10. Arbitrage for Efficient ETF Pricing

L2 12 Misaligned ETF Pricing V3

Misaligned ETF prices and Arbitrage Opportunity

The market value of an ETF share may diverge from the market value of its underlying portfolio of stocks (its NAV).
If an ETF share price is higher than its NAV, we say it’s trading at a premium.
If an ETF share price is lower than its NAV, we say it’s trading at a discount.
The difference between the ETF share price and its NAV can be called its “basis”.

L2 13 Realigning ETF Share Prices V2

Re-align ETF Share Price with Arbitrage

An Authorized Participant (AP) looks for when an ETF is trading at a premium or discount to its NAV.
The AP then buys low and sells high in order to make a profit on the difference. This trade also reduces the price discrepancy and helps to keep ETF share prices in line with their NAV.
For example, if the ETF is trading at a premium the AP will enter a create process with the ETF Sponsor. This means that the AP buys the underlying stocks (at a relatively low price) and exchanges them with the ETF Sponsor for ETF shares (which are priced at a premium). Then the AP sells those ETF shares on the stock exchange. The purchase of underlying stocks tends to push the stock prices up. The creation of more ETF shares tends to push the ETF share price downward.

Arbitrage with ETF Create/Redeem Process

The “Tomato and Avocado” ETF is market cap weighted and contains only two stocks: Tomato Corp. and Avocado Corp. Tomato is $2 per share with 5000 shares outstanding; Avocado is $5 per share with 2000 shares. There are 1000 shares of “Tomato and Avocado” ETF, linked to 2500 shares of Tomato and 1000 shares of Avocado. The price of an ETF share is $9.50 per share. What should the AP do?

SOLUTION: redeem

Next Concept