Price Dislocation and Price Discovery in the S&P 500 Options and VIX Derivatives Markets
Posted: 30 Sep 2015 Last revised: 20 May 2016
Date Written: October 21, 2015
This paper introduces the variance equivalence relation that must hold between the SPX options and VIX derivatives. Exploiting such a relation, I find that the SPX option prices were massively dislocated from the VIX derivative prices during the Lehman Brothers crisis, with the former being cheaper than the latter. The dislocation is associated with both funding liquidity and market liquidity, consistent with the limits-to-arbitrage theory. I also find that, whereas the SPX option prices adjust to eliminate the dislocation, the VIX derivative prices do not. This asymmetric result indicates that most of the price discovery occurs in the VIX derivatives rather than in the SPX options.
Keywords: VIX option; VIX future; variance swap; limit of arbitrage; implied variance; financial crisis; liquidity risk
JEL Classification: G01; G13; G14
Suggested Citation: Suggested Citation