Mutual Funds, Price Pressure, and Index Options

Abstract

As research has begun to focus on the fact of less-than-infinite liquidity in real-world financial markets, evidence has begun to accumulate on price effects caused by large trades. Cash inflows into index-based mutual funds can be large and potentially highly correlated across “herding” investors, resulting in flow-induced price effects on the index stocks. In this article, Lehnert shows that mutual fund inflows, which have been shown to push prices of illiquid stocks too far at first only to be followed by predictable reversals later, also affect index options in the form of negative shocks to risk-neutral skewness. Among the interesting results are that inflows are more powerful than outflows; only the unexpected portion of the flow seems to matter; and the effect is largely limited to short maturity options. The article goes on to consider risk-neutral volatility and kurtosis, finding behavior largely consistent with the fund flow hypothesis.

TOPICS: Mutual funds/passive investing/indexing, quantitative methods