Basket Securities, Price Formation, and Informational Efficiency

50 Pages Posted: 5 Dec 2005

See all articles by Lei Yu

Lei Yu

University of Notre Dame

Date Written: March 25, 2005

Abstract

This paper investigates the role of basket securities in the efficient price formation process of individual component securities. The study focuses on one type of basket security, exchange traded funds (ETFs), which includes some of the most actively traded securities in the U.S. equity market. A multi-asset variance decomposition methodology is developed to measure the information contributions of the return and trade innovations of ETFs. The results show that a substantial amount of the information incorporated into the efficient price of a component stock originates in the ETF market. More interestingly, ETF trades are found to have permanent impacts on component stock prices. An analysis of ETF introductions reveals that both informational efficiency and market liquidity of the component stocks improve after the ETF starts trading. The findings suggest that seemingly redundant securities can have important informational functions.

Keywords: Exchange Traded Funds, Price Discovery, Informational Efficiency

JEL Classification: G14, G12

Suggested Citation

Yu, Lei, Basket Securities, Price Formation, and Informational Efficiency (March 25, 2005). Available at SSRN: https://ssrn.com/abstract=862604 or http://dx.doi.org/10.2139/ssrn.862604

Lei Yu (Contact Author)

University of Notre Dame ( email )

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