Why are ETN's not trading at a discount?

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giftsplash
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Why are ETN's not trading at a discount?

Post by giftsplash » Wed Feb 08, 2012 12:37 am

I am trying to better understand why ETN's are not trading at a discount to Nav compared to their ETF counter parts. Since ETN carry a much larger default risk.

For example the Credit Default Swaps for most ETN providers is between 100 and 200 basis points. It means that the market is pricing in a 1/100 to 1/50 chance of a default over the next year. I am wondering why that is not reflected in the ETN pricing since they all seem to hover around NAV in the same fashion as their ETF's equivalents?

yobria
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Re: Why are ETN's not trading at a discount?

Post by yobria » Wed Feb 08, 2012 1:26 am

ETNs should be collateralized at some level to protect customers even if the issuer defaults on its bonds. But this, (like annuity products) is "contract investing", not "asset investing", so you'd have to read the individual contracts.

Nick

larryswedroe
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Re: Why are ETN's not trading at a discount?

Post by larryswedroe » Wed Feb 08, 2012 7:34 am

no one should own ETNs for exactly the reason stated. The issuers love them because they get to issue cheap funding. But the owners are not compensated for the credit risk they are taking.

Larry

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Rick Ferri
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Re: Why are ETN's not trading at a discount?

Post by Rick Ferri » Wed Feb 08, 2012 7:51 am

ETNs don't trade at a discount because that would create an immediate risk-free arbitrage opportunity for authorized participates (APs). They would buy ETNs shares on the market at a discount and turn them in to the issuer for cash. This would be free money for as long as the issuer remained solvent.

Rick Ferri
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smpatel
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Re: Why are ETN's not trading at a discount?

Post by smpatel » Wed Feb 08, 2012 8:07 am

Rick Ferri wrote:ETNs don't trade at a discount because that would create an immediate risk-free arbitrage opportunity for authorized participates (APs). They would buy ETNs shares on the market at a discount and turn them in to the issuer for cash. This would be free money for as long as the issuer remained solvent.

Rick Ferri
Why wouldn't issuer also buy it with the same market discounted rate, eliminating such risk-free arbitrage? I am sure missing something here.
Yes, ETN has the credit risk but aren't they required to hold underlying basket of securities as promised by the contract and manage like mutual fund/etf?

regards,

yobria
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Re: Why are ETN's not trading at a discount?

Post by yobria » Wed Feb 08, 2012 11:05 am

Rick Ferri wrote:ETNs don't trade at a discount because that would create an immediate risk-free arbitrage opportunity for authorized participates (APs). They would buy ETNs shares on the market at a discount and turn them in to the issuer for cash. This would be free money for as long as the issuer remained solvent.

Rick Ferri
I'm no ETN expert but I don't believe in the case of synthetic (notional) ETFs the issuer has any requirement to trade actual underlying shares for cash. In any case, taking physical possession of the ETN means accepting the risk of issuer insolvency, so any strategy like this wouldn't be a free lunch - you're getting paid to take risk.

Nick

xerty24
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Re: Why are ETN's not trading at a discount?

Post by xerty24 » Wed Feb 08, 2012 11:07 am

There's not much risk to the APs if they can convert to the underlying every day or week. The CDSs showing 1-2% credit risk are probably annual numbers, so less than 1bp per day. I could believe there was a 0.005% discount for daily credit risk.
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mas
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Re: Why are ETN's not trading at a discount?

Post by mas » Wed Feb 08, 2012 11:25 am

smpatel wrote:ETN has the credit risk but aren't they required to hold underlying basket of securities as promised by the contract and manage like mutual fund/etf?
No, the contract specifically says that they are "uncollateralized debt".

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ladders11
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Re: Why are ETN's not trading at a discount?

Post by ladders11 » Wed Feb 08, 2012 11:53 am

I don't think people take the credit risk seriously.

And, when they're investing in a large enough ETN (100M+), with a large enough backer (DB, HSBC), they know that failure would not be allowed.

Some people prefer ETNs because they aren't subject to the same tracking error risks as similar ETFs.

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Rick Ferri
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Re: Why are ETN's not trading at a discount?

Post by Rick Ferri » Wed Feb 08, 2012 12:47 pm

yobria wrote:
Rick Ferri wrote:ETNs don't trade at a discount because that would create an immediate risk-free arbitrage opportunity for authorized participates (APs). They would buy ETNs shares on the market at a discount and turn them in to the issuer for cash. This would be free money for as long as the issuer remained solvent.

Rick Ferri
I'm no ETN expert but I don't believe in the case of synthetic (notional) ETFs the issuer has any requirement to trade actual underlying shares for cash. In any case, taking physical possession of the ETN means accepting the risk of issuer insolvency, so any strategy like this wouldn't be a free lunch - you're getting paid to take risk.

Nick
There is no risk to the AP who is arbing an ETN discount. This trade is completed within minutes and the AP is hedged on the other side. It's risk-free money. This is why ETNs don't trade at discounts for very long. The exception is when the issuer is already in default, in which case the ETN will trade like the issuer's bond rather than tracking an underlying index. This was the case with Lehman Brothers in 2008. They had several ETNs trading Europe at the time.

Rick Ferri
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giftsplash
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Re: Why are ETN's not trading at a discount?

Post by giftsplash » Wed Feb 08, 2012 1:14 pm

There's not much risk to the APs if they can convert to the underlying every day or week. The CDSs showing 1-2% credit risk are probably annual numbers, so less than 1bp per day. I could believe there was a 0.005% discount for daily credit risk.
You are correct those are annual numbers. It's fascinating that if you had 2 banks and one was FDIC insured (ETF) and in another you had a 2% chance a year of losing most of your money (ETN) that those banks can get away with offering the same interest rate to attract customers.
There is no risk to the AP who is arbing an ETN discount. This trade is completed within minutes and the AP is hedged on the other side. It's risk-free money.
Rick, how can AP's be fully hedged on the other side of the trade? Do you mean through Credit Default Swaps? If you take a long position in a ETN and hedge it with say a short position of an underlying index you are still not protected against default of the provider. You are only protected against the market move that prevents you from completing the arbitrage.

yobria
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Re: Why are ETN's not trading at a discount?

Post by yobria » Wed Feb 08, 2012 1:39 pm

Rick Ferri wrote:
yobria wrote:
Rick Ferri wrote:ETNs don't trade at a discount because that would create an immediate risk-free arbitrage opportunity for authorized participates (APs). They would buy ETNs shares on the market at a discount and turn them in to the issuer for cash. This would be free money for as long as the issuer remained solvent.

Rick Ferri
I'm no ETN expert but I don't believe in the case of synthetic (notional) ETFs the issuer has any requirement to trade actual underlying shares for cash. In any case, taking physical possession of the ETN means accepting the risk of issuer insolvency, so any strategy like this wouldn't be a free lunch - you're getting paid to take risk.

Nick
There is no risk to the AP who is arbing an ETN discount. This trade is completed within minutes and the AP is hedged on the other side. It's risk-free money. This is why ETNs don't trade at discounts for very long. The exception is when the issuer is already in default, in which case the ETN will trade like the issuer's bond rather than tracking an underlying index. This was the case with Lehman Brothers in 2008. They had several ETNs trading Europe at the time.

Rick Ferri
Ah, I see, thanks. Some Googling has lead me to a better understanding of these products.

Nick

zeugmite
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Re: Why are ETN's not trading at a discount?

Post by zeugmite » Wed Feb 08, 2012 1:49 pm

xerty24 wrote:There's not much risk to the APs if they can convert to the underlying every day or week. The CDSs showing 1-2% credit risk are probably annual numbers, so less than 1bp per day. I could believe there was a 0.005% discount for daily credit risk.
This is probably the right answer. And the annual discount isn't evenly divided into every day of the year either, so on a normal day it is even smaller than that.

ftobin
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Re: Why are ETN's not trading at a discount?

Post by ftobin » Wed Feb 08, 2012 3:13 pm

We can understand why an ETN doesn't trade with a tight spread at a discount, because of minimal risk a market maker could take while arbing it away.

The real question is why are investors willing purchase the product at 0 discount from the ask, since their exposure to the credit risk is sustained.

xerty24
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Re: Why are ETN's not trading at a discount?

Post by xerty24 » Wed Feb 08, 2012 3:33 pm

ftobin wrote:The real question is why are investors willing purchase the product at 0 discount from the ask, since their exposure to the credit risk is sustained.
Good reasons would include the belief that issuer is Too Big To Fail, that the investor will monitor the issuer's credit status and sell promptly at any sign of distress, and that strategy implementation costs (futures rolls, slippage, commissions) are meaningful and not counted against the ETN index performance as compared to a similar ETF or other implementation. The typical reason I expect is ignorance - the average investor probably thinks an ETN is really an ETF, and that ETFs are FDIC insured :roll:... unless they hold gold or silver, of course, in which case the typical investor thinks they're a complete fraud.
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