The impact of arbitrage trading between the ETF and its underlying assets on market liquidity of their markets using an agent-based simulation

Abstract

An exchange-traded fund (ETF) is a mutual fund that invests in a diversified portfolio of many stocks or bonds and is also listed and traded at a stock exchange. ETFs have been widely spread to individual investors as an easy way to diversify their investments. As an ETF is exchangeable with all underlying assets held by the ETF, when the ETF's price and the total value of the underlying assets held by the ETF differ, some investors buy the cheaper one and sell the more expensive one to make a profit from the price difference (i.e., arbitrage trading). However, few studies have discussed the impact of such arbitrage trading on the liquidity of the ETF and underlying asset markets. In this study, we constructed an artificial market consisting of two underlying assets and an ETF with the same value as the sum of the two underlying assets and examined the difference in market liquidity of the markets between with arbitrage trading among the underlying assets and the ETF and without one, using representative liquidity indicators (Volume, Tightness, Resiliency, and Depth).