A Dynamic Equilibrium Model of ETFs

100 Pages Posted: 30 Aug 2016

See all articles by Semyon Malamud

Semyon Malamud

Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Multiple version iconThere are 3 versions of this paper

Date Written: August 2016

Abstract

I develop a dynamic general equilibrium model of exchange traded funds (ETFs) that accounts for the two-tier ETF market structure with both a centralized exchange (secondary market) and a creation/redemption mechanism (primary market) operating through market-making firms known as Authorized Participants (APs). The model is tractable and allows for any number of ETFs and basket securities. I show that the creation/redemption mechanism serves as a shock propagation channel through which temporary demand shocks may have long-lasting impacts on future prices. In particular, they may lead to a momentum in asset returns and a persistent ETF pricing gap. Improving liquidity in the primary market stimulates creation/redemption and therefore strengthens the shock propagation channel. As a result, it may amplify the volatility of both the underlying assets and the ETF pricing gap. At the same time, introducing new ETFs may reduce both the volatility and co-movement in the returns and may improve the liquidity of the underlying securities.

Keywords: exchange traded funds, Limits to Arbitrage, liquidity

JEL Classification: G10, G12, G23

Suggested Citation

Malamud, Semyon, A Dynamic Equilibrium Model of ETFs (August 2016). CEPR Discussion Paper No. DP11469, Available at SSRN: https://ssrn.com/abstract=2831973

Semyon Malamud (Contact Author)

Ecole Polytechnique Federale de Lausanne ( email )

Lausanne, 1015
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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