ETF Arbitrage Under Liquidity Mismatch

74 Pages Posted: 5 Nov 2020

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: December, 2017

Abstract

A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. We provide a theory and empirical evidence showing that this liquidity mismatch can reduce market efficiency and increase the fragility of these ETFs. We focus on corporate bond ETFs and examine the role of authorized participants (APs) in ETF arbitrage. In addition to their role as dealers in the underlying bond market, APs also play a unique role in arbitrage between the bond and ETF markets since they are the only market participants that can trade directly with ETF issuers. Using novel and granular AP-level data, we identify a conflict between APs’ dual roles as bond dealers and as ETF arbitrageurs. When this conflict is small, liquidity mismatch reduces the arbitrage capacity of ETFs; as the conflict increases, an inventory management motive arises that may even distort ETF arbitrage, leading to large relative mispricing. These findings suggest an important risk in ETF arbitrage.

Keywords: arbitrage, authorized participants, corporate bond, exchange-traded funds, liquidity mismatch

JEL Classification: G12, G14, G23

Suggested Citation

Pan, Kevin and Zeng, Yao, ETF Arbitrage Under Liquidity Mismatch (December, 2017). ESRB: Working Paper Series No. 2017/59, Available at SSRN: https://ssrn.com/abstract=3723406 or http://dx.doi.org/10.2139/ssrn.3723406

Kevin Pan (Contact Author)

Harvard University, Department of Economics, Students ( email )

Cambridge, MA
United States

Yao Zeng

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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