ETFs, Arbitrage, and Shock Propagation

Abstract:     
We study whether exchange traded funds (ETFs)—an asset of increasing importance—can amplify the exposure of the securities in their baskets to liquidity shocks. As a preliminary step, we show that ETFs are catalysts for high turnover investors who are, arguably, an important source of liquidity shocks. Then we show that arbitrage trades propagate the liquidity shocks from ETF prices to the underlying securities. Supporting the claim that ETFs add a layer of shocks to their basket securities, the presence of ETFs is associated with an increase in the volatility of the stocks they hold. Finally, as a case study in shock propagation through ETF arbitrage, we provide results suggesting that ETFs facilitated shock transmission between the futures market and the equity market during the Flash Crash of May 6, 2010. Overall, our results highlight the role of financial innovation in increasing non-fundamental volatility and in propagating shocks across markets, especially in association with high frequency trading.

Number of Pages in PDF File: 73

Keywords: Flash Crash, contagion, ETF, stocks, arbitrage, mispricing, overvaluation, undervaluation, volatility, excess returns, price, cross market contagion, arbitrageurs

JEL Classification: G01, G12, G14, G17

working papers series