Question

1. Suppose that an ETF trades at a price below its net asset value. Describe what authorized participants (APs) could do to take advantage of this discrepancy. What would be the likely effect of the APs’ actions?

Answer 1

An exchange traded fund’s market price is the price at which shares in the ETF can be bought or sold on the exchanges during trading hours.

The NAV of an ETF usually represents the value of each share’s portion of the fund’s underlying assets & cash at the end of the trading day.

There may be differences between market closing price for the ETF & the NAV. But the difference s would be minor. This may be because of the redemption mechanisms used by ETF’s. The ETF uses the help of an AP in order to form creation units. The AP then transfers the creation units to the ETF provider on an equal NAV value basis. In return, the AP would receive a similarly valued block of shares in the ETF. The AP can then sell those shares in the open market. The creation units are usually anywhere from 25,000 to 600,000 shares of the ETF.

The redemption mechanism helps in keeping the market & NAV values in line. The AP can easily arbitrage any discrepancies between the market value & the NAV during the day of trading. In case if the market value becomes high when compared to the NAV, the AP would come into the picture & buy the underlying components & also simultaneously selling the ETF shares.

In the alternative, the AP can buy the ETF shares and sell the underlying components if the ETF market value gets too far below the NAV. These opportunities can provide a quick and relatively risk-free profit for the AP while also keeping the values close together. There may be multiple APs for an ETF, ensuring that more than one party can step into arbitrage away any price discrepancies.