, on higher volatility days. By contrast, for the most active contract, trading between customers and market makers increases wit h volatility. We also find that market makers' income per contract decrease s with volatility for one of the least active contracts in our sample, but is not significantly affected by volatility for the other contracts. These results are consistent with the idea that, for high-cost, inactive contract s, market makers react to temporary increases in volatility by raising thei r bid-ask spreads significantly, and customers provide increased liquidity through standing limit orders. An implication of our results is that electr onic systems, where market maker participation is not required, are able to supply adequate liquidity during volatile periods. (C) 2001 John Wiley & S ons, Inc.