Exchange Traded Funds, or ETFs, are an investment vehicle traded on stock exchanges, much like stocks or bonds. ETFs are index-based investment products that allow investors to buy or sell shares of entire portfolios of stock in a single security. Moreover, an ETF is a type of investment company whose investment objective is to achieve the same return as a particular market, and is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index, such as the Dow Jones Industrial Average or the S&P 500.
ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States. similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange in 1990. The shares, which tracked the TSE 35 and later the TSE 100 stocks, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.
Standard & Poor's Depository Receipts (SPY) are shares of a family of exchange-traded funds (ETFs) traded in the United States and managed by State Street Global Advisors (SSgA). Informally, they are also known as Spyders or Spiders. The name is an acronym for the first member of the family, the Standard & Poor's Depository Receipts (SPY), the biggest ETF in the U.S., which is designed to track the S&P 500 stock market index. SPDRs were launched by Boston fund manager SSgA in 1992–1993 as the first exchange-traded fund shares still traded in the United States (preceded by the short-lived Index Participation Shares that launched in 1989.) Devised by American Stock Exchange executive Nathan Most, the
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fund first traded on that market, but has since been listed elsewhere, including the New York Stock Exchange (NYSE).
The Dow Jones Industrial Average (DJIA) is the most widely quoted stock index.
World wide media reports constantly quote DJIA updates. It may be the easiest stock index to track, but the entire index was not easy to trade until the Chicago Board of Trade (CBOT) introduced the DJIA futures contracts in October 1997. Then, it have seen the emergence of the exchange-traded fund (ETF), DIAMOND, in January 1998
The NASDAQ-100 Trust Series 1 Exchange-traded fund, sponsored and overseen since March 21, 2007 by Powershares, trades under the ticker NASDAQ: QQQQ. On December 1, 2004, it was moved from the American Stock Exchange where it had the symbol QQQ to the NASDAQ and given the new four letter code QQQQ. It is sometimes referred to as the "Quad Qs," "Cubes," or simply as "the Qs." In 2000 it was the most actively traded security in the United States, but has since dropped to second place after Standard & Poor's Depositary Receipts. On July 17, 2007, the ETF closed above $50 for the first time since early 2001.
2003 year is a turning point for ETF development occurred the mutual fund scandal which was the result of the discovery of illegal late trading and market timing practices on the part of certain hedge fund and mutual fund companies. In U.S, the number of mutual fund investors has approached half the families so that this market is corresponsively mature.
However, these illegal trading behaviors got plastered the investor’s confidence deeply.
ETFs generally provide the easy diversification, Buying and selling flexibility, Transparency, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares
frequently to implement market timing investment strategies. ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs do not have. ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade. ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions. ETFs provide an economical way to rebalance portfolio allocations and to "equitize" cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indexes, broad-based international and country-specific indexes, industry sector-specific indexes, bond indexes, and commodities.
ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.
Although there are many advantages to invest ETFs, it still go along with some risks.
When the Portfolio invests in Underlying ETFs, it will indirectly bear its proportionate share of any fees and expenses payable directly by the Underlying ETF. Therefore, the Portfolio will incur higher expenses, many of which may be duplicative. In addition, Underlying ETFs are also subject to the following risks: (i) the market price of an Underlying ETF’s shares may trade above or below its net asset value; (ii) an active trading market for an Underlying ETF’s
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shares may not develop or be maintained; (iii) the Underlying ETF may employ an investment strategy that utilizes high leverage ratios; (iv) trading of an Underlying ETF’s shares may be halted if the listing exchange’s officials deem such action appropriate, the shares are delisted from the exchange, or the activation of market wide “circuit breakers” (which are tied to large decreases in stock prices) halts stock trading generally; or (v) the Underlying ETF may fail to achieve close correlation with the index that it tracks due to a variety of factors, such as rounding of prices and changes to the index and/or regulatory policies, resulting in the deviating of the Underlying ETF’s returns from that of the index. Some Underlying ETFs may be thinly traded, and the costs associated with respect to purchasing and selling the Underlying ETFs (including the bid-ask spread) will be borne by the Portfolio.
According to capital markets are more free and international, the derivatives which provided low trading cost and high leverage rapidly develop. Especially in options and implied option investment which become the indispensable financial implements, so there are more and more investors to put money into option markets. The option trading includes abounding market information and psychology, thus the issue that the dynamic relationship between option market and spot market is become important. Because of the option market development, ETFs are also listed ETF option, such as SPY option, QQQQ option, and the DIA option. Combining long-term ETF momentum with option price, this study is desirous that whether the ETF returns influence the option price. It implies that people invest the ETF options which are less familiar whether they would care about past performance as mutual funds. In other words, whether inform traders anticipate that the behavior of momentum investors alter their trading behavior to profit from the follower’s expected reaction. Therefore, informed traders buy more the fundamental value ETF and reinforce the trading by positive feedback traders and drive the price above its fundamental option value.
To make a comprehensive survey of previous literatures, there are three particular
researching contributions in our study. First, although many literatures discuss the issue between ETF and index market or between ETF and index futures market, there is no study investigating between ETF and ETF option market. Option is one of the most important financial implements over the world, therefore investigating between ETF and ETF market is another important issue.
Second, past literatures regularly used index data to discuss the dynamic relationship between spot market and option market. It does not conform to realistic situation for arbitrage or trading index because trading the components of index has much cost and seriously asynchronous trading. Hence, Using index data has doubts for arbitrage theory and relative Price Discovery issues. ETF is the best investment to trading index instead of index data. Also, in our thesis, we adopted SPY and S&P 500 (DIA and DJIA) data to examine the cross momentum trading and to figure out whether the discrepancy caused by tradable character ( ETF and non-ETF).
Third, this study place emphasis on long-term relationship between ETF and ETF option market. We adopt implied volatility spread and past ETF returns to examine the dynamic relation. We would like to chase the more precise trading behavior and figure out how the trading strategy differs from spot market and option market.
The rest of the paper is organized as follows. In section II, we present the related literature. In section III, we describe our methodology which was used to examine the relationship between implied volatility spread and past underlying asset returns. The data selection is also introduced in Section III. Section IV reports the empirical results and robustness test and Section V concludes the paper.
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