Thursday, September 24 | 11:00am-12:30pm | Room 335, HSBC Business School Building

Abstract

We examine how does the introduction of exchange-traded fund (ETF) affects the arbitrage and price discovery mechanism between the China Securities Index (CSI) 300 spot and futures markets. We utilize a bivariate Smooth-Transition VECM (ST-VECM) to accommodate a two-speed error-correction mechanism. This allows us to differentiate price discovery contribution between no-arbitrage versus arbitrage states. Our analysis yields three main findings: i) Post-ETF trading, we see a substantial reduction in observed pricing errors. This is expected given the narrowing of arbitrage bounds due to lower transaction cost in trading ETFs; ii) The futures market still contributes more price discovery than its spot and ETF counterparts; iii) Arbitrage activity migrated from the CSI300 spot predominately to the ETF traded in Shanghai, seemingly ignoring the ETF traded in Shenzhen. When arbitrage activity is present, the Gonzalo and Granger (GG 1995) price discovery contribution is a noisy measure since a VECM averages the error-correction mechanism between no-arbitrage and arbitrage states. A modified GG measure from the ST-VECM addresses this issue. We explain why the price discovery bound that corresponds to no-arbitrage state, provides a clearer indication of cross-market price discovery contribution.