Newly examined aggregate evidence points to large-scale potential manipulation of the CBOE's Volatility Index (VIX), according to a study from the McCombs School of Business at The University of Texas at Austin.

The VIX, or "investor fear gauge," tracks market volatility levels based on rising or falling prices of S&P 500 options. The index indicates market sentiment concerning volatility: lower SPX option prices indicate lower market volatility, and higher SPX option prices indicate greater volatility, because rising option prices are an indicator that investors are uncertain about future stock performance. John M. Griffin, a McCombs Finance Professor and Amin Shams, a Ph.D. candidate at McCombs, suspect investors may be manipulating SPX option prices to generate a financial gain on the VIX.

Griffin and Shams, examined SPX option pricing and VIX data from January 2008 through April 2015 to look for manipulation patterns. An analysis of volume spikes among specific options raised their suspicions. Griffin says that the VIX design leaves it open for potential gaming. There is a large and liquid VIX derivatives market (upper-level) that settles based on the prices of SPX options (lower-level). A potential manipulator or group of manipulators with a large expiring upper-level position could buy SPX options right at the VIX settlement and influence the settlement value of their VIX derivatives.

For example, a potential manipulator could overpay by $1 million dollars for the underlying SPX options to push prices up. But, since their position in the upper-level is twice as large as in the lower-level, for every dollar they overpay, they make two dollars in the upper-level. So, the manipulator would make $2 million in the upper-level, minus the amount they overpay in the lower-level. They would be left with a $1 million dollar profit.

"VIX futures and options settle once a month based on the prices of these underlying SPX options," said Griffin. "We find that at the exact moment of settlement, the trading volume jumps on the SPX options multiple times. Those volume patterns are exactly consistent with the VIX settlement formula."

The researchers test competing explanations of hedging and liquidity trading but find consistent support for the manipulation hypothesis. "The VIX is jumping 31 basis points, on average, using our most conservative measures," said Shams.

The implication is that those on the other side of the VIX derivatives market, such as smaller institutional investors or even individual investors who are relying on the settlement price being accurate and fair, are losing money as a result. The researchers say that addressing the problem is difficult, but that settlement design is extremely important for alleviating large and costly settlement deviations.

Find the report online at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2972979