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Suppose I am a market maker making a market on an S&P ETF. Suppose that I have calculated a fair ETF price of $395. My market therefore is 394.90 (bid) and 395.1 (ask). After my bid is posted I got filled with 10 shares of the ETF. Now I want to hedge this exposure.

Suppose that 1 outstanding ETF share consists of the following underlying shares {AAPL: 0.0123, MSFT: 0.0564, FB: 0.1434, etc. }. As far as I understand, market makers try to hedge the long ETF exposure by selling the underlying assets as much as possible. However, that would require me to 1) Sell short 500 different shares and 2) give me non-exact quantities such as 0.123 AAPL and 0.564 FB shares. In addition, it could be that shorting 1 AAPL share for instance would be a greater dollar exposure than the entire NAV of the ETF.

How would a market maker that got filled for 10 shares of the ETF go about it? Would they only hedge once a certain size of bids got filled (i.e. 1000 shares of the ETF)? Or for smaller quantities rely on the futures market?

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  • $\begingroup$ The quantity you specified (10 shares of the ETF at 395/sh) is very small and would not yet trigger hedging, you would wait until you had a bigger inventory. It is also true that small adjustments could be done with futures, but 1 future $\approx$ 200,000 USD so even there you would not act immediately. $\endgroup$
    – nbbo2
    Mar 4 at 7:01

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