ETF arbitrage: Intraday evidence

•We use two S&P 500 ETFs to analyze the trading conditions when arbitrage opportunities are created.•Our correlation and error correction results suggest investors view these ETFs as close substitutes.•Spreads increase just before arbitrage opportunities, consistent with a decrease in liquidity.•Order imbalance increases as markets become more one-sided liquidity risk increases prior to the arbitrage opportunities.

We use two extremely liquid S&P 500 ETFs to analyze the prevailing trading conditions when mispricing allowing arbitrage opportunities is created. While these ETFs are not perfect substitutes, our correlation and error correction results suggest investors view them as close substitutes. Spreads increase just before arbitrage opportunities, consistent with a decrease in liquidity. Order imbalance increases as markets become more one-sided and spread changes become more volatile which suggests an increase in liquidity risk. The price deviations are followed by a tendency to quickly correct back towards parity.