On the Perils of Financial Intermediaries Setting Security Prices: The Mutual Fund Wild Card Option

Economic distortions can arise when financial claims trade at prices set by an intermediary rather than direct negotiation between principals. We demonstrate the problem in a specific context, the exchange of open-end mutual fund shares. Mutual funds typically set fund share price (NAV) using an algorithm that fails to account for nonsynchronous trading in the fund's underlying securities. This results in predictable changes in NAV, which lead to exploitable trading opportunities. A modification to the pricing algorithm that corrects for nonsynchronous trading eliminates much of the predictability. However, there are many other potential sources of distortion when intermediaries set prices.