Why Is the VIX Index Related to Liquidity Providers' Return and Sharpe Ratio?

Abstract

Market makers' compensation for supplying liquidity depends on short-term price reversal. Previous empirical studies show that when the VIX is high, the short-term price reversal effect is stronger, i.e. market makers charge a higher premium for liquidity provision. The 3-period theoretical model of this paper explains that this is the case for three reasons; when the VIX is high (1) market makers are more risk averse, (2) asset variances are higher, and thereby, an identical asset-specific liquidity shock creates a stronger short-term price reversal effect in an individual asset, and (3) asset correlations are higher, and thus, there is a higher risk of spillover of liquidity shocks among assets. Consequently, an escalated level of the VIX index rises market makers' required return for liquidity provision. Our empirical analyses robustly confirm these theoretical findings.