Book

A critical aspect of trading exchange-traded Funds (ETFs) is the arbitrage trading strategy taken by authorized participants (APs) to keep ETF prices in line with their net asset values (NAVs). ETF arbitrage trading is a strategy that exploits the discrepancies between an ETF price and the value of the ETF’s underlying assets. In this book, discover how I quantitatively examine the effect of ETF arbitrage trading on the underlying assets of an ETF. I develop a dynamic state-space model that jointly estimates the price dynamics of an ETF and its underlying assets by explicitly incorporating the ETF arbitrage mechanism. The model is estimated individually for the Dow Jones Industrial Average ETF (DIA) and the VanEck Vectors Semiconductor ETF (SMH). The empirical results show that ETF liquidity shocks propagate to the underlying assets mainly through the ETF arbitrage mechanism. These liquidity shocks add a permanent layer of transitory volatility to the underlying asset prices. In addition, I showed that it takes APs a longer time to correct deviations between the ETF price and its NAV. For instance, It takes approximately 4 and 10 minutes for APs to perform the ETF arbitrage for DIA and SMH, respectively. Finally, the findings suggest that an ETF arbitrage transaction speeds up the price discovery process in the ETF markets.