ETF Arbitrage Under Liquidity Mismatch

57 Pages Posted: 8 Jan 2017 Last revised: 19 Feb 2021

See all articles by Kevin Pan

Kevin Pan

Harvard University, Department of Economics, Students

Yao Zeng

University of Pennsylvania - The Wharton School

Multiple version iconThere are 2 versions of this paper

Date Written: March 27, 2019

Abstract

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

Pan, Kevin and Zeng, Yao, ETF Arbitrage Under Liquidity Mismatch (March 27, 2019). Fourth Annual Conference on Financial Market Regulation, Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=2895478 or http://dx.doi.org/10.2139/ssrn.2895478

Kevin Pan

Harvard University, Department of Economics, Students ( email )

Cambridge, MA
United States

Yao Zeng (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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