ETF Arbitrage 1

Suppose you are monitoring two ETFs: ETF-A, which tracks the S&P 500 index and is currently trading at $300; ETF-B, which tracks the exact same index but is trading at $301. Both ETFs are highly liquid and trading fees are negligible. Is there an arbitrage opportunity present? If so, how would you exploit it?

Answer

Yes, there’s a straightforward arbitrage:

  • First step: Sell short ETF-B at $301 and buy ETF-A at $300. Now we have %1.

  • Second step: Note that in the first step we did not close the position because the ETFs are different. So what we do is the following: we wait until prices converge into the NAV of the index, since they track the same index, in which case we really close out the positions, i.e., buy back ETF-B and sell ETF-A netting us $1; or we wait until the prices flip, in which case we do the same thing, but now the closing of positions nets us another \(P(A) - P(B) > 0\), where \(P(A)\) is the price of ETF-A and \(P(B)\) is the price of ETF-B.

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