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A Dynamic Equilibrium Model of ETFs

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  • Malamud, Semyon

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

  • Malamud, Semyon, 2016. "A Dynamic Equilibrium Model of ETFs," CEPR Discussion Papers 11469, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:11469
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    References listed on IDEAS

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    Cited by:

    1. Kharma, Céline & Eugster, Nicolas, 2021. "Is competition beneficial? The case of exchange traded funds," International Review of Financial Analysis, Elsevier, vol. 76(C).
    2. Ariah Klages-Mundt & Dominik Harz & Lewis Gudgeon & Jun-You Liu & Andreea Minca, 2020. "Stablecoins 2.0: Economic Foundations and Risk-based Models," Papers 2006.12388, arXiv.org, revised Oct 2020.
    3. Atanasova, Christina & Weisskopf, Jean-Philippe, 2020. "The price of international equity ETFs: The role of relative liquidity," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 65(C).
    4. Pagano, Marco & Sánchez Serrano, Antonio & Zechner, Jozef, 2019. "Can ETFs contribute to systemic risk?," Report of the Advisory Scientific Committee 9, European Systemic Risk Board.
    5. Hurlin, Christophe & Iseli, Grégoire & Pérignon, Christophe & Yeung, Stanley, 2019. "The counterparty risk exposure of ETF investors," Journal of Banking & Finance, Elsevier, vol. 102(C), pages 215-230.
    6. Dekker, Lennart, 2024. "Essays on asset liquidity and investment funds," Other publications TiSEM 5fc9bf77-84e7-4a36-9e3a-1, Tilburg University, School of Economics and Management.
    7. Saæglam, Mehmet & Tuzun, Tugkan & Wermers, Russ, 2021. "Do ETFs increase liquidity?," CFR Working Papers 21-03, University of Cologne, Centre for Financial Research (CFR).
    8. Chabakauri, Georgy & Rytchkov, Oleg, 2021. "Asset pricing with index investing," Journal of Financial Economics, Elsevier, vol. 141(1), pages 195-216.
    9. Damien Kunjal, 2022. "Evaluating the Liquidity Response of South African Exchange-Traded Funds to Country Risk Effects," Economies, MDPI, vol. 10(6), pages 1-20, June.
    10. Luca J. Liebi, 2020. "The effect of ETFs on financial markets: a literature review," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 34(2), pages 165-178, June.
    11. Box, Travis & Davis, Ryan & Evans, Richard & Lynch, Andrew, 2021. "Intraday arbitrage between ETFs and their underlying portfolios," Journal of Financial Economics, Elsevier, vol. 141(3), pages 1078-1095.
    12. Jilong Chen & Liao Xu & Yang Zhao, 2020. "Do ETF flows increase market efficiency? Evidence from China," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 60(5), pages 4795-4819, December.

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    More about this item

    Keywords

    Exchange traded funds; Liquidity; Limits to arbitrage;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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