Arbitrage

Buying and selling two forms of substantially the same thing at the same time to capture a price difference between them.

Example

Assembling a basket of securities at 50.00 per unit and exchanging it for fund units worth 50.12 captures the gap, less the cost of executing both sides.

Important

It is bounded by its own cost. Where executing both sides costs 18 basis points, the gap narrows to about that and stops - so a small persistent premium or discount is the price of the mechanism, not evidence it has failed.

Related terms

• Creation and redemption — The wholesale mechanism by which large blocks of exchange-traded fund units are issued in exchange for a basket of the underlying securities, or cancelled in exchange for that basket.
• Premium or discount — The gap between an exchange-traded fund's market price and the net asset value of its holdings, expressed as a percentage of that value.
• Authorised participant — A firm permitted to create and redeem exchange-traded fund units in large blocks by delivering or receiving the underlying basket of securities.
• Market maker — A participant that continuously quotes both a buying and a selling price in a security, standing ready to trade with either side and earning the spread between the two.

Lessons that explain it

• Two prices: what the holdings are worth, and what somebody will pay — Net asset value is an accounting fact struck at a moment. An exchange-traded fund's market price is a live opinion. The gap between them is sometimes a mispricing and sometimes the more honest number. (12 min)

All 578 terms in the Investing glossary