The International Journal of Banking and Finance, Volume 9 (Number 2), 2012: pages 26-43 26 THE IMPACT OF UNDERLYING MARKET CLOSURE ON FUTURES MARKET LIQUIDITY: EVIDENCE FROM CHINA Wang Chun Wei and Alex Frino University of Sydney, Australia ___________________________________________________________ Abstract This study investigates the trading activity of Chinese stock index futures, recently introduced at the open and close of the underlying trading. We document the impact of the underlying spot on the futures market liquidity as well as volatility as discussed in earlier works on market closure theory. Our empirical results support previous literature on the impact of the underlying, particularly during the open session, as a contagion effect, which is clearly at play. We find significant U-shaped patterns in liquidity factors and intraday volatility during open and close trades in the morning. Key Words: Market microstructure, Market closure theory, Liquidity, Chinese futures market JEL Classification: G14, G15 ___________________________________________________________ 1. Introduction Chang et al. (1995) argue that the price linkage between derivatives and cash implies that the closure of the underlying cash market, the spot, is likely to have a profound impact of the trading of a derivative. This impact on derivative trading is explained using King and Wadhwani’s (1990) contagion model, which suggests that price behaviour in one market affects the behaviour in related markets as traders can draw inferences from multiple markets. More precisely, we suggest information transfer from spot equities market to futures market. This information transfer would however be disrupted, when the underlying market closes and therefore trading behaviour in the derivative market would be clearly affected. Early attempts to understand the effects of market closure effect focus primarily on intraday volatility measures. Chang et al. (1995) examine intraday volatility and price changes of the S&P 500 futures traded on the CME at around NYSE (i.e. underlying market) closure times. Their research was possible due to the continuation of the futures contract for