Index Design: Hedging and Manipulation

38 Pages Posted: 6 Apr 2021 Last revised: 8 Apr 2021

See all articles by Robert Jarrow

Robert Jarrow

Cornell SC Johnson College of Business

Siguang Li

Cornell University, Dept. of Economics

Date Written: January 27, 2021

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

Suggested Citation

Jarrow, Robert and Li, Siguang, Index Design: Hedging and Manipulation (January 27, 2021). Available at SSRN: https://ssrn.com/abstract=3819072 or http://dx.doi.org/10.2139/ssrn.3819072

Robert Jarrow

Cornell SC Johnson College of Business

Ithaca, NY 14850
United States

Siguang Li (Contact Author)

Cornell University, Dept. of Economics ( email )

404 Uris Hall
Ithaca, NY Tompkins 14853
United States

HOME PAGE: http://www.siguangli.com

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