The liquidity effects associated with addition of a stock to the S&P 500 index: evidence from bid/ask spreads

Abstract

This study examines changes in stock liquidity, as measured by the bidask spread, when a stock is added to the S&P 500 Index. The paper presents evidence of a significant decrease in the bidask spread upon S&P 500 addition, however, this effect is limited to only those stocks that were not trading listed options. Further, the decrease in the bidask spread for nonoptioned stocks is accompanied by a significant and permanent increase in share price and trading volume. While optioned stocks experience a permanent increase in trading volume, they experience only a temporary increase in share price. The findings for optioned stocks support the hypothesis that the price and volume effects associated with S&P 500 addition derive from temporary price pressure. Findings pertaining to the nonoptioned stocks indicate that the price and volume effects associated with S&P addition reflect enhanced stock liquidity. The decrease in the bidask spread for nonoptioned stocks is attributed to informational efficiencies achieved via index arbitrage trading, and it is argued that this effect is mitigated for optioned stocks due to the pre-existence of arbitrage trading between the option and the underlying stock.(the editor) and an anonymous referee for useful comments on earlier drafts. We also thank Upinder Dhillon and other participants at the 1995 FMA meetings for helpful suggestions and discussions.

The Limits of Arbitrage and Stock Mispricing: Evidence from Decomposing the Market to Book Ratio

“…Therefore, the liquidity hypothesis suggests that the positive price reaction to the added stocks is simply a result of the expected liquidity improvement. Erwin and Miller (1998) examine the inclusion effect on liquidity as measured by bid/ask spread and volume. They split the sample into two categories: optioned stocks and non-optioned stocks.…”

“…This abnormal return might be driven by changes in liquidity (Erwin and Miller, 1998), volatility (Lin, 2007), changes information asymmetries and information uncertainty (Denis et. al, 2003), or transaction costs (Hedge and McDermott, 2003 Since limits of arbitrage are expected to be lower for S&P 500 members relative to non-S&P 500 stocks, then arbitrageurs are expected to be able to reduce mispricing and bring prices closer to fair value.…”

“…Hedge and McDermott, 2003;Chen et. al, 2004;Vijh, 1994;Lin, 2007;Erwin and Miller, 1998; and others). Therefore, S&P 500 stocks provide excellent conditions to examine the effect of the limits of arbitrage on the arbitrage process to eliminate stock mispricing.…”

Liquidity effects and FFA returns in the international shipping derivatives market

“…In the equity market, various studies have been conducted to measure the effect of illiquidity on stock returns (Amihud, 2002) as well as the effect of certain events on stocks' liquidity measured by bid-ask spreads (Erwin and Miller 1998) Chen et al (2007) reveal that individual bond illiquidity is priced by the market and reflected in bond spreads. Acharya et al (2013) study the exposure of the US corporate bond returns to liquidity shocks of stocks and Treasury bonds and suggest the existence of time-varying liquidity risk of corporate bond returns, conditional on episodes of flight to liquidity.…”

Anticipatory effects in the FTSE 100 index revisions

“…Accordingly, liquidity should increase for stocks that enter the index and decrease for stocks that exit the index. This impact in liquidity explains, at least partially, price responses to index revisions (Beneish and Whaley, 1996;Erwin and Miller, 1998;Hegde and McDermott, 2003;Gregoriou and Ioannidis, 2006;Chordia, 2008). For instance, if the inclusion of a stock in the index leads to a lower bidask spread, stock prices should rise in a permanent fashion (Amihud and Mendelson, 1986;Brennan and Subrahmanyam, 1996).…”