The liquidity effects associated with addition of a stock to the S&P 500 index: evidence from bid/ask spreads

Abstract

AbstractThis study examines changes in stock liquidity, as measured by the bid/ask spread, when a stock is added to the S&P 500 Index. The paper presents evidence of a significant decrease in the bid/ask spread upon S&P 500 addition, however, this effect is limited to only those stocks that were not trading listed options. Further, the decrease in the bid/ask spread for nonoptioned stocks is accompanied by a significant and permanent increase in share price and trading volume. While optioned stocks experience a permanent increase in trading volume, they experience only a temporary increase in share price. The findings for optioned stocks support the hypothesis that the price and volume effects associated with S&P 500 addition derive from temporary price pressure. Findings pertaining to the nonoptioned stocks indicate that the price and volume effects associated with S&P addition reflect enhanced stock liquidity. The decrease in the bid/ask spread for nonoptioned stocks is attributed to informational efficiencies achieved via index arbitrage trading, and it is argued that this effect is mitigated for optioned stocks due to the pre‐existence of arbitrage trading between the option and the underlying stock.