Index Price Discovery in the Cash Market

32 Pages Posted: 12 Sep 2011 Last revised: 29 Feb 2012

See all articles by Yanhao Fang

Yanhao Fang

Louisiana State University, Baton Rouge - Department of Finance

Gary C. Sanger

Louisiana State University, Baton Rouge - E.J. Ourso College of Business Administration

Date Written: September 11, 2011

Abstract

This paper employs Hasbrouck’s (2003) information share method to analyze the flow of information in equity markets. In particular we compare trading in Index ETFs with that of their underlying securities. Surprisingly, ETFs seem to play a significant role in the price discovery process, rather than serving as passive indexing/hedging vehicles. Using TAQ data we reconstruct the second-by-second intraday price series for the S&P 500 using its component stocks. Results show that the ETF contributes almost half to the price formation of the spot S&P 500. Next, comparing trades and quotes, we determine the relative amount of informed trading (versus noise) in the ETF. When trading in the ETFs is driven more by private information, the ETF contributes more to price discovery. Thus, the evidence suggests that a significant portion of ETF trading is information motivated.

Keywords: ETF, price formation, informed trading, basket security, market efficiency

JEL Classification: G11, G12, G14, G19

Suggested Citation

Fang, Yanhao and Sanger, Gary C., Index Price Discovery in the Cash Market (September 11, 2011). Midwest Finance Association 2012 Annual Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1926287 or http://dx.doi.org/10.2139/ssrn.1926287

Yanhao Fang (Contact Author)

Louisiana State University, Baton Rouge - Department of Finance ( email )

2900 BEC
Baton Rouge, LA 70803
United States
2254561636 (Phone)

Gary C. Sanger

Louisiana State University, Baton Rouge - E.J. Ourso College of Business Administration ( email )

2163 CEBA
Baton Rouge, LA 70803-6308
United States
225-578-6353 (Phone)
225-578-6366 (Fax)

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