45 Pages Posted: 16 Nov 2010 Last revised: 24 Jan 2013

Date Written: November 16, 2010

Abstract

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, we show that their minor differences are not responsible for the mispricing. 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 economically significant (mean profit of 6.6% p.a. net of spreads) and are followed by a tendency to quickly correct back towards parity.