A Dynamic Equilibrium Model of ETFs

Semyon Malamud
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Semyon Malamud: Ecole Polytechnique Federale de Lausanne and Swiss Finance Institute

No 15-37, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: I develop a dynamic general equilibrium model of exchange traded funds (ETFs) that accounts for the two-tier ETF market structure with both a centralized exchange (secondary market) and a creation/redemption mechanism (primary market) operating through market-making firms known as Authorized Participants (APs). The model is tractable and allows for any number of ETFs and basket securities. I show that the creation/redemption mechanism serves as a shock propagation channel through which temporary demand shocks may have long-lasting impacts on future prices. In particular, they may lead to a momentum in asset returns and a persistent ETF pricing gap. Improving liquidity in the primary market stimulates creation/redemption and therefore strengthens the shock propagation channel. As a result, it may amplify the volatility of both the underlying assets and the ETF pricing gap. At the same time, introducing new ETFs may reduce both the volatility and co-movement in the returns and may improve the liquidity of the underlying securities.

Keywords: exchange-traded funds; liquidity; volatility; co-movement; mis-pricing (search for similar items in EconPapers)
Pages: 74 pages
Date: 2015-09
New Economics Papers: this item is included in nep-dge
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Citations: View citations in EconPapers (13)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1537

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