Abstract
Previous studies find as the VIX goes up, the return and the Sharpe ratio on liquidity provision increase. We argue these two phenomena are correlated because they depend on the same fundamentals: investors’ risk aversion, asset variances and asset correlations. Our theoretical model shows (1) when investors are more risk-averse, they expect a higher return for providing liquidity, (2) when assets are volatile, liquidity shocks create stronger trading demands and thus liquidity demanders pay a higher premium, and (3) when assets are highly correlated, the higher risk of spillover of liquidity shocks across assets raises the price of liquidity. An increase in any of these three factors, besides increasing the expected return and the Sharpe ratio of liquidity providers, leads to a higher value for the VIX index. Our empirical analyses show that one standard-deviation increase in each of these three factors raise liquidity providers’ expected daily return (annualized Sharpe ratio) by 0.16%, 0.38% and 0.40% (0.82, 1.27 and 2.10 units), respectively.
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Disclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.