Why Is the VIX Index Related to Liquidity Providers' Return and Sharpe Ratio?
49 Pages Posted: 24 Dec 2015 Last revised: 2 Feb 2018
Date Written: January 31, 2018
Previous studies find as the VIX goes up, return and Sharpe ratio to liquidity provision increase. We argue these two phenomena are correlated because they both depend on the same fundamentals: investors' risk aversion, asset variances and asset correlations. Our theoretical model shows (1) when investors are more risk-averse, they expect a higher return for providing liquidity, (2) when assets are volatile, liquidity shocks create stronger trading demands and urge liquidity demanders to pay a higher premium, and (3) when assets are highly correlated, the higher risk of spillover of liquidity shocks across assets raises the price of liquidity. An increase in any of these factors, besides increasing the VIX, leads to a higher expected return and Sharpe ratio for liquidity providers. Our empirical analyses show that one standard-deviation increase in each of these three factors raise liquidity providers' expected daily return (annualized Sharpe ratio) by 0.16%, 0.36% and 0.39% (0.84, 1.20 and 2.02 units), respectively.
Keywords: Short-term Reversal, VIX, Liquidity Spillover, Market Maker
JEL Classification: G12, D41
Suggested Citation: Suggested Citation