ETF Arbitrage Under Liquidity Mismatch
57 Pages Posted: 8 Jan 2017 Last revised: 19 Feb 2021
Date Written: March 27, 2019
We study arbitrage in ETFs holding illiquid corporate bonds, focusing on authorized participants (APs) and their balance sheet space constraints. As unique ETF arbitrageurs, most APs are also bond dealers, and they use their own balance sheet in both roles. We find that bond market illiquidity limits ETF arbitrage. Using novel AP-level balance sheet data, we further find that large bond flow shocks to AP balance sheets also limit ETF arbitrage, leading to persistent relative mispricings. These findings reveal an important risk in ETFs and suggest that financial intermediaries' balance sheet space constraints matter for asset pricing through arbitrage.
Keywords: ETF, authorized participant, arbitrage, corporate bond, liquidity, balance sheet space constraints
JEL Classification: G12, G14, G23
Suggested Citation: Suggested Citation