ETF arbitrage is principally an institutional creation-and-redemption mechanism. When an ETF trades away from the value of its creation basket, authorised participants and market makers may trade the ETF, hedge with the underlying securities and create or redeem large blocks of shares. Retail investors normally trade in the secondary market and cannot assume that a displayed premium or discount is directly capturable after spreads, hedging costs, taxes, timing and creation-unit constraints.
The Theory Behind ETF Arbitrage
ETFs are designed to track the performance of an index, commodity, or a basket of assets. They trade on exchanges similar to stocks, allowing their prices to fluctuate throughout the trading day. However, the price of an ETF should, in theory, be closely aligned with the Net Asset Value (NAV) of its underlying assets. This is because the ETF structure allows for the continuous creation and redemption of shares, which helps maintain the market price near the ETF's NAV.
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