November 2020

Arbitrage and Liquidity: Evidence from a Panel of Exchange Traded Funds

David E. Rappoport W. and Tugkan Tuzun

Abstract:

Market liquidity is expected to facilitate arbitrage, which in turn should affect the liquidity of the assets traded by arbitrageurs. We study this relationship using a unique dataset of equity and bond ETFs compiled from big trade-level data. We find that liquidity is an important determinant of the efficacy of the ETF arbitrage. For less liquid bond ETFs, Granger-causality tests and impulse responses suggest that this relationship is stronger and more persistent, and liquidity spillovers are observed from portfolio constituents to ETF shares. Our results inform the design of synthetic securities, especially when derived from less liquid instruments.

Keywords: Exchange traded funds, ETF, market liquidity, law of one-price, arbitrage, ETF premium.

DOI: https://doi.org/10.17016/FEDS.2020.097

PDF: Full Paper

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Last Update: November 30, 2020