How Effective Is Arbitrage of Foreign Stocks? The Case of the Malaysia Exchange-Traded Fund

Multinational Business Review, Fall 2003 by Hughen, J Christopher

(1) The size of ETF premiums is affected by the availability of fundfacilitated arbitrage.

(2) The size of ETF premiums is affected by the transaction costs associated with arbitrage.

(3) Without fund-facilitated arbitrage, the premiums on an ETF fluctuate in a similar manner to a closed-end country fund.

The only ETF that has experienced an extended suspension of arbitrage is the i Shares Malaysia Fund, which is an ETF that trades on the American Stock Exchange and tracks the MSCI Malaysia Index. The suspension of arbitrage was a direct result of the capital controls imposed by the Malaysian government during the Asian financial crisis.

CAPITAL CONTROLS IN MALAYSIA

The Asian financial crisis was related to the explosion in foreign investment in Southeast Asia during the early 1990s that financed the region's rapidly growing economies. Capital inflows were an average of 1.4 percent of GDP from 1986 to 1990 but this increased to 6.7 percent of GDP for the years from 1990 to 1996.4 Due in part to the trend towards liberalizing the financial markets in the area, this capital was able to move quickly between countries. The financial crisis began in july 1997 when the central bank in Thailand ended its policy of pegging the baht against the U.S. dollar. The crisis in Thailand led to fears that other countries would be unable to maintain a strong currency. The financial panic quickly spread as investors lost faith in the currencies of these developing countries.

In Malaysia, this process started on july 14, 1997 when Bank Negara Malaysia, the country's central bank, allowed the ringgit to float by abandoning its policy of pegging its value at approximately 2.52 MYR per US$. This allowed premiums on the iShares Malaysia Fund to grow substantially because the policy change indirectly increased the costs of ETF arbitrage. The Malaysian stock market plummeted as the ringgit lost value relative to the dollar. From july 14, 1997 to September 1, 1998, the NAV of the iShares Malaysia Fund fell by 84 percent.

As a percentage of share price, the bid-ask spread and the transaction fee charged by the fund for arbitrage increased dramatically. Assuming a value of 15 cents, the bid-ask spread on july 11,1997 was 1.15 percent of the ETF NAV.5 By September 1, 1998, this transaction cost had gone up to 7.38 percent of the ETF NAV Furthermore, the cost of hedging foreign exchange risk rose after the ringgit was allowed to float. With higher transaction costs, the ETF share price could fluctuate in a wider range around NAV without arbitrage being profitable. Thus, the premium showed a significant increase in volatility and magnitude even in the presence of arbitrage.

On September 1, 1998 the Malaysian central bank impeded the trading of the ringgit in overseas markets by restricting transactions in the country's external account.6 The Malaysian officials hoped these capital controls would allow them to lower interest rates and stimulate the economy without setting off a severe devaluation of the currency.