Thursday, May 19, 2011

The CBOE and the Weirdness in VIX Settlement (VXX; TVIX; VZZ; XXV)

Whenever there is a convergence problem you are right to be suspicious.
Market participants got their first hints of possible manipulation of cotton in 2008 and wheat in 2010 from discrepancies between cash and futures prices at expiration.

I'm not saying that is what is going on here as the market is very different from those commodities, just that something doesn't feel right about the way volatility has been trading. See: "Must Read: Is Volatility Broken? Normalcy Bias And Abnormal Variance" (VIX; VXX; TVIX)" among others.

From FT Alphaville:
News comes our way of there being some concern in the market about the Vix settlement process.
In one phrase: It’s off.
That is to say, it is not settling as it ought to.
According to the CBOE, the settlement process is as follows:
“The Final Settlement Price for VIX Futures is determined from a Special Opening Quotation (SOQ) of VIX. The SOQ is calculated from the sequence of opening prices of the SPX options used to calculate the VIX index on the settlement date (the “Constituent Options”). The opening prices for SPX options used in calculating the SOQ are determined through an automated auction mechanism (“Hybrid Opening System” or “HOSS”) that matches buy and sell orders residing on the Electronic Order Book prior to the opening of trading....
...Which sounds pretty simple.
On the day of expiry the future is priced for settlement at whatever the opening price is for the set of SPX options currently determining the Vix. In the event there is no opening price, the average of that option’s bid and ask is used instead. It’s called the Special Opening Quotation (SOQ) process.

Logically speaking, that suggests wherever the futures may have been trading prior to the settlement, they must and should converge to that opening price on settlement.

Yet this is not what’s happening.

At this Wednesday’s settlement, for example, the Vix opened at 17.56, traded no higher than 17.68, yet the Vix futures contract settled at 18.02. Which, of course, is above the day’s trading range....MORE