Event Arbitrage

The third type of ETF arbitrage is event arbitrage. When an ETF’s constituent stock is suspended or hits the price limit (up or down), traders can exploit ETFs to arbitrage—either capturing gains on bullish stocks or reducing exposure to bearish ones. The profitability of event arbitrage depends on the specifics of the suspended constituent stock and generally follows two approaches.

If a constituent stock is expected to surge after resumption, discount arbitrage involves buying the ETF on the secondary market, redeeming it in the primary market to obtain a basket of stocks, keeping the suspended stock and selling the others. For example, on October 9, 2008, Changan Automobile was suspended and resumed trading on February 16, 2009. During this period, the SZ100 Index rose 32%. The auto sector rose even more due to supportive government policies. Changan was expected to hit the upper limit at opening, and buying it directly on the market was difficult. Investors could instead redeem the SZ100 ETF, obtaining Changan shares at the pre-suspension price of 3.67 yuan. After resumption, the stock hit the daily limit seven times.

If a constituent stock is expected to drop sharply upon resumption, premium arbitrage involves buying the other constituent stocks in the secondary market, using cash to replace the suspended stock (if “cash substitution” is allowed), subscribing to the ETF in the primary market, then selling the ETF in the secondary market. The 2008 "Changjiang Power event" is a classic case: On May 8, 2008, Changjiang Power was suspended due to a merger. The stock market dropped significantly afterwards—Shanghai Composite Index fell nearly 50%. To minimize losses and cash out Changjiang Power, investors could buy the other 49 stocks in the SSE 50 ETF, subscribe to the ETF in the primary market, and then sell the ETF on the secondary market.

Cash-and-Carry Arbitrage

The introduction of index futures and margin financing provided better tools for shorting the A-share market. The CSI 300 Index Futures is the first and only index futures product in China's A-share market. As the CSI 300 Index includes 300 constituents, full replication is difficult. ETFs track the benchmark index and are tradable on the secondary market, making them ideal spot instruments for arbitrage.

Due to technical constraints, there is no ETF in China that directly tracks the CSI 300. Most arbitrageurs use a combination of 75% SSE 180 ETF and 25% SZSE 100 ETF as a proxy.

Since the launch of index futures on April 16, 2010, trading volumes of SSE 180 ETF and SZSE 100 ETF have surged. At the beginning, there was a premium on futures over spot prices, and the typical arbitrage strategy was to buy the ETF and short the index futures. Once the price gap narrowed, they would close the position by selling the ETF and buying the futures contract.