Index Design: Hedging and Manipulation

Robert Jarrow () and Siguang Li
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Siguang Li: Department of Economics, Cornell University, Ithaca, NY14853, USA

Quarterly Journal of Finance (QJF), 2022, vol. 12, issue 02, 1-36

Abstract: This paper studies optimal index design to facilitate both hedging and alleviate illegal manipulation in a competitive equilibrium paradigm, modified to deal with manipulation. Specifically, a large trader is trading both derivatives and assets that effectively hides her trades behind the competitive market clearing mechanism. Unlike the strategic game paradigm, a volume-weighted average pricing (VWAP) index 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 preserves market completeness and discourages manipulation.

Keywords: Index design; index manipulation; VWAP; EWAP; competitive equilibrium (search for similar items in EconPapers)
JEL-codes: D84 G12 G14 G18 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1142/S2010139222500057

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