Exchange Trading Funds Mispricing

In this paper, I extend Malamud (2015) to study ETF and Leveraged ETF mispricing. I proceed as follows. First, I show that Malamud’s model is inherently dynamic since it does not bring any mispricing for a finite horizon; this happens because at the final period price of the underling security is equal to dividend, while ETF price is a fixed mix of these dividends, which means APs always fully arbitrage, and ETF is redundant. Second, I introduce an execution risk for ETFs to capture the mechanism of infinite horizon. This execution risk can be explained differently; for example, actual weights of basic securities in ETF can be different from the announced or there can be a transaction risk. I show that the model with these settings indeed has a pricing gap between ETFs price and Net Asset Value. Third, I also extend the model by studying leveraged ETFs: exchange traded products that amplify the return of an index (for example, twice or three times higher return: 2x and 3x respectively). In order to maintain higher returns and target stock-to-cash ratio, Leveraged Exchange Traded Funds buy rising stocks and sell the falling. This process stimulates the increase in the volatility of the underlying stocks and thus creates bigger mispricing. My model indeed demonstrates that the higher is the leverage ratio the greater is the the pricing gap. I also show that income shocks of ETF clients and Basic securities dealers can both diminish and magnify the mispricing.