Abstract
We propose a simple model of trading based on the Kyle (1985) framework for securities that are included in Exchange Traded Funds (ETFs). The model postulates that trading in ETFs will increase volatility in their component stocks, and that volatility spillovers will be increasing in liquidity and the relative proportion of each stock held by the fund. An empirical analysis of trading in the S&P 500 SPDR and three heavily traded industry ETFs confirms these hypotheses, using both Amihud’s (2002) measure of illiquidity as well as stock turnover as proxies for liquidity. The results are consistent with a positive volume-volatility relation as well as tradingbased explanations of volatility. The findings are relevant to market practitioners, regulators and investors in these increasingly popular products, since ETFs may in fact contribute to volatility in their underlying component stocks, and thus to the stock market in general.
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