Learning Module 1 Exchange-Traded Funds Mechanics and Applications

Learning Module 1 Exchange-Traded Funds: Mechanics and Applications CREATION/REDEMPTION ASSET CLASS DIFFERENCES The creation/redemption mechanism described is broadly representative of how most ETFs work, regardless of their particular legal structure. Depending on the asset class, however, some differences exist. Fixed-income ETFs generally hold large amounts of bonds, which may be illiquid to trade (for example, a high-yield municipal bond ETF holds securities that might trade only every few days). Because of this, ETF issuers may choose not to do in-kind creations and redemptions but instead accept equivalent cash value. This makes the process easier for APs, encouraging greater ETF activity, but does result in trading costs and tax impact for the ETF. ETF issuers must balance those costs against the benefit of having the AP participate more actively in the market, keeping spreads tight and the price of the ETF close to fair value. Similarly, many leveraged and inverse ETFs and commodity ETFs may use cash creation/ redemption because it makes managing their underlying swap positions easier. Because swaps are generally negotiated OTC transactions, it would be difficult to have APs par- ticipate in increasing or decreasing those swap positions. EXAMPLE 1 Comparison of US ETF Trading Costs A way to the liquidity and patialak wsirading mehmet The SFDSL ETF) the hum Cine S&P 500 ETF (VV) and the Vanged 542 00 ETT (VODE bechmarket to the S&P 500 e ingray ETT he hures MSCI USA Sal Weiglard ETF (ELSA) bendesasked to the MICI USA Momated to the Ru Exhibit Selected US Equity Index (TF Trading Comparison ETF T W Semihmark Index S&P 500 SAF 500 SAP 300 MSCI USA Equal Rasel 2000 FUUSA Weighted 14.47 vien ETF TOH Benchmark Indes SPT NV S&P 5000 S&P 500 S&P S DUSA MSCI USA Egal Wrightat GUER -Lies the largest by AIMET ene of the most laped securities in the mall IVV and VOC, with the beachmark, are wed mae by intermediate and longer horse investor bet so have very night see of lipodity in the onderlying natiti dmc comparse with median of for IVV The norage bil k prod www that hehe highly Kyuik, in abikius, buth her tight and la comast, ELSA has a large opera The lipadity and higher OF ELSA as he attet that the hecho notarys and uerade prate for hedging me by nae makes the OCI USA Wetted indessho includes cine IWA, benkassed to the Bussell 2000 ba more securities thuy the period ETF ny cap that have widespreads Wh, how, trades tibi aperus and penudacasts close to the How is that posible Fint, trading achty ngh through the rang de Second the Red 2000 lades lain active resoubet, making it say the Duhal 10 bom the US ET US-Tinary besed noboctrudelitahide All des among the muciged Exed-inores ETFs and have tight ved De 5 High We Corporate Bond El the pad, with mediasdey les and a higher median premium the hathong Baniya High Vind KONOHYG hers instand postomost of the 12th prod Esbit 10 and really paid above fuit af ETE Theme meally hench larger he bond Els componed with the equity Town The sec the underlying tises trale in dele market and are at contienes pred in the cases the sand woome ETFs, which trafe on change mom prising, may be hottier and demand in the portholes heen the sanderlying harus mey set trade fogart, pencilady nestiese rurken ondries Learning Module 2 Using Multifactor Models EXAMPLE 1 Determining the Parameters in a One-Factor APT Model Suppose we have three well-diversified portfolios that are each sensitive to the same single factor. Exhibit 1 shows the expected returns and factor sensitivities of these portfolios. Assume that the expected returns reflect a one-year investment horizon. To keep the analysis simple, all investors are assumed to agree upon the expected returns of the three portfolios as shown in the exhibit. Exhibit 1: Sample Portfolios for a One-Factor Model Portfolio Expected Return Factor Sensitivity A 0.075 05 B 0.150 20 C 0.070 04 We can use these data to determine the parameters of the APT equation. According to Equation 2, for any well-diversified portfolio and assuming a single factor explains returns, we have E(R) The factor sensitivities and expected returns are known; thus there are two unknowns, the parameters R and A₁. Because two points define a straight line, we need to set up only two equations. Selecting Portfolios A and B, we have E(R) 0,075 R+0.5 and E(R) 0.15082 From the equation for Portfolio A, we have Rp=0.075-0.51]. Substituting this expression for the risk-free rate into the equation for Portfolio B gives 0.15-0.075-0.50 - 20 0.15-0.075151 So, we have A₁ = (0.15-0.075)/1.5 0.05. Substituting this value for A, back into the equation for the expected return to Portfolio A yields 0.075 0.05 0.5. R0.05. So, the risk-free rate is 0.05 or 5%, and the factor premium for the common factor is also 0.05 or 5%. The APT equation is E(R)-0.05 0.0501 From Exhibit 1. Portfolio C has a factor sensitivity of 0.4. Therefore, according to the APT, the expected return of Portfolio C should be E(R)-0.05(0.05×0.4)-007, which is consistent with the expected return for Portfolio C given in Exhibit 1. EXAMPLE 2 Checking Whether Portfolio Returns Are Consistent with No Arbitrage in the mampin, we say how us tell whether expected t activities for a set of well-divesited poraslion may bodicate the presence of at arbitrage opportunity Exhibit 2 provides data on hur hypothetical portadikos The data fe Portfisline A. IR, and Cane repeats) from Exhibit 1. Portfolia Dis now portholin. The factor sensitivities gren rolate to the one to API model - desired in Example 1. As in Lample L. all intors are assumed in agree apon the expected retama of the portfolios. The questom ratest be the addon of this new Porthalie D is whether the ants of this portliche crated opportunity porfido can be formed trom Fortidas A. B and C that has the same factor sensitivity as Portfele D but a different expected retsas then as arbitrage opportunity exibe Portfolio D woold be esther understand if it ollers a relatively high export a mervakard of offen a relatively low expected rotar Exhibit 2: Sample Portfolios for a One Factor Model Portfolio Expected Retur Factor Sensitivity D 945 Ishikat 2 gives date for an epally weighted portfolio of A and C. The espect return and facior semitivity of this new portfolio are calculated as weighted averages of the expected retams and sensities of & and C. Espeel return in this or 25%. The facter 10.50000озан белокола 0:45. No cut the facter sensity of 645 manches the factor semitivity of Portiolis D. la this case, the confliacatio of expected relation to factor is presents an arrage opport uhing Paths A, C, and D Portfolio Dallers, at as, an expected return that is to get faciteits, Asconding to the amumed APT model the capected retar on Persilio should be 1006045-90725,715 Parti Dr is ondervaland celate to risk. We will bay D thold a long in the pants that gleis the arbitrage opportunity (the arbitrage portfolio) perchase Dusing the proouds Som selling shast an equally woghted portfolio of A end with exactly the same 645övity as D The arbitrage has inteloos the kicking strategy: best Siteco Part D and fand that investment by selling shert un aspaily weighand portiolin Portfolios A and C. thee chose out the den pinition at the nad of on yer the westment berson for expected wremd. Exhibit 3 demonstrates the aststrage prides to the arhstrage stertegy. The and now at the eshabt shows the set och flow to the achttrage portfalia Exhibit 3: Arbitrage Opportunity within Sample Portfolios Final Cash Facter Sensitivity 10000 800725.00 At Exhibet 3 feboy$10000 of Portfolio D and sell 10000 of an pally weighned portain of Festidos A and C, what an intaal net ch few of St. The expected salt of curvestment in Porta Dat the end of ans wis $10,00010000110100. The expected value of our short position in Pestion & and Cat the end if one year is-507155-310725, the conshuwd expected cuti Bow bon our investment position in one your $75. What about the Exit 3hows that the beter risk has been eliminated Parhaing Dandslag whort an equally weighted portfole of A and Cerentes sportfaiin with a facter umutity of 045-450. The portes and well direnfiod, and we asttane aty anet specific disk is negligikle Because an arbitrage problers A. C and D cannot all be consistere with the same aspirin if Partidis Dactually had an exte evestors would bid ap its price until the expected retare fell and the achitrage ppormmunity vunked Thosathitragerestores poletom raps amongus