ETFs and Volatility - An empirical study in the Swedish stock market

University essay from Handelshögskolan i Stockholm/Institutionen för finansiell ekonomi

Abstract: ETFs have experienced tremendous growth and with it have gained increased relevance in the market over the last decade. Because of their special characteristics and close connection to their underlying securities, ETFs may propagate liquidity shocks through arbitrage channels into their underlying securities and thus increase the volatility of these securities. We estimate regression models to examine a connection between ETFs and the volatility of the underlying securities in the Swedish stock market. The results show, that increased ETF ownership in a stock is related to an increase in the volatility of the stock. Examining this relation in more detail on the OMXS30 index level, we find, that the ETF creation and redemption flows are unrelated to an increase in volatility. On the other hand, ETF trading volume is related positively to volatility and the relationship is magnified in periods of high ETF mispricing. This increased volatility constitutes both noise and fundamental volatility, which indicates, that ETFs may increase noise in the market, but also act as a price discovery channel.

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