EXCHANGE TRADED FUNDS AND INDEX ANALYSIS: VOLATILITY AND OPTIONS

Exchange Traded Funds (ETFs) track their underlying index closely and are relatively inexpensive instruments for risk diversification. We examine the volatility of the three most liquid ETFs (DIA, SPY and QQQQ) and their tracking indexes (DOW, S&P 500 and NASDAQ 100). We find no significant difference in the realized return volatility between ETFs and indexes even controlling for nonsynchronous trading. However, as the best predictor of volatility, the option-implied volatility of ETFs is significantly different from that of indexes. We further examine the implied volatility function of stock options and index options using unique pair samples of ETFs and their tracking indexes. We find that the differential implied volatility function is related to open interest. Our results are consistent with the net buying pressure theory proposed by Bollen and Whaley (2002), and inconsistent with the argument of Bakshi, Kapadia and Madan (2003) which attributes the difference to differential return distributions. Our study also explores whether ETF options are used more for speculation or hedging, and whether they are a viable, stand alone new investment opportunity or they are just an alternatives to index options