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Exchange Traded Funds

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Exchange traded funds (ETF) are a recent financial innovation. When you purchase an ETF, you are buying the same combination of stocks on a given index. For example, the best known ETF is Standard and Poor's Depository Receipt (SPDR), pronounced "spider," which is based on the S&P 500 index.

What makes an ETF different from an index fund is that it can be traded in the open markets, leaving the possibility for arbitrage. Arbitrage is an activity that involves simultaneously buying and selling a security to take advantage of a price difference in two markets. In plain language, if a company's stock is selling for $12 on the NYSE and $9 on the AMEX, then arbitrageurs will buy the stock on the AMEX and sell the same stock on the NYSE for as much as they can and as fast as they can. The increased buying on the AMEX will cause the price to rise on the exchange while on the other hand the increased selling on the NYSE will cause the price on that exchange to fall until the price is the same on each exchange. In finance we say that arbitrage keeps prices in line by forcing price convergence or one-price for the same asset such as a stock. This is also known as the law of one price.