A1614
Title: The ETF-index volatility spread
Authors: Hitesh Doshi - University of Houston (United States)
Jaideep Oberoi - University of Kent (United Kingdom) [presenting]
Abstract: Major exchange traded funds (ETFs) that track an underlying index are known to track it closely due to the manner in which they are organized. Deviations of ETF share prices from the underlying basket of stocks lead to arbitrage opportunities that institutions can profit from. Options written on the ETFs and the benchmark indices offer an opportunity to study the difference between cash settled and delivery-based contracts, where other features of the contracts can be adjusted for in standard ways. We document systematic and predictable patterns in the difference between the prices (implied volatilities) of ETFs and the underlying benchmark indices they are designed to track. We explore this predictability and seek explanations for its time variation among factors such as institutional liquidity, the liquidity of underlying securities and the liquidity of the contracts themselves. We argue that the delivery-based nature of ETF options offers a unique opportunity to identify changes in the liquidity of index constituents in times of financial market stress.
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