In the wake of sharp drop in VIX-related exchange traded fund prices, investors have become aware of the potential pitfalls premiums may pose on any exchange traded fund investment. One particular China ETF has been trading at elevated premiums since its inception, but it has only recently started to fall back down.
"PEK trading an elevated premium to its NAV in the past was not a function of it not being able to create and redeem shares as was the case with TVIX," Chris Hempstead, head of institutional sales and trading at WallachBeth Capital, said in a MarketWatch article. "There are completely separate reasons why PEK's NAV has been elevated compared to TVIX and some of the other products."
Premiums in PEK were expected since the fund provides exposure to China's A shares market - access to the A share market has been strictly restricted by regulatory capital controls. The fund utilizes swaps and derivatives instruments to accomplish its stated objective.
"PEK goes to a bank and enters a swap agreement, but because China's A shares aren't easily accessible, the bank has to charge a higher premium on the swaps to hedge its own risk," Hempstead said. "That leads to the premium to NAV in PEK."
However, China recently boosted its equity investment quotas for foreign investors. The investment quota for the QFII program has been raised by $50 billion to $80 billion early April, reports Andrew Galbraith for The Wall Street Journal. Policy makers are allowing more capital to enter the country since the economy experienced net outflows late last year.
On Friday, China raised quotas to $100 billion and cut barriers to moving foreign currency in and out of the country, reports Nick Edwards for Reuters.
Consequently, PEK's premiums have steadily declined over the past couple of weeks.
"One risk to a collapse in premium in PEK is that later investors will get better pricing because of the fallen premium," Hempstead added. "From a structural standpoint, PEK does what it's supposed to do."
Market Vectors China ETF
Max Chen contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.