Essays on exchange-traded funds

Abstract

This thesis investigates the consequences of exchange-traded fund industry growth. In particular, I study the ETF arbitrage mechanism, the impact of ETF trading on international diversification and on price efficiency of distressed stocks. In the first chapter, I show that, although low on average, ETF premiums/ discounts can be as high as 16% when considering international country-level ETFs. I propose a risk-based limits to arbitrage explanation of such deviations. I show that while currency and equity illiquidity risks are important in explaining ETF premiums there is still a large portion of premium that remains unexplained. I argue that ETF premiums represent a reward arbitrageurs demand for being exposed to financial frictions risk and show that the absolute value of ETF deviations is a good proxy for multiple dimensions of financial frictions such as funding illiquidity, credit risk and information uncertainty. I show that it can be used as an aggregate financial friction proxy at the country-level and that it is priced in the cross-section of stock returns internationally. In the second chapter, I show that investment decisions of ETF market participants when trading country ETFs are driven by shocks to U.S. fundamentals, rather than local risks. Investors react only to negative news about local economies. When U.S. economic uncertainty increases, investors switch to Cash ETFs. I demonstrate that ETF arbitrage mechanism is one of the key channels through which U.S. shocks propagate to local economies leading to increased return correlation with the U.S. market, limiting the benefits from international diversification. I find that countries with stronger ETF price discovery and lower limits to arbitrage have a higher comovement with the U.S. market. In the third chapter, I examine the effect of exchange traded funds on the underlying stocks conditional on the credit quality of securities in the basket. I show that U.S. industry ETFs help to alleviate the short-selling constraint present for distressed securities at the individual stock level by providing the alternative trading route to gain the negative exposure via cheap short-selling of ETFs. As a result, ETF basket membership has a positive effect on distressed stocks price efficiency. In addition, I show that distressed stocks that are members of ETF basket do not show signs of distress anomaly unlike the non-member securities