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

ETF Creation and Redemption Process Explained

Updated 7 October 2026 · Fact-checked

An ETF keeps its price close to NAV through authorized participants (APs). APs create shares by delivering a basket of securities (or cash) to the fund and receiving ETF shares. They redeem by returning shares for the basket. They trade in the primary market; investors trade in the secondary market on an exchange.

Understand ETF Structure and Creation/Redemption Process

An exchange-traded fund (ETF) is a pooled fund whose shares trade on an exchange all day. The fund holds a portfolio of securities. Each share represents a slice of that portfolio, and its value is the net asset value (NAV) per share.

Two markets exist. In the secondary market, investors buy and sell ETF shares from each other on the exchange. The fund does not issue or cancel shares in these trades. In the primary market, only authorized participants (APs) deal directly with the ETF sponsor. APs are large institutions, usually broker-dealers or market makers, that have signed an agreement with the fund.

The process is called creation and redemption. To create, an AP assembles the creation basket, which is a specified list of securities, and delivers it to the ETF issuer. The AP receives a block of new ETF shares, called a creation unit. To redeem, the AP delivers ETF shares (a creation unit) and receives the redemption basket of securities. Because securities move rather than cash, this is in-kind creation and redemption. Some ETFs, such as certain fixed income or foreign market funds, may allow or require cash.

This is how arbitrage keeps price near NAV. If the ETF trades at a premium (price above NAV), the AP buys the basket, creates shares and sells them at the higher price. Supply rises and the price falls. If it trades at a discount (price below NAV), the AP buys cheap ETF shares, redeems them for the basket and sells the securities. Supply falls and the price rises. The AP earns the spread, less costs.

In-kind transfers also help with tax efficiency. The fund gives out low-cost-basis securities in redemptions instead of selling them, so it realizes fewer capital gains. This matters for investors in jurisdictions where fund-level gains are passed through. Also note the fund's own cost: APs, not the ETF's long-term holders, bear the transaction costs of creating and redeeming.

Key formulas to remember

Premium or discount to NAV
Premium/discount = (ETF market price − NAV per share) ÷ NAV per share
Positive means premium, negative means discount. Many questions give price and NAV and ask the sign or size.
NAV per share
NAV per share = (Fund assets − Fund liabilities) ÷ Shares outstanding
Use it to compare with the market price.
Premium arbitrage rule
Price > NAV (net of costs): AP buys basket, delivers it, receives ETF shares, sells shares
Creation increases the share supply and pushes price down toward NAV.
Discount arbitrage rule
Price < NAV (net of costs): AP buys ETF shares, redeems for basket, sells securities
Redemption reduces share supply and pushes price up toward NAV.
Arbitrage profit per share
Profit ≈ |Price − NAV| − transaction costs − fees
Arbitrage only occurs if the gap exceeds the AP's costs, so small gaps can persist.

How to solve ETF Structure and Creation/Redemption Process questions

For any item set question on ETF structure or creation and redemption, work from the vignette data to the AP action and its market effect.

  1. 1Identify who is acting: an AP in the primary market or an investor in the secondary market.
  2. 2Find the ETF price and NAV per share in the exhibit, then compute the premium or discount and note its sign.
  3. 3Choose the AP action: premium means create (deliver basket, get shares); discount means redeem (deliver shares, get basket).
  4. 4Check the costs given in the vignette. If the gap is smaller than costs, no arbitrage is expected.
  5. 5State the effect on ETF share supply and price, and that NAV is driven by the underlying securities.
  6. 6Check whether the transfer is in-kind or cash, and link it to tax efficiency or cost where asked.
  7. 7Match your conclusion to the answer options, watching for reversed direction.

Quickest way: Premium means create, discount means redeem

When to use it: Use it when a question gives a price and NAV and asks what an AP does or what happens to price.

  1. Compare price with NAV. Above is premium, below is discount.
  2. Premium: AP creates and sells new shares, so price falls.
  3. Discount: AP redeems and sells the securities, so price rises.
  4. Subtract costs from the gap. If nothing is left, no trade.
  5. Eliminate any option where retail investors deal with the fund directly.

Common mistakes in ETF Structure and Creation/Redemption Process

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

    Mutual fund habits, where investors transact with the fund at NAV.

    Fix: Only APs use the primary market. Investors trade on the exchange in the secondary market.

  • Reversing the action: redeeming at a premium.

    Students memorize the words but not the profit logic.

    Fix: Ask where the AP sells high. At a premium the AP sells ETF shares, so it must create them first.

  • Assuming arbitrage always closes the gap fully.

    Textbook models ignore costs.

    Fix: Subtract trading costs, fees and risks. Gaps inside the cost band can persist.

  • Treating in-kind as cash settlement.

    The word in-kind is unfamiliar.

    Fix: In-kind means securities are exchanged for ETF shares. Cash is a different, and often less tax efficient, method.

  • Believing the ETF sponsor or the AP sets the NAV.

    Confusing market price with NAV.

    Fix: NAV comes from the value of the underlying holdings. The market price is set by supply and demand on the exchange.

Worked examples

Example 1

An ETF has a NAV of $50.00 per share. It trades at $50.60. An AP faces total costs of $0.15 per share for a creation and sale. Q1: Is the ETF at a premium or discount, and by what percent? Q2: What does the AP do, and what is the profit per share? Q3: What is the effect on price?

Show the solution
  1. Q1: Gap = 50.60 − 50.00 = 0.60.
  2. Premium = 0.60 ÷ 50.00 = 0.012, or 1.2%.
  3. Q2: Price is above NAV, so the AP buys the basket, delivers it, receives new ETF shares and sells them.
  4. Profit per share = 0.60 − 0.15 = $0.45.
  5. Q3: New shares increase supply, so the price falls toward NAV.

Answer: Premium of 1.2%; the AP creates shares and earns $0.45 per share; the price falls toward NAV.

Example 2

A fund's NAV is $80.00. The ETF trades at $79.50 and the AP's costs are $0.30 per share. Q1: What is the premium or discount? Q2: What does the AP do? Q3: What happens if costs were $0.60 instead?

Show the solution
  1. Q1: Gap = 79.50 − 80.00 = −0.50.
  2. Discount = −0.50 ÷ 80.00 = −0.00625, or −0.625%.
  3. Q2: Price is below NAV. The AP buys ETF shares at $79.50, redeems them for the basket worth $80.00 and sells the securities.
  4. Profit = 0.50 − 0.30 = $0.20 per share.
  5. Q3: Costs of 0.60 exceed the 0.50 gap, so profit is −0.10 and the AP does not trade. The discount can persist.

Answer: Discount of 0.625%; the AP redeems and earns $0.20 per share; with $0.60 costs there is no arbitrage and the discount can persist.

Exam tips

  • Draw the two-market picture quickly: investors on the exchange, APs at the fund.
  • Always compute price minus NAV first. The sign decides the action.
  • Watch for costs in the vignette. They often decide whether the AP acts.
  • Link in-kind transfers to tax efficiency when a question asks why ETFs distribute fewer gains.
  • Expect the same logic to appear in questions on tracking error and trading costs.

ETF Structure and Creation/Redemption Process: frequently asked questions

Who are authorized participants in an ETF?

They are large financial institutions, often broker-dealers or market makers, with an agreement to deal with the ETF issuer. Only they can create or redeem shares directly with the fund. They profit from arbitrage between price and NAV.

What does in-kind creation and redemption mean?

The AP exchanges a basket of securities for ETF shares, or ETF shares for a basket, rather than cash. It lowers fund trading costs and helps tax efficiency. Some ETFs use cash for certain securities.

What is the difference between the ETF primary and secondary market?

The primary market is where APs create and redeem shares with the issuer. The secondary market is the exchange, where investors trade existing shares with each other. Secondary trades do not change the number of shares outstanding.

Why can an ETF still trade away from NAV?

Arbitrage only happens when the gap exceeds the AP's costs and risks. Stressed or illiquid underlying markets can widen gaps. Stale NAV inputs for foreign holdings can also create apparent gaps.