Arbitrage and Valuation in the Market for Standard and Poor's Depositary Receipts

By Ackert, Lucy F.; Tian, Yisong S. | Financial Management, Autumn 2000 | Go to article overview

Arbitrage and Valuation in the Market for Standard and Poor's Depositary Receipts


Ackert, Lucy F., Tian, Yisong S., Financial Management


Yisong S. Tian [*]

This paper examines pricing in the market for depositary receipts, securities designed to track the performance of a stock index that trade like shares of stock. Arbitrage costs are low because these assets have low fundamental risk, low transactions costs, and high dividend yields. We find that Standard and Poor's Depositary Receipts (SPDRs), or spiders, do not trade at economically significant discounts, unlike closed-end mutual fund shares. Although individual investors invest much more heavily in SPDRs than in S&P 500 stock, investor sentiment is not an important determinant of the discount. The SPDRs redemption feature facilitates arbitrage so that sophisticated traders can take advantage of and eliminate mispricing. However, we also report a larger, economically significant discount for MidCap SPDRs. MidCap SPDRs are designed to track the performance of the S&P MidCap 400 index, an index of moderate capitalization firms, and are expected to have higher arbitrage costs. Finally, we find that SPDRs and Mi dCap SPDRs returns are not excessively volatile, also unlike closed-end funds.

Recently stock exchanges have introduced index derivative products that trade just like shares of stock. Because traded stock baskets are simple assets like closed-end mutual funds, they provide an ideal experiment to study pricing. These products are not actively managed, but rather track an existing stock index. [1] For example, in January 1993 the American Stock Exchange (AMEX) introduced Standard and Poor's Depositary Receipts (SPDRs), or spiders, designed to track the performance of the S&P 500 index. [2] The price of a depositary receipt should not deviate from its fundamental value as predicted by the level of the underlying index if all investors are rational. This paper examines whether depositary receipts trade at prices that reflect fundamental value.

Perhaps no question in finance has received greater attention than the extent to which asset prices reflect fundamental values. Keynes (1936) argued that markets are unstable and driven by waves of irrational psychology. In contrast, if markets are efficient, price reflects all information so that the profits made by acting on information do not exceed the costs of trading (Jensen, 1978). Accordingly, assets trade at prices that reflect their fundamental values and no arbitrage opportunity exists. However, the costs of trading are surely positive so that the extreme form of the efficient market hypothesis does not hold.

Even with rational traders in the market, an asset may be mispriced if traders have limited ability to take advantage of arbitrage opportunities. Significant arbitrage costs prevent rational traders from exerting sufficient price power to force prices to return to fundamental values (Shiller, 1984 and DeLong, Shleifer, Summers, and Waldmann, 1990). For example, arbitrage strategies based on mispricing may be restricted because of limits on short sale proceeds, the cost of portfolio rebalancing, and the possibility of forced liquidation (Lee, Shleifer, and Thaler, 1991). In a costly arbitrage framework with noise traders, Pontiff (1996) identifies factors that affect the profitability of arbitrage and, in turn, the magnitude of mispricing, Using a sample of closed-end mutual funds, Pontiff concludes that the magnitude of mispricing can be explained by various security characteristics, including how difficult the fund is to replicate, the security's dividend yield, and transaction costs. Although a closed-end fund is a very simple security that typically holds other publicly traded securities, these funds are perplexing, because they frequently trade at prices different from net asset value, i.e., market prices deviate from the actual value of the stock portfolio held by the fund. [3]

This paper studies the pricing efficiency of traded stock baskets and examines the impact of arbitrage costs in the pricing of these relatively new, but high volume, financial instruments. …

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