Abstract

Authorized Participants (APs), primarily market makers, possess the right to create and redeem Exchange Traded Funds (ETF) shares based on market demand. The important role they play in facilitating liquidity provision and eliminating ETF mispricing makes their behavior crucial to the well-functioning of the ETF market. Using a novel regulatory dataset that covers the primary and secondary market transactions of 128 ETFs from 2018 to 2022, we identify a connection between mispricing (the difference between ETF prices and the Net Asset Value (NAV) of their underlying baskets) and APs’ inventory. We formulate a dynamic model that explains ETF mispricing with APs’ inventory management skills and market demand. Empirical findings are consistent with our model predictions in that the proposed factors are useful for explaining the observed mispricing on top of other common macro and fundamental factors in the ETFs and underlying markets. Our model is helpful for understanding the incentive structure of APs’ market making and arbitraging, as well as the mechanisms  behind the significant mispricing observed in March 2020 across various ETF classes.

Ponente

Andrei Kirilenko is Founding Director of the Cambridge Center for Finance, Technology and Regulation (CCFTR) at Cambridge Judge Business School. His research interests include the intersection of finance, technology, and regulation, fintech, asset pricing, data, digital technologies, and the design of automated financial markets. Andrei previously served as Chief Economist of the US Commodity Futures Trading Commission (CFTC), where he used modern analytical tools and methods to design and enforce an effective regulatory regime of financial markets. Andrei Kirilenko is a member of the Finance subject group at Cambridge Judge Business School, which focuses on the investment and financial decisions of institutions.