Essays on Exchange Traded Notes
Exchange traded products (“ETPs”) have been experiencing tremendous growth as a class of financial products for the past twenty years. One of the more recent innovations in the ETP market is the exchange traded note (“ETN”), which first came into existence in 2006. An ETN is an unsecured debt liability of the issuing financial institution that provides an investor economic exposure to a variety of asset classes, trading strategies, and markets with the convenience that comes with trading on an exchange. As the ETN market has grown, a number of phenomena have developed that pose interesting asset pricing questions. The chapters in this dissertation will describe ETNs and the ETN market, highlight a variety of stylized facts about ETNs, and provide an explanation for one of the most prominent ETN puzzles.
The first chapter provides a detailed description of ETNs as a financial product, including an outline of their defining institutional features. The growth of the ETN market from the inception of the first product in June 2006 to a $23 billion market by the end of 2013 is documented throughout the chapter. Since financial industry references and discussions of ETNs often comingle ETNs with exchange traded funds (“ETFs”), the chapter offers a comparison of ETNs and ETFs, highlighting key similarities between the two classes of ETP and, more importantly, the key differences. A main contribution of this chapter is a documentation of the “ETN premium puzzle.” As derivatively-priced products, the market price of an ETN should align with its fundamental value. This chapter shows that on average the market prices of ETNs exceed their fundamental values by 31 basis points with certain individual ETNs trading at premiums well above 100 basis points. ETNs trading at a discount are far less likely and the absolute magnitude of discounts are far lower than those of premiums. Collectively, these stylized facts constitute the “ETN premium puzzle.”
The second chapter presents a number of selected ETN case studies that motivate a preliminary explanation for the ETN premium puzzle. The first case study focuses on the ETNs that were issued by Lehman Brothers. As unsecured debt obligations of Lehman Brothers, those ETNs suffered substantial losses as a result of Lehman’s failure. The case study highlights that two of the three Lehman ETNs continued to trade at premiums up until the day of bankruptcy despite the generally increasing market concern about Lehman’s solvency. The chapter also uses the Lehman failure to study the ETN market’s general consideration of counterparty credit risk in ETN pricing, finding that the market became more attentive to the credit risk of ETNs after the failure, but that such attention did not last beyond a couple months. The chapter also uses case studies to demonstrate the effects of the two most significant factors that explain the ETN premium puzzle: (i) the suspension of new share creation by the issuer and (ii) the degree of competition that an ETN faces in providing exposure to its targeted asset class or market. The first factor serves as a limit to arbitrage, while the second factor contributes to the overall demand for the ETN.
The third chapter presents a full explanation of the ETN premium puzzle. The chapter motivates the story of the explanation through the noise trader / arbitrager framework of De Long, et al. (1990) and Shleifer and Summers (1990). As applied to the ETN market, it is more appropriate to label noise traders as demand traders, since the noise trader definition presumes irrationality, while in the ETN context, there are rational non-arbitrageur market participants. The results of this chapter show that many of the institutional features of ETNs lead to substantial limits to arbitrage, which alone explain much of the ETN premium puzzle. The chapter conducts a cross sectional regression of ETN arbitrage speeds (i.e. the daily error correction rate for ETNs with stationary premiums) on various factors that limit arbitrage, showing which factors weaken the arbitrage mechanisms the most. The chapter then adds a number of factors that account for the demand of ETNs. In a panel regression that combines the limits to arbitrage with the demand factors, the chapter provides a fuller explanation of the ETN premium puzzle.