Chasing Your Own Tail: The Market Stability Impact of Leveraged and Inverse Exchange-Traded Funds

University essay from Handelshögskolan i Stockholm/Institutionen för finansiell ekonomi

Abstract: This thesis explores the market stability impact of the positive feedback mechanism of leveraged and inverse exchange-traded funds' (LETFs) rebalancing trades. We explore potential market stability effects by analysing intraday minute-by-minute data for underlying stocks in the OMXS30 and aggregate rebalancing flows for LETFs tracking the index. We find that a 1 % index move causes LETFs to originate an average of SEK 89 million worth of rebalancing flows. Daily rebalancing flows are demonstrated to contribute to both end-of-day price pressure and volatility in underlying stocks, with more severe effects during times of high market volatility or crisis. The indirect impact from trading in anticipation of rebalancing accounts for the bulk of the total end-of-day price and volatility impacts in underlying stocks. Using predictions from market microstructure invariance, we calculate implied price impacts for both the Financial Crisis and the Corona Crisis to show that rebalancing flows may have contributed to substantial price declines and extra volatility during these periods. Implied price impact calculations show that large index moves risk causing a 'cascade' reaction of self-sustaining rebalancing, leading to significant price declines.

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