The VIX Futures Basis: Determinants and Implications

Abstract

After the Chicago Board Option Exchange’s (CBOE) introduction of VIX futures contracts, and the subsequent introduction of exchange-traded products for volatility investing, investors have allocated non-trivial portions of their portfolios to volatility-linked investments. Since 2003, when significant changes were made to the VIX methodology, the CBOE has asserted that the VIX methodology provides a script for replicating volatility exposure using SPX options. The authors of this article find that, to the contrary, significant option market frictions, particularly among out-of-the-money put options, result in significant barriers to replicating this exposure. They connect option market frictions to changes in the VIX futures basis and find that market information from the most illiquid options is reflected in the VIX, but often not in VIX futures. Because investors frequently advance tail risk hedging as the main portfolio benefit of volatility exposure, the fact that out-of-the-money put option innovations drive the VIX futures basis suggests that, in practice, VIX futures do not provide the desired tail risk hedge.