Question #1
Reading: Reading 35 Exchange-Traded Funds - Mechanics and Applications
PDF File: Reading 35 Exchange-Traded Funds - Mechanics and Applications.pdf
Page: 1
Status: Correct
Correct Answer: B
Question
The arbitrage gap for an ETF is most likely to be narrow when:
Answer Choices:
A. the ETF and the securities underlying the ETF trade in the same market
B. the securities underlying the ETF are illiquid
C. the ETF represents securities that are difficult to invest in directly
Explanation
Since the liquidity of the securities in an ETF basket determines the transaction cost, the
arbitrage gap tends to be wider for ETFs with illiquid holdings. Due to difference in time
zones, an ETF on a foreign index may exhibit a difference between its NAV and the last
closing price when the foreign market was open. This timing difference increases risk for
the authorized participants (APs), leading to a wider arbitrage gap. This timing difference
would not be present for an ETF and underlying securities trading in the same market. If
the underlying securities are hard to invest in directly, the APs would not be able to
create/redeem ETFs easily, leading to a larger arbitrage gap.