Direct and Indirect Effects of Index ETFs on Spot‐Futures Pricing and Liquidity: Evidence from the CAC 40 Index

AuthorCarole Gresse,Béatrice de Séverac,Laurent Deville
DOIhttp://doi.org/10.1111/j.1468-036X.2011.00638.x
Date01 March 2014
Published date01 March 2014
European Financial Management, Vol. 20, No. 2, 2014, 352–373
doi: 10.1111/j.1468-036X.2011.00638.x
Direct and Indirect Effects of Index
ETFs on Spot-Futures Pricing and
Liquidity: Evidence from the CAC 40
Index
Laurent Deville
CNRS, GREDEG, 250 rue Albert Einstein – Batiment 2, 06560 Valbonne, France and EDHEC
Business School 400 Promenade des Anglais, BP 3116, 06202 Nice Cedex 3, France
Email: laurent.deville@gredeg.cnrs.fr
Carole Gresse
Universit´
e Paris-Dauphine, DRM, Place du Mar´
echal de Lattre de Tassigny 75775 Paris cedex 16,
France
Email: carole.gresse@dauphine.fr
B´
eatrice de S´
everac
Universit´
e Paris Ouest NanterreLa D ´
efense, 200, avenue de la R´
epublique, 92001 Nanterre cedex,
France
Email: bseverac@u-paris10.fr
Abstract
This paper investigates how the introduction of an Exchange-Traded Fund (ETF)
directly or indirectly impacts the underlying-index spot-futures pricing. Using
intraday data for financial instruments related to the CAC 40 index, we do not find
that the spot-futures price efficiency improvementobserved after ETF introduction
is explained either by the direct effect of ETF sharesbeing used in arbitrage trades
or by the indirect effect of ETF trading improving the liquidity of index stocks in
the short-run. Some of our findings suggest that the efficiency improvement could
rather result from a structural change in the way index traders distribute across
The authors gratefully acknowledge the financial support of the Europlace Institute of
Finance.
We are thankful to an anonymous referee for their high-value contribution to our paper.
We also thank Claudette Babusiaux, Jonathan Dark, Bertrand Jacquillat, Terry Hendershott,
Andrea Heuson, Alexander Kurov, Laurence Lescourret, Maureen O’Hara, Patrice Poncet,
Christian Rabeau, and participants at the ESSEC seminar, as well as participants at the 2005
EIF meetings in Paris, the 2006 FMA European conference in Stockholm, the 2006 EFMA
meetings in Madrid, and the 2006 FMA conference in Salt Lake City, for helpful comments.
Correspondence: Carole Gresse.
C
2012 Blackwell Publishing Ltd
E-mail:
E-mail:
E-mail:
Effects of Index ETFs on Spot-Futures Pricing and Liquidity 353
index markets, with the ETF market absorbing the liquidity demand from some
hedgers or passive index traders.
Keywords: futures,exchange-traded fund,ETF ,efficiency,arbitrage,liquidity.
JEL classification: G12; G13; G14
1. Introduction
Exchange-Traded Funds (ETFs) are investment funds designed to replicate the per-
formance of an index or a specified benchmark as closely as possible. Contrary to
conventional index mutual funds, ETFs are listed on an exchange and can be traded
at any time in the trading day at market prices. Their shares may also be created and
redeemed by the issuer in large blocks on a daily basis, either in cash or in kind. ETFs
which replicate benchmark stock indices have developedrapidly since their introduction
in North America in the 1990s. Their number reached 2,422 funds by the end of
November 2010, with 5,413 listings and assets of US$1,231.0 billion from 133 providers
on 46 exchanges around the world.1These liquid exchange-traded index securities offer
new trading facilities for index portfolio managers, index risk hedgers, and arbitrageurs.
They may therefore change trading equilibriums and cross-market pricing relations.
In particular, the introduction of ETFs has been shown to tighten the spot-futures
no-arbitrage price relation (see Park and Switzer (1995) for the case of the Toronto
35 Index, Switzer et al. (2000) for the S&P 500 Index, and Kurov and Lasser (2002)
for the NASDAQ-100 Index).2However, the literature has not yet investigated how this
efficiency improvement actually developed. The present paper aims to fill this gap and
draws on high-frequency data to identify the channel(s) by which the spot-futures price
relation tightens.
Increased arbitrage trading is the traditional explanation of why the introduction of an
ETF would tighten the spot-futures no-arbitrage price relation (Kurov and Lasser, 2002;
Hegde and McDermott, 2004). Because of their low trading costs,3it is usually claimed
that ETFs are used to establish the cash leg in arbitrage portfolios. With the opening of
an ETF market, more arbitrage tools are available to arbitrageurs. Arbitrage trading is
thus facilitated, which consequently improves the efficiency of futures prices. We refer
to this effect, which stems from the ETF shares being used in spot-futures arbitrage
portfolios, as the direct effect of ETF trading on price efficiency.
Another explanation for the efficiency improvement following the introduction of an
ETF lies in the linkage between liquidity and efficiency. Empirical studies on index
spot-futures relations show that liquidity and trading costs play an important role in
enforcing no-arbitrage pricing. Arbitrageurs do not trade unless the difference between
the theoretical futures price and the market futures price is greater than the transaction
costs incurred to implement arbitrage strategies. The higher these costs, or the lower
1Barclays, ETF Landscape Industry Review (November 2010)
2Deville and Riva (2007) also show that ETF introduction significantly improves the joint
efficiency of spot and options prices.
3For instance, De Winne et al. (2011) show that executing a round-trip trade in an ETF
market is substantially less costly than a round-trip trade of the same size executed in the
markets for the underlying stocks.
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2012 Blackwell Publishin
g
Ltd

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