ETFs utilize an "in-kind" creation/redemption process whereby ETF units can be created and redeemed. These transactions are generally entered into in response to changes in demand for ETF units. If demand increases, ETF units are created to meet this demand; conversely, they are redeemed.
An ETF creation occurs when a designated broker, who has entered into a contractual relationship with the ETF provider, delivers the underlying securities that constitute the Prescribed Basket of Securities (Basket) and cash to the ETF provider. In exchange, the broker receives units of the ETF which are allotted in large aggregated block sizes referred to as the Prescribed Number of Units (PNU). See below for an example of what constitutes the Basket and how the net asset value (NAV) of the Basket and equivalently the PNU is calculated. The designated broker will then break up the PNUs into individual ETF units which the broker can then sell on the open market or use to cover a short position. Conversely, an ETF redemption occurs when the designated broker buys a large block of ETF units equivalent to the PNU in the open market and delivers them to the ETF provider in exchange for the underlying securities that constitute the Basket and cash.
This creation/redemption process and the arbitrage mechanism ascribed to ETFs is what helps keep the price of an ETF in line with its NAV per unit. ETF units are purchased and sold in the secondary market at market prices. This price typically deviates slightly from the ETF’s NAV because market prices fluctuate during the trading day as a result of various factors, while the ETF’s NAV is calculated on the basis of the value of its underlying basket of securities. So an ETF’s market price may trade at a premium or at a discount to its underlying value. Any differential opens up an arbitrage opportunity providing an economic incentive to act on it. Designated brokers and other traders can arbitrage this difference to make a profit. This arbitrage activity tends to move the market price of the ETF back in line with its NAV per share or underlying value.
Let's take a look at an example:
|Ticker||Prescribed Basket||Last Price||Value|
|Value per unit||6.43|
|Net Asset Value||6.55|
This is an example of an ETF with very few securities in its underlying index.
The 10 securities comprising the Basket are the securities comprising the ETF’s underlying index. The number of shares of each security required to make up the Basket is based on that security’s weighting in the index. The number of shares of each security multiplied by its price equals its contribution to total value. The total value of $1,286,081 is then divided by the number of units in a PNU, in this case 200,000, to determine the value per unit. In this example, the NAV per unit is $6.43 before the cash adjustment of $0.12. This cash component covers such things as dividends and disbursements. The NAV per unit of this ETF is calculated to be $6.55.
Let’s assume that the ETF units are trading at a premium to their NAV. This implies that demand for the ETF units exceeds supply. During the trading day, the designated broker will sell short the ETF (1 in the diagram) and buy the underlying Basket (2 in the diagram). At the end of the trading day, he can exchange the Basket for the equivalent ETF units at NAV (3 in the diagram). In our example, if the ETF units were trading at $7.00, and the NAV of the Basket is $6.55 per unit, the designated broker has locked in a profit of $0.45 per unit. Note that this is a numeric example to demonstrate a point and not indicative of typical spreads. So long as the ETF units are trading at a premium to their NAV, this arbitrage activity is repeated throughout the trading day until the profit incentive is gone and the ETF price is realigned to its NAV. The process is described in the diagram below.
Conversely, if the ETF units are trading at a discount to their NAV, this implies that the supply of ETF units exceeds demand. During the trading day, the designated broker will buy the ETF units on the market (1 in the diagram) and sell short the Basket (2 in the diagram). At the end of the trading day, he can exchange the ETF units for the equivalent Basket at NAV (3 in the diagram). If the ETF units were trading at $6.10, and the NAV of the Basket is $6.55 per unit, the designated broker has locked in a profit of $0.45 per unit. So long as the ETF units are trading at a discount to their NAV, this arbitrage activity likewise generates a profit and the activity will be repeated throughout the trading day until the profit incentive is gone and the ETF price is realigned to its NAV. This process is described in the diagram below.
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