HEC Research Papers Series,
HEC Paris

Abstract: As most Exchange-Traded Funds (ETFs) engage in securities lending or are based on total return swaps, they expose their investors to counterparty risk. To mitigate the funds' exposure, their counterparties must pledge collateral. In this paper, the authors present a framework to study collateral risk and provide empirical estimates for the $40.9 billion collateral portfolios of 164 funds managed by a leading ETF issuer. Overall, our findings contradict the allegations made by international agencies about the high collateral risk of ETFs. Finally, the authors theoretically show how to construct an optimal collateral portfolio for an ETF.

Keywords: Asset management; passive investment; derivatives; optimal collateral portfolio; systemic risk

JEL-codes: G20; G23

47 pages, August 10, 2014

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