New evidence on the price and liquidity effect of the FTSE100 index revisions.

Abstract

We study the price and liquidity effects following the FTSE 100 index revisions. We employ the standard GARCH(1,1) model to allow the residual variance of the single index model (SIM) to vary systematically over time and use a Kalman filter approach to model SIM coefficients as a random walk process. We show that the observed price effect depends on the abnormal return estimation methods. Specifically, the OLS-based abnormal returns indicate that the price effect associated with the index revision is temporary, whereas both SIM with random coefficients and GARCH(1,1) model suggest that both additions and deletions experience permanent price change. Added (removed) stocks exhibit permanent (temporary) change in trading volume and bid-ask spread. The analysis of the spread components suggests that the permanent change associated with additions is a result of non-information-related liquidity. We interpret the permanent price effect of additions and deletions combined with the permanent (temporary) shift in liquidity of added (removed) stocks as evidence in favour of the imperfect substitution hypothesis with some non-information-related liquidity effects in the case of additions.