Abstract

Does the increasingly popular passive investments via Exchange Traded Products (ETF/ETNs) affect underliers? Yes, at least for the most liquid ETP sector: VIX ETPs. This paper exploits rich instruments in VIX market as a perfect laboratory to test both level and roll effects of ETP demand on underliers. I show clean evidence that VIX futures (ETP underliers) have persistently priced in significant “fear premium” above fair value, and this non-fundamental component is predominantly driven by dealers' ETP hedging demand. While providing liquidity to ETPs as issuers, dealers pass hedging pressure to underlying futures. Analogous to the normal backwardation theory, net long hedging pressure steepens VIX contango. By exploiting exogenous demand shift from mechanical daily ETP roll, price impact is identifiable using a novel instrument. Given reduced-form evidence of the ETP feedback channel, I construct a structural model with preferred-habitat demands to endogenize VIX futures' “carry”. My estimates indicate that the tail wags the dog.

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