ETFs, High-Frequency Trading and Flash Crashes

In this article, the author presents a model of distributional properties of returns on financial instruments tied to ETFs via high-frequency statistical arbitrage. As the author's model shows, the securities subject to an ETF arbitrage exhibit a well-defined behavior, largely dependent on the behavior of other securities comprising the ETF. The model can be used to improve risk management of long-term portfolios, and, in particular, allow hedging of flash crashes. Furthermore, the analysis shows that in the electronic markets that allow high-frequency trading, the intraday downward volatility for the underlying securities comprising an ETF is bounded from below, and, is, as a result, less extreme than that of securities not included in any ETFs. Also, in the markets where the high-frequency trading is restricted, downward price movements are more extreme than in the markets where high-frequency trading is present