The impact of ETF mechanics and the bank of Japan intervention on the intraday volatility of the underlying stocks

Abstract

Due to their low trading costs and superior liquidity, exchange-traded funds (ETFs) attract short-term liquidity traders. The liquidity shocks can pass to the underlying securities through the ETF mechanism. ETF may therefore increase the non-fundamental volatility of the underlying stocks. I carry out the test daily which allows me to timely measure the high-frequency variable of arbitrage activity between Nikkei 225 ETFs and their components. I find the consistent result with Ben-David et al. (2018) that stocks with higher ETF holding display significantly higher volatility and the intensity of arbitrage activity, proxied by stock-level mispricing, magnifies the impact of ETFs on intraday volatility. In addition, I find that the sign of stock-level mispricing has a different impact on intraday volatility where the negative sign of net mispricing (ETFs are traded discounted) has less impact. This is because arbitrage treading involves higher costs. I further investigate the direct and indirect impact of BOJ ETFs purchase on intraday volatility. The evidence confirms the effectiveness of BOJ intervention as it could lower intraday volatility and reduce the impact of ETF arbitrage on stock price volatility. Moreover, during the COVID-19 pandemic, the effect of interest is lower because during the crisis, a market, in general, is illiquid. Hence, there is less intensity of ETF arbitrage and less volatility.