Variance disparity and market frictions

Abstract

This paper introduces a new model-free approach to measuring the expectation of market variance using VIX derivatives. This approach shows that VIX derivatives carry different information about future variance than S&P 500 (SPX) options, especially during the 2008 financial crisis. I find that the segmentation is associated with frictions such as funding illiquidity, market illiquidity, and asymmetric information. When they are segmented, VIX derivatives contribute more to the variance discovery process than SPX options. These findings imply that VIX derivatives would offer a better estimate of expected variance than SPX options, and that a measure of segmentation may be useful for policymakers as it signals the severity of frictions.

The Law of One Price in Equity Volatility Markets

“…Existing studies either estimate a risk premium for VIX futures that relies on time-series data and a parametric statistical forecasting model as inCheng (2018) or they compute a deviation measure that relies on synthetic variance swap rates and a convexity adjustment from VIX options(Dong (2016),Park (2019)). This paper estimates synthetic variance swap forward rates from the S&P 500 index options market to obtain an upper bound, thus avoiding VIX options which are less liquid and only available starting in 2006.…”