Index Design: Hedging and Manipulation

Abstract

This paper studies optimal index design to both facilitate hedging and alleviate illegal manipulation in a competitive equilibrium paradigm, modified to deal with manipulation. Specifically, a large trader is trading both derivatives and stocks, and effectively hides her trades behind the competitive market clearing mechanism. Unlike the strategic game paradigm, a volume-weighted average pricing (VWAP) index both introduces basis risk and encourages manipulation because of the additional randomness in volume weight and the greater price impact enjoyed by the large trader. In contrast, an equal-weighted average pricing (EWAP) index both preserves market completeness and discourages manipulation.

Keywords: Index Design, Hedging, Index Manipulation, Hidden Trades, VWAP, EWAP, Competitive Equilibrium

JEL Classification: G12, G14, G18, D84