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ETFs, Arbitrage, and Contagion

Author

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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

We study arbitrage activity between Exchange Traded Funds (ETFs)--an asset class that has gained paramount importance in recent years--and their underlying securities. We show that shocks to ETF prices are passed down to the underlying securities via the arbitrage between the ETF and the assets it tracks. As a result, the presence of ETFs increases the volatility of the underlying securities. Also, we find evidence consistent with the conjecture that ETFs contributed to 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 and that High Frequency Trading adds noise to market prices and can pose a threat to market stability.

Suggested Citation

  • Ben-David, Itzhak & Franzoni, Francesco & Moussawi, Rabih, 2011. "ETFs, Arbitrage, and Contagion," Working Paper Series 2011-20, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  • Handle: RePEc:ecl:ohidic:2011-20
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    References listed on IDEAS

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