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CFA Level II Exam · Exchange-Traded Funds: Mechanics and Applications

ETF Pricing, Premiums, Discounts and Arbitrage

Updated 7 October 2026 · Fact-checked

An ETF trades on an exchange at a market price that can differ from its net asset value (NAV). The gap is the premium or discount: (price − NAV) ÷ NAV. Authorized participants arbitrage the gap through creation and redemption, which pulls price back toward NAV, within the limits of trading costs.

Understand ETF Pricing, Premiums/Discounts and Arbitrage

An ETF has two prices. The NAV is the value of the fund's assets minus liabilities, divided by shares outstanding. It is usually calculated once a day at the close. The market price is what shares trade for on the exchange all day, set by supply and demand.

During the day, the NAV is stale. To help investors, the exchange or a data provider publishes an indicative NAV (iNAV), also called intraday NAV. It re-values the fund's holdings using live prices, often every 15 seconds. It is an estimate, not a trading price. If the holdings trade in a different time zone, the iNAV can be stale or misleading.

The market price can sit above NAV (a premium) or below (a discount). The mechanism that keeps the gap small is arbitrage by authorized participants (APs). Only APs can create or redeem ETF shares directly with the fund, usually in large blocks called creation units. Most trades by ordinary investors happen in the secondary market and do not touch the fund.

If the ETF trades at a premium, the AP buys the underlying basket, delivers it to the fund, receives new ETF shares (creation), and sells those shares at the higher price. Selling pushes the price down. If the ETF trades at a discount, the AP buys cheap ETF shares, delivers them to the fund, receives the basket (redemption), and sells the basket. Buying pushes the price up.

Arbitrage is not free. The AP faces trading costs, bid-ask spreads, creation/redemption fees and hedging risk. So the price can stay away from NAV by roughly the cost of the arbitrage. Gaps widen when the underlying market is closed, illiquid, or stressed, or when the basket is hard to trade (such as bonds or foreign shares). In-kind creation and redemption keep costs low, while cash creation adds cost and widens the band.

Key formulas to remember

Premium or discount to NAV
Premium/(discount) = (ETF market price − NAV) ÷ NAV
Positive means premium, negative means discount. Use NAV per share at the same time as the price.
NAV per share
NAV per share = (Assets − Liabilities) ÷ Shares outstanding
Usually computed at the end of the day.
Arbitrage when at a premium
Buy basket + create ETF shares + sell ETF shares
Profit is the price minus basket cost, less costs and fees. Selling pressure narrows the premium.
Arbitrage when at a discount
Buy ETF shares + redeem for basket + sell basket
Profit is basket proceeds minus ETF cost, less costs and fees. Buying pressure narrows the discount.
Arbitrage profit per share
|Price − NAV| − transaction costs and fees
Arbitrage only works if the gap exceeds costs.

How to solve ETF Pricing, Premiums/Discounts and Arbitrage questions

Use this sequence for any item set question on ETF pricing or arbitrage.

  1. 1Identify the ETF market price and the NAV or iNAV in the vignette. Check the time each was measured.
  2. 2Compute premium or discount as (price − NAV) ÷ NAV, and note the sign.
  3. 3Decide the direction: premium means create, discount means redeem.
  4. 4Write the AP's trade: which side of the basket and which side of the ETF to buy and sell.
  5. 5Subtract costs, fees and spreads from the gross gap to see if arbitrage is profitable.
  6. 6State the effect on the ETF price: selling ETF shares pushes price down, buying pushes it up.
  7. 7Check for reasons the gap may persist: closed markets, illiquid or stale underlying prices, stress, cash creation.

Quickest way: Sign, direction, costs

When to use it: Use when the question asks which action an AP takes or whether arbitrage is viable.

  1. Price above NAV: AP creates, selling ETF shares.
  2. Price below NAV: AP redeems, buying ETF shares.
  3. Compare the gap per share to total costs; if gap is smaller, no arbitrage.
  4. Remember the band: price can stay within about NAV ± cost of arbitrage.

Common mistakes in ETF Pricing, Premiums/Discounts and Arbitrage

  • Reversing the trade, such as redeeming when the ETF is at a premium.

    Students memorise the words create and redeem without tracing who buys what.

    Fix: Ask which is cheap and which is expensive. Buy the cheap one, sell the expensive one. At a premium the ETF is expensive.

  • Treating the iNAV as the official NAV or as a price at which you can trade.

    Both look like a fund value.

    Fix: The iNAV is an intraday estimate. The NAV is the official end-of-day value. Neither is a guaranteed execution price.

  • Ignoring costs and calling any gap an arbitrage profit.

    The textbook mechanism is shown without frictions.

    Fix: Subtract fees, spreads and hedging costs from the gap. If nothing remains, the gap can persist.

  • Thinking ordinary investors create and redeem shares with the fund.

    Confusing secondary-market trading with the primary market.

    Fix: Only authorized participants deal with the fund directly. Investors trade on the exchange.

  • Dividing the gap by price instead of NAV.

    Habit from return calculations.

    Fix: The denominator is NAV: (price − NAV) ÷ NAV.

  • Assuming premiums and discounts are always small.

    Overstating the arbitrage rule.

    Fix: They can be large when underlying markets are closed, illiquid or stressed, or when the AP is unable or unwilling to act.

Worked examples

Example 1

A global equity ETF closes at a market price of $50.40. Its NAV per share is $50.00. The AP's total cost to arbitrage is $0.15 per share. (1) What is the premium or discount? (2) What does the AP do? (3) What is the profit per share?

Show the solution
  1. (1) Premium = (50.40 − 50.00) ÷ 50.00 = 0.40 ÷ 50.00 = 0.8%.
  2. (2) The ETF is at a premium, so it is expensive relative to the basket. The AP buys the underlying basket, delivers it to the fund, receives new ETF shares, and sells them in the market.
  3. (3) Gross gap = $0.40. Less costs $0.15 = $0.25 per share.

Answer: The ETF trades at a 0.8% premium. The AP creates shares and sells them, earning $0.25 per share, and the selling pushes the ETF price down toward NAV.

Example 2

A bond ETF has an iNAV of ₹1,000 per share at mid-day, while it trades at ₹985. The AP's costs to redeem and sell the bonds total ₹20 per share. (1) Premium or discount? (2) Is arbitrage profitable? (3) What might explain why the gap persists?

Show the solution
  1. (1) Discount = (985 − 1,000) ÷ 1,000 = −1.5%.
  2. (2) The AP would buy the ETF at ₹985 and redeem for bonds worth ₹1,000, a gross gap of ₹15. Costs are ₹20, so the net is ₹15 − ₹20 = −₹5 per share, a loss.
  3. (3) Bond baskets are costly to trade and wide-spread, so the arbitrage band is wide. The iNAV may also rely on stale bond prices.

Answer: The ETF is at a 1.5% discount, but arbitrage is not profitable (−₹5 per share), so the discount can persist because the gap is inside the cost band.

Exam tips

  • Always read when NAV and price were measured in the vignette; mismatched times often explain a gap.
  • Questions often ask which AP action fits a premium or discount. Trace buy and sell on both sides.
  • Expect a link to illiquid or foreign underlying markets to explain wider gaps.
  • Compare the gap with costs before concluding that arbitrage occurs.
  • Know that the iNAV is an estimate and the NAV is official.

ETF Pricing, Premiums/Discounts and Arbitrage in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

ETF Pricing, Premiums/Discounts and Arbitrage: frequently asked questions

What is the difference between ETF price and NAV?

The price is set by trading on the exchange and moves all day. The NAV is the per-share value of the fund's net assets, normally computed at the end of the day. The two can differ, producing a premium or discount.

What is iNAV in an ETF?

The indicative NAV is an estimate of the fund's per-share value during the trading day, updated using live prices of the holdings. It is a guide for investors, not an official value. It can be unreliable when underlying markets are closed.

How does ETF arbitrage work?

Authorized participants exploit gaps between the ETF price and the value of its basket. At a premium they create shares and sell them; at a discount they buy shares and redeem them. This trading pushes the price back toward NAV.

Why can an ETF trade at a large discount or premium?

Arbitrage has costs and risks. If the underlying market is closed, illiquid or stressed, or APs step back, the gap can exceed the normal band and last longer.