ETFs and Market Equilibrium: Evidence from FX and Equity

Sanjay Misra, PhD
Foreign exchange, ETF, market anomalies, FX and equity markets, VAR model,

Abstract :

ETF Flows and FX: The thesis examines ETF markets' effect on anomalies on anomalies in FX and Equity markets. In the first chapter, we study the linkage between two different types of ETF order flows and foreign exchange rates. We find that equity and currency ETF order flows provide two separate information sources that currency markets aggregate. We report that equity ETF order flows represent demand or buying pressure for the currency and do not (or only marginally) explain exchange rate returns. On the other hand, currency ETF order flows represent investor expectations of future exchange rate returns and support investors' forecasting ability when aggregated.

In the second chapter, we investigate changes in anomaly returns for well-documented stock market anomalies in the light of the development of the ETF market. We provide evidence of the effect of ETF order flows on anomaly returns. Using a VAR model, we find that ETF order flows do not explain anomaly returns. However, the volatility of ETF order flows, as a proxy of heterogeneous belief about future returns, can explain anomaly returns over and above the lagged anomaly returns. We analyze the magnitude of effect in different periods and infer that the effect increases over time in line with ETFs evolution as a preferred investment vehicle. We also estimate a time-varying parameter VAR and find that the coefficients for lagged volatility equity ETF order flows do not exhibit time-variability. However, the correlations with anomaly returns show time-variability over the period and change the sign for many of the anomalies. To the best of our knowledge, we are the first to document these effects.

Publication date of the thesis

Thesis committee

Supervisor: Abraham Lioui, EDHEC Business School

External reviewer: Dimitris Korobilis, University of Glasgow

Other committee member: Nikolaos Tessaromatis, EDHEC Business School