Does index arbitrage distort the market reaction to shocks?

0521171 - NHÚ 2020 RIV CZ eng V - Research Report
Anatolyev, Stanislav - Seleznev, S. - Selezneva, Veronika
Does index arbitrage distort the market reaction to shocks?.
Prague: CERGE-EI, 2019. 47 s. CERGE-EI Working Paper Series, 651. ISSN 1211-3298
Institutional support: RVO:67985998
Keywords : high-frequency data * stock market * ETF
OECD category: Applied Economics, Econometrics
https://www.cerge-ei.cz/pdf/wp/Wp651.pdf

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.

Permanent Link: http://hdl.handle.net/11104/0305809