Quantifying the Effects of New Derivative Introduction on Exchange Volatility, Efficiency and Liquidity

Leveraged Exchange Traded Funds and Volatility: An Exploratory Discussion

“…As the number of LETFs has continued to grow, especially in the last few years, there has been a growing interest in the effect that daily rebalancing has on the end of day market volatility. We can see in [3,9,21,22,23,27,28,29,30,31] that there is a growing belief that the rebalancing of LETFs does in fact alter the state of the market. Cheng and Madhavan argue in [8] while LETFs do not compose a major share of the entire market, the volume of trades executed by these funds at the end of the day is clearly capable of accelerating volatility in the market.…”

“…Bai et al also argue that the magnitude of trading at the close of the day does in fact cause a notable increase in market volatility. Leung and Sircar demonstrate how the intrinsic volatilities of LETFs eventually lead to a significant if not complete attrition of fund value for a given investor in[3].Corbet, in[22], provides interesting empirical evidence using GARCH and EGARCH analysis showing the effects of LETFs on market volatility; the model used in[22] demonstrates that LETFs cause an increase in volatility in commodities markets. The increase in end of day trades is specifically addressed in[29]: in 2006,20.7% of stock trading volume in the S&P 500 occurred in the last hour (the year LETFs were first available); by November 2008, the volume of trades in the last hour had increased to 26.2%.…”