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A Dynamic Equilibrium Model of ETFs

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  • Semyon MALAMUD

    (Ecole Polytechnique Federale de Lausanne and 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.

Suggested Citation

  • Semyon MALAMUD, 2015. "A Dynamic Equilibrium Model of ETFs," Swiss Finance Institute Research Paper Series 15-37, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1537
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    File URL: http://ssrn.com/abstract=2662433
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    Citations

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    Cited by:

    1. Kenechukwu E. Anadu & Mathias S. Kruttli & Patrick E. McCabe & Emilio Osambela, 2018. "The Shift from Active to Passive Investing : Potential Risks to Financial Stability?," Finance and Economics Discussion Series 2018-060r1, Board of Governors of the Federal Reserve System (U.S.), revised 29 Jun 2020.
    2. Itzhak Ben-David & Francesco A. Franzoni & Rabih Moussawi, 2016. "Exchange Traded Funds (ETFs)," Swiss Finance Institute Research Paper Series 16-64, Swiss Finance Institute.
    3. Vandermarliere, B. & Ryckebusch, J. & Schoors, K. & Cauwels, P. & Sornette, D., 2017. "Discrete hierarchy of sizes and performances in the exchange-traded fund universe," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 469(C), pages 111-123.
    4. Agarwal, Vikas & Hanouna, Paul & Moussawi, Rabih & Stahel, Christof W., 2021. "Do ETFs increase the commonality in liquidity of underlying stocks?," CFR Working Papers 21-04, University of Cologne, Centre for Financial Research (CFR).
    5. Staer, Arsenio & Sottile, Pedro, 2018. "Equivalent volume and comovement," The Quarterly Review of Economics and Finance, Elsevier, vol. 68(C), pages 143-157.
    6. Marshall, Ben R. & Nguyen, Nhut H. & Visaltanachoti, Nuttawat, 2018. "Do liquidity proxies measure liquidity accurately in ETFs?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 55(C), pages 94-111.
    7. Pan, Kevin & Zeng, Yao, 2017. "ETF arbitrage under liquidity mismatch," ESRB Working Paper Series 59, European Systemic Risk Board.
    8. Karamfil Todorov, 2021. "Passive funds affect prices: evidence from the most ETF-dominated asset classes," BIS Working Papers 952, Bank for International Settlements.
    9. Fabrice Riva & Thomas Marta, 2022. "Do ETFs increase the comovements of their underlying assets? Evidence from a switch in ETF replication technique," Post-Print hal-03969597, HAL.
    10. John J Shim & Karamfil Todorov, 2021. "ETFs, illiquid assets, and fire sales," BIS Working Papers 975, Bank for International Settlements.

    More about this item

    Keywords

    exchange-traded funds; liquidity; volatility; co-movement; mis-pricing;
    All these keywords.

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