Volatility, open interest, volume, and arbitrage: evidence from the S&P 500 futures market

Abstract

Using a vector autoregressive (VAR) approach, the dynamic interactions and causal relationships among volatility, open interest, trading volume and arbitrage opportunities in the S&P 500 index futures market is examined. It is found that increased volatility lowers pricing error. This implies that as market volatility increases, investors sell off their equity and futures positions with relatively larger drops in futures prices. Pricing error plays a critical role in linking implied volatility and the level of open interest. Open interest rises for a few days in response to a pricing error shock, but pricing error declines over the next day after an initial rise in response to an innovation in open interest. This suggests that the level of open interest is a good proxy for examining the capital flows into and out of the nearest S&P 500 index futures contract.