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International Journal of Financial Engineering and Risk Management

 

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International Journal of Financial Engineering and Risk Management (1 paper in press)

Special Issue on: Applications of Optimisation in Finance

  • Factor-Based Optimization and the Creation/Redemption Mechanism of Fixed Income Exchange-Traded Funds
    by Ananth Madhavan 
    Abstract: Fixed income exchange-traded funds (ETFs) trade on organized exchanges, often with narrow spreads, liquidity, and pre- and post-trade transparency. The remarkable success of fixed income ETFs relies critically on the efficient functioning of the ETF creation-redemption mechanism which helps drive the funds’ market price to stay closely in line with the underlying values of the bond portfolios they represent. Creation of fixed income ETFs faces challenges though because of the less liquid nature of the markets for many bonds. In this article, we explain how custom fixed income baskets can be used with exchange-traded funds in a systematic, auditable, and repeatable manner. We use factor-based optimization to create ETF baskets for one or more ETFs and with one or many counter-parties. We conclude that optimization can improve the efficiency of ETF basket creation, which in turn induces higher liquidity and tighter spreads, benefitting investors.
    Keywords: Fixed Income, ETFs, Factors