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

Abstract

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 mutualfund shares. Although individual investors invest much more heavily in SPDRs than in S&P500 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 MidCap 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