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Exchange-traded funds, liquidity and volatility

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  • Timothy Krause
  • Sina Ehsani
  • Donald Lien

Abstract

Given the exponential growth in exchange-traded fund (ETF) trading, ETFs have become a significant factor in the volatility generating process of their largest component stocks. A simple model of trading is developed for securities that are included in ETFs, and empirical support is provided for the model hypotheses. Volatility spillovers from ETFs to their largest component stocks are economically significant. These spillovers are increasing in liquidity, the proportion of each stock held by the fund, deviations from net asset value, ETF flow of funds and ETF market capitalization. The results are consistent with a positive volume-volatility relation and trading-based explanations of volatility, and are generally stronger for smaller stocks.

Suggested Citation

  • Timothy Krause & Sina Ehsani & Donald Lien, 2014. "Exchange-traded funds, liquidity and volatility," Applied Financial Economics, Taylor & Francis Journals, vol. 24(24), pages 1617-1630, December.
    • Handle: RePEc:taf:apfiec:v:24:y:2014:i:24:p:1617-1630
    DOI: 10.1080/09603107.2014.941530
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    References listed on IDEAS

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    1. Francis X. Diebold & Kamil Yilmaz, 2009. "Measuring Financial Asset Return and Volatility Spillovers, with Application to Global Equity Markets," Economic Journal, Royal Economic Society, vol. 119(534), pages 158-171, January.
    2. Christopher P. Clifford & Jon A. Fulkerson & Bradford D. Jordan, 2014. "What Drives ETF Flows?," The Financial Review, Eastern Finance Association, vol. 49(3), pages 619-642, August.
    3. Itzhak Ben‐David & Francesco Franzoni & Rabih Moussawi, 2018. "Do ETFs Increase Volatility?," Journal of Finance, American Finance Association, vol. 73(6), pages 2471-2535, December.
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    Citations

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    Cited by:

    1. Yang Liu & Yongchen Zhao, 2024. "Liquidity Spillover between Exchange-Traded Funds: Variations across News Regimes," JRFM, MDPI, vol. 17(9), pages 1-18, September.
    2. Hua Wang & Liao Xu, 2019. "Do exchange‐traded fund flows increase the volatility of the underlying index? Evidence from the emerging market in China," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 58(5), pages 1525-1548, March.
    3. Chang, Shu-Lien & Lee, Yun-Huan, 2019. "Returns spillovers between tourism ETFs," The North American Journal of Economics and Finance, Elsevier, vol. 50(C).
    4. Zura Kakushadze & Willie Yu, 2021. "ETF Risk Models," Papers 2110.07138, arXiv.org.
    5. Mike Buckle & Jing Chen & Qian Guo & Xiaoxi Li, 2019. "The impact of multilateral trading facilities on price discovery: Further evidence from the European markets," Financial Markets, Institutions & Instruments, John Wiley & Sons, vol. 28(4), pages 321-343, November.
    6. Xu, Liao & Yin, Xiangkang, 2017. "Does ETF trading affect the efficiency of the underlying index?," International Review of Financial Analysis, Elsevier, vol. 51(C), pages 82-101.
    7. Mitra, Sovan & Raju Chinthalapati, V.L. & Clark, Ephraim & McGroarty, Frank, 2019. "Stock-ADR Arbitrage: Microstructure Risk," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 63(C).
    8. Marszk, Adam & Lechman, Ewa, 2021. "Reshaping financial systems: The role of ICT in the diffusion of financial innovations – Recent evidence from European countries," Technological Forecasting and Social Change, Elsevier, vol. 167(C).
    9. Rhodes, Meredith E. & Mason, Joseph R., 2023. "ETF ownership and firm-specific information in corporate bond returns," Journal of Financial Markets, Elsevier, vol. 63(C).
    10. Luca J. Liebi, 2020. "The effect of ETFs on financial markets: a literature review," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 34(2), pages 165-178, June.
    11. Lawrence Glosten & Suresh Nallareddy & Yuan Zou, 2021. "ETF Activity and Informational Efficiency of Underlying Securities," Management Science, INFORMS, vol. 67(1), pages 22-47, January.
    12. Xin Guan & Takanobu Mizuta & Isao Yagi, 2024. "Impact of arbitrage trading between an ETF and its underlying assets on market liquidity of their markets using an agent-based simulation," Journal of Computational Social Science, Springer, vol. 7(3), pages 2839-2870, December.
    13. Son, D. Pham & Marshall, Ben R. & Nguyen, Nhut H. & Visaltanachoti, Nuttawat, 2023. "Liquidity spillover between ETFs and their constituents," International Review of Economics & Finance, Elsevier, vol. 88(C), pages 723-747.
    14. Itzhak Ben-David & Francesco A. Franzoni & Rabih Moussawi, 2016. "Exchange Traded Funds (ETFs)," Swiss Finance Institute Research Paper Series 16-64, Swiss Finance Institute.
    15. Tang, Lu & Tan, Eric K.M. & Low, Rand, 2024. "Complements or substitutes? The effect of ETFs on other managed funds," International Review of Financial Analysis, Elsevier, vol. 95(PB).
    16. Xu, Liao & Gao, Han & Shi, Yukun & Zhao, Yang, 2020. "The heterogeneous volume-volatility relations in the exchange-traded fund market: Evidence from China," Economic Modelling, Elsevier, vol. 85(C), pages 400-408.
    17. Zura Kakushadze & Willie Yu, 2022. "ETF Risk Models," Bulletin of Applied Economics, Risk Market Journals, vol. 9(1), pages 1-17.
    18. Cheng Jiang & Kose John & David Larsen, 2021. "R&D investment intensity and jump volatility of stock price," Review of Quantitative Finance and Accounting, Springer, vol. 57(1), pages 235-277, July.
    19. Leung, David Wing Yu & Wong, Joe Ho-Yeung & Fong, Tom Pak-Wing, 2024. "Run risks of cash-redeemable ETFs," Pacific-Basin Finance Journal, Elsevier, vol. 85(C).
    20. Doron Israeli & Charles M. C. Lee & Suhas A. Sridharan, 2017. "Is there a dark side to exchange traded funds? An information perspective," Review of Accounting Studies, Springer, vol. 22(3), pages 1048-1083, September.
    21. Chen, Wei-Peng & Ling Lin, Shu & Lu, Jun & Wu, Chih-Chiang, 2018. "The impact of funding liquidity on market quality," The North American Journal of Economics and Finance, Elsevier, vol. 44(C), pages 153-166.

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