Volatility Feedback Loop in the VIX Index and Its Derivatives

The VIX index is a measure of the stock market's expectation of volatility over the next 30 days. The VIX futures are a derivative contract that allows traders to bet on the future direction of the VIX index.  The VIX index is calculated using the prices of SP500 options. The VIX futures are based on the VIX index. The lead-lag relationship between the spot VIX and the VIX futures is an important concept for traders to understand.

Reference [1] utilized high-frequency data to examine the lead-lag relationship between VIX futures, spot VIX, and the implied volatility of VIX options. It pointed out,

…there is unidirectional causality between VIX futures, VIX spot, and the implied volatility of VIX options. VIX spot is leading VIX futures, while VIX futures are leading the implied volatility of VIX options. This indicates that the markets have a unidirectional price-discovery function between each other during volatile periods. There is no causality effect for any other time series. Empirical data shows that VIX spot values are significantly higher than VIX futures values, especially during market volatility periods, as in our sample period.

Using these findings, the authors attempted to explain the reasons behind the largest increase in volatility in February 2018,

These findings show that the existing and previous explanation attempts do not fully cover the interaction of the VIX index and its derivatives during the turbulent events of February 5th and thereafter. While synthetic leveraged structures can create and amplify market jumps, they do not explain the bidirectional lead-lag causality between the VIX spot and the implied volatility of SPX options. However, it is essential to note that the unidirectional causality from VIX spot to VIX futures to the implied volatility of VIX options is explainable by the mechanisms of volatility exchange-traded products and market participants. Given the surge in the VIX earlier on February 5th, market participants may anticipate leveraged long volatility ETPs to rebalance their holdings by purchasing more VIX futures towards the end of the trading day to maintain their target daily exposure.

References

[1] Kia Farokhnia, Joerg Osterrieder, High-Frequency Causality in the VIX Index and its derivatives: Empirical Evidence, 2022, https://doi.org/10.48550/arXiv.2206.13138

Originally Published Here: Volatility Feedback Loop in the VIX Index and Its Derivatives