ETF Arbitrage Under Liquidity Mismatch
Fourth Annual Conference on Financial Market Regulation
Jacobs Levy Equity Management Center for Quantitative Financial Research Paper
57 Pages Posted: 8 Jan 2017 Last revised: 30 Mar 2019
There are 2 versions of this paper
ETF Arbitrage Under Liquidity Mismatch
ETF Arbitrage Under Liquidity Mismatch
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: Suggested Citation