Does Index Arbitrage Distort the Market Reaction to Shocks?

CERGE-EI Working Paper Series No. 651

50 Pages Posted: 5 Mar 2020

See all articles by Stanislav Anatolyev

Stanislav Anatolyev

New Economic School; CERGE-EI

Sergei Seleznev

INECO Capital Ltd

Veronika Selezneva

Charles University in Prague - CERGE-EI (Center for Economic Research and Graduate Education - Economics Institute)

Date Written: February 4, 2020

Abstract

We show that ETF arbitrage distorts the market reaction to fundamental shocks. We confirm this hypothesis by creating a new measure of the intensity of arbitrage transactions at the individual stock level and using an event study analysis to estimate the market reaction to economic shocks. Our measure of the intensity of arbitrage is the probability of simultaneous trading of ETF shares with shares of underlying stocks estimated using high frequency data. Our approach is direct, and it accounts for statistical arbitrage, passive investment strategies, and netting of arbitrage positions over the day, which the existing measures cannot do. We conduct several empirical tests, including the use of a quasi-natural experiment, to confirm that our measure captures fluctuations in the intensity of arbitrage transactions. We focus on oil shocks because they contain a large idiosyncratic component which facilitates identification of our mechanism and interpretation of the results. Oil shocks are identified using weekly oil inventory announcements.

Keywords: high-frequency data, stock market, ETF, arbitrage intensity, oil shock, market efficiency

JEL Classification: G12, G14, G23, Q43

Suggested Citation

Anatolyev, Stanislav and Seleznev, Sergei and Selezneva, Veronika, Does Index Arbitrage Distort the Market Reaction to Shocks? (February 4, 2020). CERGE-EI Working Paper Series No. 651, Available at SSRN: https://ssrn.com/abstract=3531658 or http://dx.doi.org/10.2139/ssrn.3531658

Stanislav Anatolyev (Contact Author)

New Economic School ( email )

Skolkovskoe shosse, 45
Moscow, 121353
Russia

CERGE-EI ( email )

P.O. Box 882
7 Politickych veznu
Prague 1, 111 21
Czech Republic

Sergei Seleznev

INECO Capital Ltd ( email )

Cyprus

Veronika Selezneva

Charles University in Prague - CERGE-EI (Center for Economic Research and Graduate Education - Economics Institute) ( email )

P.O. Box 882
7 Politickych veznu
Prague 1, 111 21
Czech Republic

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