The Market Liquidty of Diamonds, Qubes, and Their Underlying Stocks

Abstract

We investigate the market liquidity effects of the introduction of index-tracking stocks for the Dow Jones Industrial Average (DIAMONDS) and the NASDAQ 100 index (QQQ). Consistent with the general predictions of recent theoretical models, we find the two baskets have significantly lower liquidity costs over the first 50 days of trading than the portfolios of component stocks, primarily because of lower adverse selection costs. Further, our results show that even the liquidity of component stocks improves after the introduction of basket trading, again largely because of a decline in the cost of informed trading. Finally, the introduction of these baskets is followed by an increase in the volume and open interest of DJIA and NASDAQ 100 index futures contracts. Thus, we find the advent of portfolio trading generally improves the market liquidity of all assets.

Keywords: Liquidity market microstructure index portfolio

JEL Classification: G10