ETFs, Arbitrage, and Contagion

Itzhak Ben-David, Francesco A. Franzoni, Rabih Moussawi
2011 Social Science Research Network  
We study arbitrage activity between Exchange Traded Funds (ETFs)-an asset class that has gained paramount importance in recent years-and their underlying securities. We show that shocks to ETF prices are passed up to the underlying securities via the arbitrage between the ETF and the underlying assets. As a result, the presence of ETFs increases the volatility of the underlying securities. Also, we present evidence consistent with the conjecture that ETFs contributed to shock propagation
more » ... propagation between the futures market and the equity market during the Flash Crash on May 6, 2010. Overall, our results suggest that arbitrage activity may induce contagion and that High Frequency Trading adds noise to market prices and can pose a threat to market stability. ____________________ We thank participants at seminars at SAC Capital Advisors, University of Lugano, University of Verona, and at the 4 th Paris Hedge Funds Conference for helpful comments and suggestions. Founded on the concept of limits-of-arbitrage, a number of recent studies argue that institutional trading can significantly affect the first and second moments of asset returns (see Gromb and Vayanos 2010 for a survey). On the theory side, asset pricing models have been developed that explicitly incorporate the impact of institutions on asset prices (e.g., Basak and Pavlova 2011, Vayanos and Wooley 2011). Empirically, there is plenty of evidence on the effect of institutional investors on expected returns (Shleifer 1986, Barberis, Shleifer, and Wurgler 2005, Coval and Stafford that arbitrageurs (as opposed to long-term institutional investors) adversely affect the quality prices due to their investment strategies, and lead to contagion across asset classes. Our paper studies empirically arbitrage activity between two similar assets, where arbitrageurs can transmit liquidity shocks across the securities that are part of their relative value strategies. As an example of the effects that we identify, consider a situation in which the price of an asset drops because of an exogenous non-fundamental decrease in demand. Arbitrageurs will buy this asset and sell a similar asset whose price has not changed. The selling activity, however, can lead to downward price pressure on the latter asset. As a result, the initial liquidity shock is propagated to the price of the second asset, which falls without a fundamental reason. In this sequence of events, arbitrageurs' activity induces contagion of liquidity shocks. This issue is especially relevant in the current financial environment. The explosion of new financial products has introduced arbitrage relations between the newly created assets and existing securities. If arbitrage activity can propagate shocks, one can expect faster transmission of liquidity shocks across assets that are part of these arbitrage relations. Ultimately, this channel can cause an increase in non-fundamental volatility in financial markets. This seems like an unintended consequence of arbitrage and a yet-unexplored outcome of financial innovation. 1 1 In the framework of rational expectations models, some authors have explored the possibility of contagion arising from investors that trade simultaneously in different markets. As in the case that we have in mind, Kodres and Pritsker (2002) model the propagation of liquidity shocks. However, in their model contagion results from portfolio rebalancing rather than arbitrage between correlated assets. In Pasquariello (2007) , contagion is the result of speculators trading in related assets, but the shocks that are propagated are fundamental. Cespa and Foucault (2012) provide the most fitting theoretical counterpart to our empirical analysis, as their model contemplates liquidity shock
doi:10.2139/ssrn.1967599 fatcat:fsumx6dgvvdrbnhzr2j5poggk4