Decimalization, trading costs, and information transmission between ETFs and index futures

Abstract

The impact of changes in trading costs, due to decimalization, on informed trading and speed of information transmission between exchange-traded funds (ETFs) and their corresponding index futures is examined. ETFs began to trade in decimals on January 29, 2001, and index futures continued to trade in their original tick sizes. The focus is on whether the decrease in the minimum tick size of ETFs influences the relative performances of these two types of index instruments in the price-discovery process. It is found that for ETFs, the trading activity increases, but the market depth drops significantly after decimalization. The spreads for ETFs generally decrease, but the adverse selection component of ETF spreads increases. Furthermore, after decimalization, ETFs start to lead index futures in the price-discovery process and its share of information also increases. Although index futures still assume a dominant role in information discovery, the information content of the ETFs' prices improves significantly after decimalization. (c) 2006 Wiley Periodicals, Inc.