Comment by nickles | Hacker News Reader

Comment by nickles | Hacker News Reader

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> Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy

Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade.

When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.

> ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV

Many closed ended funds do in fact trade at a discount to their NAV.

> Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade.

Those are the same thing. An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium.

> When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.

Again...slippage is the thing caused by a lack of liquidity.

> An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium.

We agree here.

> Those are the same thing.

We disagree here.

"In economics, a liquidity premium is the explanation for a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity." [0]

"With regard to futures contracts as well as other financial instruments, slippage is the difference between where the computer signaled the entry and exit for a trade and where actual clients, with actual money, entered and exited the market using the computer’s signals."

The concepts are related, but not identical.

[0] https://en.wikipedia.org/wiki/Liquidity_premium

[1] https://en.wikipedia.org/wiki/Slippage_%28finance%29

Yes, but they are functionally identical in this context. The liquidity premium exists because of slippage.

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