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ETFs, Arbitrage, and Contagion

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  • Ben-David, Itzhak

    (OH State University)

  • Franzoni, Francesco

    (Swiss Finance Institute and University of Lugano)

  • Moussawi, Rabih

    (University of PA)

Abstract

Recent literature suggests that trading by institutional investors may affect the first and second moments of returns. Elaborating on this intuition, we conjecture that arbitrageurs can propagate liquidity shocks between related markets. The paper provides evidence in this direction by studying Exchange Traded Funds (ETFs), an asset class that has gained paramount importance in recent years. We report that arbitrage activity occurs between ETFs and the underlying assets. Then, we show that ETFs increase the volatility of the underlying assets, and that the prices of the underlying assets are affected by shocks to ETFs. Finally, we present findings consistent with the idea that ETFs served as a conduit for shock propagation between the futures market and the equity market during the Flash Crash on May 6, 2010. Overall, our results suggest that arbitrage activity may induce contagion.

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Bibliographic Info

Paper provided by Ohio State University, Charles A. Dice Center for Research in Financial Economics in its series Working Paper Series with number 2011-20.

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Date of creation: Dec 2011
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Handle: RePEc:ecl:ohidic:2011-20

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  1. Cristina Cella & Andrew Ellul & Mariassunta Giannetti, . "Investors’ Horizons and the Amplification of Market Shocks," FMG Discussion Papers dp717, Financial Markets Group.
  2. Jeffrey Wurgler, 2010. "On the Economic Consequences of Index-Linked Investing," NBER Working Papers 16376, National Bureau of Economic Research, Inc.
  3. Coval, Joshua & Stafford, Erik, 2007. "Asset fire sales (and purchases) in equity markets," Journal of Financial Economics, Elsevier, vol. 86(2), pages 479-512, November.
  4. Allaudeen Hameed & Wenjin Kang & S. Viswanathan, 2010. "Stock Market Declines and Liquidity," Journal of Finance, American Finance Association, vol. 65(1), pages 257-293, 02.
  5. Basak, Suleyman & Pavlova, Anna, 2012. "Asset Prices and Institutional Investors," CEPR Discussion Papers 9120, C.E.P.R. Discussion Papers.
  6. Dimitri Vayanos & Denis Gromb, 2010. "Limits of Arbitrage: The State of the Theory," FMG Discussion Papers dp650, Financial Markets Group.
  7. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
  8. Greenwood, Robin & Thesmar, David, 2011. "Stock price fragility," Journal of Financial Economics, Elsevier, vol. 102(3), pages 471-490.
  9. Scott W. Barnhart & Stuart Rosenstein, 2010. "Exchange-Traded Fund Introductions and Closed-End Fund Discounts and Volume," The Financial Review, Eastern Finance Association, vol. 45(4), pages 973-994, November.
  10. Pontiff, Jeffrey, 2006. "Costly arbitrage and the myth of idiosyncratic risk," Journal of Accounting and Economics, Elsevier, vol. 42(1-2), pages 35-52, October.
  11. Cespa, Giovanni & Foucault, Thierry, 2011. "Learning from Prices, Liquidity Spillovers, and Market Segmentation," CEPR Discussion Papers 8350, C.E.P.R. Discussion Papers.
  12. Lee, Charles M C & Ready, Mark J, 1991. " Inferring Trade Direction from Intraday Data," Journal of Finance, American Finance Association, vol. 46(2), pages 733-46, June.
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