How Index Futures and ETFs Affect Stock Return Correlations
53 Pages Posted: 21 Jun 2015 Last revised: 24 Aug 2016
Date Written: April 24, 2016
We examine both theoretically and empirically whether increased trading activity in index futures and exchange traded funds (ETFs) is associated with higher equity return correlations. Our model predicts that demand shocks to ETFs and futures lead to stronger price comovement for index stocks and non-index stocks. Moreover, demand shocks to ETFs have a higher impact on stock return correlations than shocks to futures. We confirm the model predictions by studying the correlation of U.S. stocks after the inception of S&P 500 futures and ETFs. Furthermore, our empirical results suggest that the return comovement induced by index trading is excessive.
Keywords: Asset correlations, limits to arbitrage, ETFs, futures
JEL Classification: G01, G12, G13
Suggested Citation: Suggested Citation