IDEAS home Printed from https://ideas.repec.org/a/inm/ormnsc/v69y2023i4p2517-2535.html
   My bibliography  Save this article

Leveraged Exchange-Traded Funds with Market Closure and Frictions

Author

Listed:
  • Min Dai

    (Department of Applied Mathematics, The Hong Kong Polytechnic University, Kowloon, Hong Kong)

  • Steven Kou

    (Questrom School of Business, Boston University, Boston, Massachusetts 02215)

  • H. Mete Soner

    (Department of Operations Research and Financial Engineering, Princeton University, Princeton, New Jersey 08540)

  • Chen Yang

    (Department of Systems Engineering and Engineering Management, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong)

Abstract

Although leveraged exchange-traded funds (ETFs) are popular products for retail investors, how to hedge them poses a great challenge to financial institutions. We develop an optimal rebalancing (hedging) model for leveraged ETFs in a comprehensive setting, including overnight market closure and market frictions. The model allows for an analytical optimal rebalancing strategy. The result extends the principle of “aiming in front of target” introduced by Gârleanu and Pedersen (2013) from a constant weight between current and future positions to a time-varying weight because the rebalancing performance is monitored only at discrete time points, but the rebalancing takes place continuously. Empirical findings and implications for the weekend effect and the intraday trading volume are also presented.

Suggested Citation

  • Min Dai & Steven Kou & H. Mete Soner & Chen Yang, 2023. "Leveraged Exchange-Traded Funds with Market Closure and Frictions," Management Science, INFORMS, vol. 69(4), pages 2517-2535, April.
    • Handle: RePEc:inm:ormnsc:v:69:y:2023:i:4:p:2517-2535
    DOI: 10.1287/mnsc.2022.4407
    as

    Download full text from publisher

    File URL: http://dx.doi.org/10.1287/mnsc.2022.4407
    Download Restriction: no
    File URL: https://libkey.io/10.1287/mnsc.2022.4407?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. repec:bla:jfinan:v:43:y:1988:i:3:p:617-37 is not listed on IDEAS
    2. Ludovic Moreau & Johannes Muhle-Karbe & H. Mete Soner, 2017. "Trading With Small Price Impact," Mathematical Finance, Wiley Blackwell, vol. 27(2), pages 350-400, April.
    3. Acharya, Viral V. & Pedersen, Lasse Heje, 2005. "Asset pricing with liquidity risk," Journal of Financial Economics, Elsevier, vol. 77(2), pages 375-410, August.
    4. Nicolae Gârleanu & Lasse Heje Pedersen, 2013. "Dynamic Trading with Predictable Returns and Transaction Costs," Journal of Finance, American Finance Association, vol. 68(6), pages 2309-2340, December.
    5. Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers 88, Princeton, Department of Economics - Financial Research Center.
    6. Greenwood, Robin, 2005. "Short- and long-term demand curves for stocks: theory and evidence on the dynamics of arbitrage," Journal of Financial Economics, Elsevier, vol. 75(3), pages 607-649, March.
    7. repec:eme:mfppss:v:39:y:2013:i:5:p:476-508 is not listed on IDEAS
    8. Adrian, Tobias & Capponi, Agostino & Fleming, Michael & Vogt, Erik & Zhang, Hongzhong, 2020. "Intraday market making with overnight inventory costs," Journal of Financial Markets, Elsevier, vol. 50(C).
    9. Lockwood, Larry J & Linn, Scott C, 1990. "An Examination of Stock Market Return Volatility during Overnight and Intraday Periods, 1964-1989," Journal of Finance, American Finance Association, vol. 45(2), pages 591-601, June.
    10. Tang, Hongfei & Xu, Xiaoqing Eleanor, 2013. "Solving the Return Deviation Conundrum of Leveraged Exchange-Traded Funds," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 48(1), pages 309-342, February.
    11. Christoph Frei & Nicholas Westray, 2015. "Optimal Execution Of A Vwap Order: A Stochastic Control Approach," Mathematical Finance, Wiley Blackwell, vol. 25(3), pages 612-639, July.
    12. William J. Breen & Laurie Simon Hodrick & Robert A. Korajczyk, 2002. "Predicting Equity Liquidity," Management Science, INFORMS, vol. 48(4), pages 470-483, April.
    13. Obizhaeva, Anna A. & Wang, Jiang, 2013. "Optimal trading strategy and supply/demand dynamics," Journal of Financial Markets, Elsevier, vol. 16(1), pages 1-32.
    14. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    15. Lakshithe Wagalath, 2014. "Modelling the rebalancing slippage of leveraged exchange-traded funds," Quantitative Finance, Taylor & Francis Journals, vol. 14(9), pages 1503-1511, September.
    16. Stoll, Hans R & Whaley, Robert E, 1990. "Stock Market Structure and Volatility," The Review of Financial Studies, Society for Financial Studies, vol. 3(1), pages 37-71.
    17. Rama Cont & Arseniy Kukanov & Sasha Stoikov, 2014. "The Price Impact of Order Book Events," Journal of Financial Econometrics, Oxford University Press, vol. 12(1), pages 47-88.
    18. Jarrow, Robert A., 2010. "Understanding the risk of leveraged ETFs," Finance Research Letters, Elsevier, vol. 7(3), pages 135-139, September.
    19. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," The Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
    20. Lars Peter Hansen & Thomas J. Sargent, 2013. "Recursive Models of Dynamic Linear Economies," Economics Books, Princeton University Press, edition 1, number 10141.
    21. Bertsimas, Dimitris & Lo, Andrew W., 1998. "Optimal control of execution costs," Journal of Financial Markets, Elsevier, vol. 1(1), pages 1-50, April.
    22. Gârleanu, Nicolae & Pedersen, Lasse Heje, 2016. "Dynamic portfolio choice with frictions," Journal of Economic Theory, Elsevier, vol. 165(C), pages 487-516.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Peter Bank & Ibrahim Ekren & Johannes Muhle‐Karbe, 2021. "Liquidity in competitive dealer markets," Mathematical Finance, Wiley Blackwell, vol. 31(3), pages 827-856, July.
    2. Gârleanu, Nicolae & Pedersen, Lasse Heje, 2016. "Dynamic portfolio choice with frictions," Journal of Economic Theory, Elsevier, vol. 165(C), pages 487-516.
    3. Olivier Guéant, 2016. "The Financial Mathematics of Market Liquidity: From Optimal Execution to Market Making," Post-Print hal-01393136, HAL.
    4. Masamitsu Ohnishi & Makoto Shimoshimizu, 2024. "Trade execution games in a Markovian environment," Papers 2405.07184, arXiv.org.
    5. Paolo Guasoni & Marko H. Weber, 2018. "Rebalancing Multiple Assets with Mutual Price Impact," Journal of Optimization Theory and Applications, Springer, vol. 179(2), pages 618-653, November.
    6. Jorge Guijarro-Ordonez, 2019. "High-dimensional statistical arbitrage with factor models and stochastic control," Papers 1901.09309, arXiv.org, revised Jun 2021.
    7. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1289-1361, Elsevier.
    8. Adrian Buss & Bernard Dumas, 2019. "The Dynamic Properties of Financial‐Market Equilibrium with Trading Fees," Journal of Finance, American Finance Association, vol. 74(2), pages 795-844, April.
    9. Peter Bank & Ibrahim Ekren & Johannes Muhle-Karbe, 2018. "Liquidity in Competitive Dealer Markets," Papers 1807.08278, arXiv.org, revised Mar 2021.
    10. Fernando Duarte & Thomas M. Eisenbach, 2021. "Fire‐Sale Spillovers and Systemic Risk," Journal of Finance, American Finance Association, vol. 76(3), pages 1251-1294, June.
    11. Vayanos, Dimitri & Wang, Jiang, 2012. "Market liquidity - theory and empirical evidence," LSE Research Online Documents on Economics 119044, London School of Economics and Political Science, LSE Library.
    12. Masahiro Watanabe, 2003. "A Model of Stochastic Liquidity," Yale School of Management Working Papers ysm385, Yale School of Management.
    13. Johannes Muhle-Karbe & Xiaofei Shi & Chen Yang, 2020. "An Equilibrium Model for the Cross-Section of Liquidity Premia," Papers 2011.13625, arXiv.org.
    14. Ma, Guiyuan & Siu, Chi Chung & Zhu, Song-Ping, 2022. "Portfolio choice with return predictability and small trading frictions," Economic Modelling, Elsevier, vol. 111(C).
    15. Alain Bensoussan & Guiyuan Ma & Chi Chung Siu & Sheung Chi Phillip Yam, 2022. "Dynamic mean–variance problem with frictions," Finance and Stochastics, Springer, vol. 26(2), pages 267-300, April.
    16. Obizhaeva, Anna A. & Wang, Jiang, 2013. "Optimal trading strategy and supply/demand dynamics," Journal of Financial Markets, Elsevier, vol. 16(1), pages 1-32.
    17. Vayanos, Dimitri & Wang, Jiang, 2009. "Liquidity and asset prices: a united framework," LSE Research Online Documents on Economics 29303, London School of Economics and Political Science, LSE Library.
    18. Cebiroglu, Gökhan & Hautsch, Nikolaus & Walsh, Christopher, 2019. "Revisiting the stealth trading hypothesis: Does time-varying liquidity explain the size-effect?," CFS Working Paper Series 625, Center for Financial Studies (CFS).
    19. Chordia, Tarun & Roll, Richard & Subrahmanyam, Avanidhar, 2008. "Liquidity and market efficiency," Journal of Financial Economics, Elsevier, vol. 87(2), pages 249-268, February.
    20. Masamitsu Ohnishi & Makoto Shimoshimizu, 2022. "Optimal Pair–Trade Execution with Generalized Cross–Impact," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 29(2), pages 253-289, June.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:inm:ormnsc:v:69:y:2023:i:4:p:2517-2535. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Chris Asher (email available below). General contact details of provider: https://edirc.repec.org/data/inforea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.