Dean Diavatopoulos

Exchange Traded Notes: An Introduction

The first Exchange-Traded Note (ETN) was introduced in 2006. Since then, at least 64 other ETNs have been issued, with more announced. This financial security, which is growing in number and popularity, is often confused with Exchange-Traded Funds (ETFs) and seems to be largely misunderstood by the general investing public and even by institutional investors and academicians. Since no academic work has been published on the subject, this article offers a seminal introduction to ETNs. It provides five basic categories of information: 1) descriptive information about ETNs, 2) fine print related to ETNs that we believe investors should understand before purchasing shares, 3) a few simple examples of ETNs that are available, 4) a simple analysis of how closely ETN market prices track their indicative values (something akin to NAV), and 5) a discussion of why ETNs may appeal to various investor classes. The authors believe this article will provide the catalyst for much future empirical work on these financial securities.

The Indicative Value–Price Puzzle in ETNs: Liquidity Constraints, Information Signaling, or an Ineffective System for Share Creation?

The prices of ETNs often significantly exceed their indicative values. Since ETNs share many features in common with zero-coupon bonds, this empirical finding is unexpected. (Adopting the language of Wright, Diavatopoulos, and Felton (2010), we refer to this as the negative WDFD puzzle.) Using a sample of 93 ETNs over the period June 6, 2006 to December 31, 2009, we explore three possible explanations for the negative WDFD puzzle. We find that the puzzle is not a result of liquidity constraints. In fact, increased trading volume is mildly correlated with more extreme mispricing in ETNs. We also find that ETN prices significantly exceeding their corresponding indicative values do not possess information about the future prospects of the asset, commodity, or index tied to the ETN. Instead, we conclude that the negative WDFD puzzle is the result of (1) uninformed, return-chasing investors and (2) an ineffective current system for creating new shares of existing ETNs. To work towards eliminating the negative WDFD puzzle, we recommend that ETN issuers restructure their systems for creating new ETN shares by allowing profit-motivated investors to initiate the process of share creation as they identify extreme mispricing in the market place.

The Creation and Control of Speculative Bubbles in a Laboratory Setting

Persistent divergence of an asset price from its fundamental value has been a subject of much theoretical and empirical discussion. This paper takes an alternative approach of inquiry – that of using laboratory experiments – to study the creation and control of speculative bubbles. The following three factors are chosen for analysis: the compensation scheme of portfolio managers, wealth and supply constraints, and the relative risk aversion of traders. Under a short investment horizon induced by a tournament compensation scheme, speculative bubbles are observed in markets of speculative traders and in mixed markets of conservative and speculative traders. These results maintain with super-experienced traders who are aware of the presence of a bubble. A binding wealth constraint dampens the bubbles as does an increased supply of securities. These results are unchanged when traders risk their own money in lieu of initial endowments provided by the experimenter.

Does Corporate Governance Matter for Equity Returns

In this paper we reexamine the findings of Gompers, Ishii, and Metrick (2003) and Bebchuk, Cohen, and Ferrell (2009) and find the link between corporate governance (as measured by the G index and E index) and firm stock returns is much weaker than previously suggested. We extend the sample period and find a reversal of the relationship between governance and stock returns documented in these works over the 1990s and early 2000s. We further explore the source of the observed superior performance of good governance firms during the 1990s and find this relationship is partially driven by large firms and the Nasdaq bubble. We conclude corporate governance is less important for firm stock returns than suggested by previous literature.

Implied Volatility Changes as Evidence of Stock Price Disequilibrium

Past works have documented the predictive power of short-term stock return momentum and option volume ratios for future stock returns. In this article, the authors find option volume ratios have greater power to predict future returns when evidence exists that prices are out of equilibrium, proxied for by increases in implied volatility. In the studied sample, short-term momentum has significant power to predict future stock returns only in the presence of evidence prices are out of equilibrium. The authors document that option volume ratios, changes in option implied volatility, and short-term momentum together have significant predictive power for the cross-section of stock returns in subsequent periods. The difference between firms predicted to be strong performers and those predicted to be weak performers is more than 1% a month. Buy-and-hold returns for an equally weighted portfolio of predicted strong performers are 249% over the 1996–2009 period compared with a loss of 38% for predicted weak performers. S&P 500 Index returns over the same period were 60%.

Mispricing and Trading Profits in Exchange-Traded Notes

This article investigates whether a simple long–short weekly trading strategy based on mispricing among exchange-traded notes (ETNs) generates profits in excess of the S&P 500 Index over the sample period of June 6, 2006 to January 30, 2012. Ignoring transaction costs, liquidity, and short-selling constraints, the authors find the following: 1) Mispricing is prevalent among ETNs. They enter into 90 trades over our 295-week period using a mispricing threshold of 5% and requiring a minimum average daily volume of 20,000 shares. 2) Total returns to the authors’ strategy are significantly higher than the S&P 500, which had a total return of 3.70% over the same period. The strategy generated total returns ranging from 9% to 110% over a mispricing threshold range of 8% to 14%, depending on the study’s minimum daily trading volume requirements. 3) Nearly all the trades and all the profits from this strategy come from the short side of the portfolio. This is consistent with previous empirical work demonstrating that ETNs are more likely to be overpriced than under priced.

The Impact of Option Introduction on Real Estate Investment Trusts

This paper examines the impact of option introduction on the returns, volatility, and volume of shares traded of the Real Estate Investment Trusts (REITs) that underlie the new derivative securities. The paper looks at both the initial and then longer term impact on each of these variables and then compares the impact to what previous research finds when options are introduced on non-REIT equities. We find evidence of an initial decline in price when option introduction is announced and also find significant negative returns over a longer post-announcement period. There is not a significant change in volatility at option introduction but we do find a significant increase in trading volume. We find that in most of the areas examined, REITs have a similar reaction to option introduction as do non-REIT equities.

Anchoring and Probability Weighting in Option Prices

Cumulative prospect theory argues that the human decision-making process tends to both incorporate reference points and improperly weight low probability events. In this study, we find evidence that equity option market investors anchor to prices and incorporate a probability weighting function similar to that proposed by cumulative prospect theory. The biases result in inefficient prices for put options when firms have relatively high or relatively low implied volatilities. This has implication for the cost of hedging long portfolios and long individual equity positions.

A Daily Trading Strategy in the ETN Space

This article investigates whether the weekly trading strategy in the ETN space reported by Diavatopoulos et al. [forthcoming] may be profitably deployed as a daily strategy. Replicating their strategy on a daily basis, we report the following findings: 1) Mispricing is prevalent among ETNs on a daily basis. We enter into 451 trades over our 295-week period, using a mispricing threshold of 5% and requiring a minimum average daily volume of 20,000 shares. 2) Total returns to our strategy are significantly higher than the S&P 500 and also considerably higher than the returns to the weekly strategy. Our strategy generated total returns reaching as high as 276%, depending on our minimum daily trading volume requirements and mispricing thresholds. In contrast, the S&P 500 returned only 3.70% over this same period, while the weekly strategy generated returns reaching as high as 114%. 3) Similar to the weekly strategy, most of the trades and profits from the daily strategy come from the short side of our portfolio. 4) The daily strategy results in strikingly different returns than the weekly strategy in the lower mispricing thresholds. The weekly strategy was highly unprofitable at low mispricing thresholds; however, the daily strategy generated impressive total returns at mispricing thresholds as low as 0.50%.

Do REIT Repurchases Signal Value Changes in Rivals? An Analysis of the Stock Price Reaction of Non-Repurchasing REITs

We examine REITs at the announcement of plans for open market repurchases and determine the impact of these announcements on competing REITs. Consistent with prior research, we find evidence of significant positive returns to the repurchasing firms, on average, at announcement. We do not find evidence of a significant reaction for rival REITs. When we divide the sample based on sign of the announcement day returns to the repurchasing REITs, we find the impact for rivals differs. When there is a positive announcement effect for the repurchasing REIT, rivals do not react. When there is a negative announcement effect for the repurchasing REIT, rivals also have significant negative returns.