CONVERGENCE RISK: THE PROBLEM WITH THE NEW VIX FUTURES

Ivelina Pavlova Doctoral Candidate Florida International University

Robert T. Daigler* Knight Ridder Research Professor of Finance Florida International University Department of Finance RB 208 College of Business Miami, Florida 33199 (H) 954-434-2412 (O) 305-348-3325

* Corresponding author

Keywords: VIX, convergence, expiration day effects The authors thank John Hiatt (CBOE) for helpful discussions concerning the VIX futures settlement procedure. We wish to thank the participants of the 2007 Eastern Finance Meetings in New Orleans for helpful comments. This paper will also be presented at the 2007 Financial Management Meetings in Orlando. September 29, 2007

CONVERGENCE RISK: THE PROBLEM WITH THE NEW VIX FUTURES

ABSTRACT We examine the issue of non-convergence of the VIX futures to the cash VIX, the associated expiration day effects, and their sources. Significant disparities are found between the value of the cash VIX and the VIX futures at settlement of the contract. The reasons for this difference include the settlement procedure of the exchange and the underlying S&P 500 options order imbalances at settlement, the latter affected by traders unwinding arbitrage positions. We propose an alternative settlement procedure that mitigates these problems.

I. Introduction VIX futures typically do not converge to the underlying VIX cash index at expiration. VIX futures settlement prices differ by an average of 26 basis points ($260 per contract) from the cash VIX index, with a standard deviation of 43 basis points and a maximum deviation of $1,766. Consequently, the size of the non-convergence problem is large and economically significant. There is no known method to estimate the size of the nonconvergence ex-ante, with possible forecasting variables possessing little evidence of an association with the non-convergence bias at settlement. Given the growing importance of volatility derivatives, the size and ongoing bias is an important issue to this category of derivatives and to the structure of future derivative instruments. This paper identifies the issues causing the bias and investigates the historical characteristics associated with the non-convergence of the futures and cash index. Previous futures convergence problems fall into three categories. First, squeezes in commodity markets have caused significant pricing and delivery issues. Examples are the wheat squeeze of the 1980s (Easterbrook, 1986, and Paul, 1986), the Maine versus 1

Idaho potato controversy (Easterbrook, 1986, and Pirrong, 1993), and the attempted Hunt silver squeeze (Williams, 1995). Second, more common settlement problems involve contract development issues, such as futures without a tradable underlying cash market. Examples of such markets include catastrophy futures, inflation and GNP futures, and weather derivatives. Such contracts typically fail or only exist as specialized over-thecounter options instruments. Third, some index-based futures contracts are based on cash markets that are difficult to match exactly at expiration. The defunct commercial paper futures were based on the commercial paper of 40 companies, with the specific composition of the index changing frequently, creating basket-matching problems. In addition, stock index futures are based on a weighted index of the prices of all stocks in the index, which is difficult to replicate exactly (for arbitrage) when some of the stocks do not trade at the futures settlement. The settlement issues with VIX futures are most like the index-based futures pricing problems, except the discrepancies for stock index futures are relatively small. The reason for the large and variable difference between the futures settlement and the corresponding cash index is the procedure that determines the settlement price. Specifically, while the cash VIX employs the average of the bid and ask prices of each of the S&P 500 options that are used to calculate the cash VIX, the futures settlement uses a special procedure which employs the actual option prices traded at the market open following the last day of futures trading. Typically, at this open the majority of the option strikes trade at the bid (or at the ask) for a given expiration settlement, based on the supply and demand pressures from dealers, arbitrageurs, or hedgers closing their positions.

The uncertainty arising from the futures settlement procedure causes the futures to trade nearly 2% below the cash index, on average, for several days before futures expiration. 1 The S&P 500 options volume creating the price convergence problem averages less than 16% of the remaining VIX futures open interest at settlement, showing that a relatively small position in S&P 500 options can cause a large price divergence from the cash VIX for the futures settlement price. This raises questions of whether traders could manipulate the VIX futures settlement price. We propose an alternative settlement procedure that substantially reduces the price divergence relative to the current procedure.

II. The Issues and Literature Futures contracts are settled either via the delivery of the physical asset or through cash settlement, the latter initiated with stock index futures in the early 1980s. Jones (1982) explores the economics of futures contracts based on cash settlement, showing that the major purpose of the delivery procedure is to cause the futures and cash prices to converge during the delivery period. One of the key differences between physical delivery and cash settlement is that the settlement price for the physical delivery procedure can be determined through futures trading, 2 while with the cash settlement procedure the settlement price is determined by the value of the underlying cash market. Garbade and Silber (1983) discuss the construction of an accurate settlement index as a
1

However, when individual contract behavior is examined for these two days then the direction of the futures-cash basis is only weakly associated with the direction of the settlement basis. Moreover, there is no association between the size of the ex-ante basis and the settlement basis. 2 The settlement price for most commodity futures is based on the futures price during the delivery period. For financial futures the T-bond/T-note settlement price is based on the futures price and the conversion factor of the bond delivered, with the conversion factor determined from the coupon and maturity of the delivered bond/note.

fundamental requirement for the design of a cash-settled futures contract, with special consideration being given to the exclusion of intentionally distorted quotations from the settlement index. For example, Eurodollar futures settle by obtaining twelve bid-ask quotations on the LIBOR 90-day interest rate on the day of cash settlement; the exchange then drops the two highest and two lowest quotations to avoid bias, averaging the remaining eight quotes to determine the futures settlement price. In the 1990s the focus on cash index-based contracts moved from design issues to price manipulation. Kumar and Seppi (1992) developed a model in which uninformed traders can profit by executing trades in the spot market to manipulate the associated futures price during the delivery period. 3 Kumar and Seppi show that profitable

manipulation can take place based on their model, although the profit from manipulation falls to zero as the number of manipulators grows. However, even in the zero-profit case the actions of the manipulators influence liquidity, and the existence of manipulation is robust to a variety of distributional, timing, and preference assumptions. A number of studies investigate the derivatives expiration day manipulation and pricing effects in stock index markets. In particular, the so-called triple watching hour, when all index futures, index options and equity options expire at the same time, attracted considerable attention from academics, regulators and practitioners, especially given the large price movements that occurred on expiration day. 4 The factors found to contribute to the undesirable expiration day effects include stock index arbitragers liquidating their
There are four types of market participants included in their model a strategic risk-neutral informed trader, a group of uninformed noise traders, risk-neutral floor traders or specialists, and a risk-neutral uninformed manipulator. 4 Price volatility issues associated with the S&P 500 futures expiration caused its settlement to be moved from its Friday close to the open on the third Friday of the expiration month. See Stoll and Whaley (1991, 1997).
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positions, stock market procedures related to offsetting sudden imbalances caused by the liquidation of positions, and deliberate attempts to directly and indirectly manipulate prices (Stoll and Whaley, 1997). Stoll and Whaley (1987, 1991, 1997), among others, investigate the impact of these expiration day factors on volume, volatility, and price. They find that all of the above factors are related to expiration day price behavior. Specifically, an index arbitrager could attempt to manipulate the cash stock index if he had a long position in stock and a short position in futures contracts by selling some of his stocks at non-equilibrium prices in order to reduce the futures settlement price. Stoll and Whaley observe small (economically insignificant) stock prices movements at derivative expiration in U.S. and Japanese stock markets, but not in the Australian market. Illueca and LaFuente (2006) examine the realized volatility Spanish futures market, finding a significant increase in realized volatility on the expiration day. Most interesting is the Alkeback and Hagelin (2004) study which examines the Swedish stock market index futures expiration day effects, where they find no evidence of price distortions at settlement. The reason they provide for a lack of price distortion is that the settlement price for the Swedish index is determined by the average volumeweighted value over the entire last trading day. This longer settlement period is in contrast with the practice used in the U.S. and other futures markets where settlement occurs at the opening or closing of a trading day. Hence, the length of time of the settlement period could have important implications for exchanges and policy makers to minimize expiration day effects on cash-settled contracts.

III. The Cash VIX and VIX Futures Contract A. The CBOE Volatility Index (VIX) The CBOE Volatility Index is calculated in real time using the time values of out-ofthe-money options on the S&P 500 cash index and consequently reflects the expectations of options market participants regarding the future 30-day volatility. The original VIX (now called the VXO) is still available, and is calculated using the implied volatilities of only four call and four put strike prices of the S&P 100 index by employing the binomial option pricing model. The new VIX employs all available strikes of the S&P 500 index by means of the following non-distributional formula: 5

2 1 K = 2i e RT Q ( Ki ) T i Ki T
2

F K 1 0

where VIX = x 100 T = time to expiration (in years, calculated in minutes) F = the forward index level derived from index option prices (the strike price for the near-the-money option adjusted for time, the interest rate, and option prices) Ki = strike price of the ith out-of-the-money option Ki = the size of the interval between strike prices K0 = the first strike price below the forward index level F; this is the nearest-to-themoney strike price R = the risk-free interest rate until option expiration
5

Once the nearest-to-the-money option is determined then all remaining options for the cash VIX calculation must be out-of-the-money. The nearest-to-the-money option is todays forward rate of the underlying index, as shown below. The options must have non-zero bid prices to be used in the calculation. Options are selected until two consecutive strikes have non-zero bids, at which time no more strikes are employed in the calculation.

Q(Ki) = the midpoint of the bid-ask spread for the option with strike Ki. Note that the contribution of any given strike price to the calculation of the cash VIX is proportional to the price of the option and inversely proportional to the strike price. The put and call option prices used in the calculation of the cash VIX employ the next two monthly expirations in order to obtain a constant 30-day maturity. 6 Jiang and Tian (2007) do show that the procedure to calculate the cash VIX does cause biases in the estimation of the VIX compared to a model-free implied variance. However, the cash VIX calculation biases can not be corrected with adjustments to real world trading procedures using CBOE options. 7 Moreover, Jiang and Tians procedure to correct for these biases would create an untradable VIX index, which would affect liquidity and pricing for the VIX futures contract (since dealers could not hedge their positions). In any case, the errors in the cash VIX calculation procedure are not important here, since it is the difference between the cash VIX and the VIX futures we are concerned about. B. VIX Futures On March 26, 2004, the trading of futures on the VIX index began on the Chicago Futures Exchange (CFE). The open interest as of May, 2007 was over 44,000 contracts, which represents 90% of the total open interest for the CFE. 8 The Chicago Futures

When the nearby option has exactly 30 days until expiration then only one expiration is employed to calculate the cash VIX. This occurs at the settlement f the VIX futures. 7 Jiang and Tians simulations show that errors are generally small for typical parameters for actual S&P 500 options. In general, they conclude that the CBOE procedures tends to underestimate (overestimate) true volatility when the underlying cash VIX is high (Low). When the true volatility is 20% then the error averages less than three basis points. However, low volatility levels (10%) show simulated Black-ScholesMerton differences of 19 to 25 basis points, while high volatility (30%) show differences of a negative 35 to 51 basis points. Using a stochastic jump model creates even larger differences. However, the nonconvergence biases found in our analysis are not strongly associated with the level of volatility. 8 Until March 26, 2007 the Volatility Index (VIX) futures were quoted as $100 times the Increased-Value VIX (VBI), the latter equaling ten times the value of the cash VIX. On that date the VIX futures quotation

Exchange (CFE) can list up to three near-term serial months plus eight months on the February quarterly cycle. The price of a VIX futures contract depends on a number of factors, such as stochastic volatility, how quickly volatility reverts to the mean, and the expectation of the market participants regarding future volatility. C. Settlement Day Procedures The last trading day of the VIX futures contracts is on the day prior to the settlement date. The settlement date is the Wednesday that is thirty days before the third Friday of the next calendar month after the futures contract expires. Typically this is the

Wednesday prior to the third Friday of the futures expiration month. The final settlement value for the VIX futures contract is determined from a Special Opening Quotation (SOQ) of the cash VIX, calculated from the relevant opening option prices used to calculate the VIX index on the settlement date (the average of the bid and ask are employed for any relevant strike prices not traded; which strikes used for the settlement value calculation follow the procedure employed to calculate the cash VIX). 9 The opening option prices are established by an auction mechanism known as the "Rapid Opening System" (ROS). ROS is responsible for matching the buy and sell orders in the Electronic Order Book prior to 8:28 a.m. Central time. If there are no opening traded prices for the option then the bid-ask quote for each eligible option series is used. 10

was re-scaled, with the futures prices divided by 10 to provide direct comparison with the cash VIX. Consequently, the contract multiplier was changed from 100 to 1000 times the VIX, thus eliminating the use of the VBI. For simplicity and clarity, the results in this paper adjust previous VIX futures quotes to conform with the number of decimals used for the cash VIX. 9 The final settlement value for the VIX futures contract was determined as ten times a Special Opening Quotation (SOQ) of the VXB until March 26, 2007 (similar to the price quotes discussed above). Multiplying by ten is no longer needed. Here we adjust the VIX futures settlement to be consistent with the cash VIX. 10 For the SPX (S&P 500 options) ROS opening on the futures expiration day, all orders that are placed in the electronic book for this opening can be only on the one SPX option contract month whose prices are used to estimate the VIX, i.e. the options contract month with exactly 30 days until expiration. For

IV. Empirical Evidence A. Cash and Futures Settlement Prices Analysis of whether VIX futures prices converge to the cash VIX is based on data for the first 33 expirations of the VIX futures. Table I provides detailed information about the VIX cash and futures values at the close on the last futures trading day and the open on the settlement day, as well as their differences. Column 4 provides the official VIX futures settlement price. As seen in column 5, the difference between the VIX cash and futures values at the close of the last trading day is greater than 0.30 for ten cases and greater then 0.50 for five cases. One possible explanation for such large differences is the expectation in the futures market for supply/demand mismatches of the options at the next days open that will affect the VIX settlement price. However, column 6 shows that the futures market at the close of trading is a poor forecast of the next days settlement price, as determined by the options opening prices. Also, there is no pattern as to direction of the forecast error. In fact, column 7 shows that the cash VIX often changed significantly from the close on the last trading day to the next days open. Hence, the overnight change in the options time values does affect the cash VIX. But none of these factors explains the differences in column 8 between the cash VIX open and the VIX futures settlement price. Table I The focus of this paper is the lack of convergence at expiration between the VIX futures and cash VIX: column 8 of Table I presents ample evidence of this lack of
example, only June 2007 option prices are needed to calculate the May 2007 VIX settlement price. Moreover, SPX option orders associated with positions in the expiring VIX futures must be received prior to 8 a.m. during the ROS opening procedure.

convergence. The difference between the opening value of the cash VIX and the settlement price of the VIX futures using the special opening procedure was greater than 0.30 ($300 per contract) for 18 out of 33 expirations, and greater than 0.50 ($500 per contract) on eight occasions. In July 2004, the disparity was a striking 1.77 points or $1,770 per contract, more than 10% of the total underlying value of the position. These disparities arise as a result of the settlement procedure of the expiring VIX futures contract, which is based on the option trade prices during the ROS opening. The differences are significant and do not decrease with the seasoning of the futures contract; for example, four of the five expirations in 2007 all had disparities greater than 0.20 and two of them were greater than 0.30. Table II reports various descriptive statistics regarding the differences shown in Table I. The minimum and maximum values show the wide range of differences for this contract, particularly on the settlement day. The differences between the VIX open and the futures settlement price is greater than 0.30 for 55% of the expirations and greater than 0.50 for 24% of the expirations. 11 TABLE II Figure 1 examines the average convergence over time to expiration of the VIX futures to the cash VIX. For the last three days before settlement the cash VIX is on average higher than the VIX futures price, and they do not converge. Figures 2 and 3 present the convergence of the two expirations with the largest and smallest differences

We examined whether any correlation exists for the differences outlined in tables I and II with the levels of the cash VIX at the close and next days open. Little correlation exists ( < 0.08) between higher values of the Volatility Index and the differences between the close and next days settle of the futures contract. Moreover, larger values of the VIX only possess a moderate association with larger disparities at settlement ( < 0.20).

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between the cash VIX open on settlement day and the futures settle price. 12 Comparing Figures 2 and 3, the difference the day before settlement provides no relation with the size of the non-convergence bias. Figures 1 and 2 and 3 B. The Settlement Procedure and Arbitrage The settlement value of the VIX futures is based on the trade prices of the constituent options during the special ROS opening. 13 Previously we showed that substantial differences can exist between the VIX futures settlement value based on these option trade prices and the cash VIX at the open on settlement day. Here we show the cause of this disparity by examining the option trades during an ROS opening. Figures 4 (puts) and 5 (calls) depict the bid-ask spread of these options and the difference between the opening option price and the bid quote for the April 2006 ROS settlement. The figures show that the opening bid-ask spreads are smaller for options that are more out-of-themoney. Moreover, the opening price is much closer to the opening bid quote than to the ask for both put and call options. In fact, for most of the constituent options series the opening price was at or near the bid. These order imbalances on the bid side of the market are consistent with arbitrageurs who are selling their options positions to close long option positions (matching their short futures positions). Figures 4 and 5 Exhibit I shows the offsetting positions taken by arbitrageurs at initiation and how they close their positions at futures settlement. Part A shows when futures are priced

Traditionally, the major purpose for the delivery or cash settlement procedures of futures contracts is to cause convergence of the price of the futures contract and the cash price during the delivery period, the latter providing the basis for the futures contract pricing. 13 The bid-ask average is included for those options not traded but which still possess a bid-ask spread.

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high relative to the forward cash VIX at time t, and Part B covers the situation when futures prices are low compared to the forward cash VIX. The key aspect of the settlement procedure for dealers and arbitrageurs is the knowledge that the futures and options positions can be exactly offset at futures expiration, based on the ROS settlement procedure guaranteeing a profit. However, while this settlement procedure benefits Specifically, when the

dealers and arbitrageurs, it causes convergence problems.

proportion of dealers/arbitrageurs or hedgers unwinding their positions dominates the options market on the futures settlement date, then the opening options prices will be biased in one direction. This causes a significant difference between the futures

settlement value and the cash VIX, the latter based on the average of the bid and ask prices of the same options. Moreover, it may be possible for traders to manipulate opening options prices in order to magnify profits from holding a position in VIX futures. Such a strategy would depend on trading a relatively small number of options contracts relative to the position in futures. Hence, the question becomes whether a small options position can significantly affect the VIX futures settlement price. Exhibit I Table III shows the volume of options traded at the options opening on the futures settlement days to examine the size of the positions that determine the futures settlement price. The difference between the cash VIX and the futures settlement price averaged 0.34 over all expirations presented in Table III. More striking is that the average options volume at the ROS opening only comprises 15.73% of the VIX futures open interest at settlement, and only 14.40% for larger differences in the cash VIX vs. the futures

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settlement price. Hence, the possibility of affecting a much larger futures settlement open interest position with options trading does exist. Table III C. A New Procedure for VIX Cash Settlement An alternative procedure to the ROS option trade price method is to use the average of the one-minute cash VIX values on either the last trading day or the settlement day to determine the settlement value. Table IV presents the results of using such a procedure. Column (1) shows the difference between the cash VIX and the futures settlement price using the current ROS method. Columns (2) and (3) show the relevant differences using the one-minute average VIX value to determine the futures settlement price. 14 Columns (4) and (5) show the one-minute standard deviations for the VIX on these two days. TABLE IV For 21 of the 33 expirations in Table IV the average one-minute VIX values over the last trading day (column 2) provides smaller differences in the cash VIX vs. futures settlement price than does the current method (column 1). On average these differences are only -0.10 points, compared to the 0.26 points for the current method. More

importantly, when the current method is superior to the proposed method then the difference in the two methods was greater than 0.10 for only four expirations. Alternatively, the differences using the current method are greater than |0.50| for 24% of the time, while this size difference occurs for the proposed method only 15% of the time. Consequently, the average VIX procedure on the last trading day provides a viable alternative to the current settlement method.
14

On the other hand, using the current

Column (2) uses the closing cash VIX value for the relevant comparison to that days average VIX value. If the settlement price is based on the one-minute average cash VIX value then no opening procedure is needed to determine the futures settlement price.

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settlement day (column 3) is only slightly better on average than the current method and provides substantially greater variability and several very large differences in its cash VIX versus average VIX values.

V. Conclusions The empirical investigation of the VIX futures contract expirations conducted in this study shows a lack of convergence of the futures settlement value to the cash VIX value, as well as significant disparities between the futures price and cash VIX value. The size of the non-convergence of futures and cash is unique for futures markets. Previous non-convergence problems were either isolated supply issues for a given maturity month or associated with futures that subsequently failed. Thus, identifying and examining this consistent bias is an important step in eventually modeling a procedure to forecast the size of the non-convergence. The reasons for the non-convergence of the futures and cash values include the ROC settlement procedure (which utilizes actual trade prices of the constituent options) and the resultant options order imbalances during this procedure. These order imbalances are caused either by traders unwinding dealer/arbitrage positions, or by speculators manipulating prices. Traders could close out their positions before settlement. However, this solution does not solve the underlying problem, since the futures price can deviate significantly from the cash VIX value before futures expiration. Moreover, traders want to know the potential fair futures value prior to the settlement, which is not known due to the effect of the ROS opening procedure.

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The uncertainty of the settlement price due to the ROS opening procedure creates risk for futures traders as well as an options bid-ask band around the fair futures price. On the other hand, such a settlement procedure provides opportunities for dealers and arbitrageurs, since the ROS method allows them to close their arbitrage positions without price risk. This procedure allows dealers to stabilize the futures price before futures expiration and therefore increase the liquidity for the contract, since it reduces risk for the dealers. Hence, our suggestion to change the settlement procedure would substantially reduce the price convergence problems but increase the price risk for dealers and arbitrageurs.

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References Alkebck, Per and Niclas Hagelin. 2004. "Expiration Day Effects of Index Futures and Options: Evidence from a Market with a Long Settlement Period." Applied Financial Economics, 14:6, 385-96. CBOE. 2003. "VIX Primer." CBOE. 2005. "CFE Information Circular IC05-07." CBOE Futures Exchange. Easterbrook, Frank H. 1986. Monopoly, Manuipulaiton, and the Regulatio of Futures Markets. Journal of Business, 59:2, S103-S127. Garbade, Kenneth D. and William L. Silber. 1983. "Price Movements and Price Discovery in Futures and Cash Markets." The Review of Economics and Statistics, 65:2, 289-97. Illueca, Manuel and Juan A. LaFuente. 2006. New Evidence on Expiration-Day Effects Using Realized Volatility: An Intraday Analysis for the Spanish Stock Exchange. The Journal of Futures Markets, 26: 9. 923-938. Jones, Frank J. 1982. "The Economics of Futures and Options Contracts Based on Cash Settlement." Journal of Futures Markets, 2:1, 63-82. Jiang, George J. and Yisong S. Tian. 2007. Extracting Model-Free Volatility Prices: An Examination of the VIX Index. The Journal of Derivatives, 32:3, 35-60. Kumar, Praveen S and Duane J Seppi. 1992. "Futures Manipulation with "Cash Settlement." Journal of Finance, 47:4, 1485-1502. Paul, Allen B. 1986. Liquidation Bias in Futures Price Spreads. Agricultural Economics, 68:2, 313-321. American Journal of

Pirrong, Stephen Craig. 1993. Manipulation of the Commodity Futures Market Delivery Process. Journal of Business, 66:3, 335-369. Stoll, Hans R. and Robert E. Whaley. 1987. "Program Trading and Expiration-Day Effects." Financial Analysts Journal, 43:2, 16-28. Stoll, Hans R. and Robert E. Whaley. 1991. "Expiration-Day Effects: What Has Changed?" Financial Analysts Journal, 47:1, 58-73. Stoll, Hans R. and Robert E. Whaley. 1997. "Expiration-Day Effects of the All Ordinaries Share Price Index Futures: Empirical Evidence and Alternative Settlement Procedures." Australian Journal of Management, 22:2. Williams, Jeffrey. 1995. Manipulation on Trial: Economic Analysis and the Hunt Silver Case, Cambridge University Press.

Table I VIX Cash and Futures Values

This table presents the values of the cash VIX and the VIX futures prices on the last trading day and the settlement day of the futures. The last four columns show the differences between the two days and between the cash VIX and the futures.
(1) (2) (3) (4) (5) VIX close and Futures settle price on last trading day 0.08 0.05 0.15 0.42* 0.06 0.03 0.63** 0.15 0.02 0.07 -0.08 0.63** 0.91** 0.76** 0.36* 0.04 0.20 0.30* 0.09 -0.08 0.37* -0.25 -0.12 0.19 0.16 0.50** 0.25 -0.27 0.15 -0.09 0.21 0.27 0.05 (6) Difference Between: Futures price on last trading day and Futures settle price 0.895 1.006 1.176 -0.889 -0.225 1.863 -0.264 -0.452 -0.043 -0.546 0.786 0.148 -0.209 -0.602 -0.436 0.975 -0.905 -0.093 0.385 -0.461 -1.045 -0.345 0.855 0.945 0.531 -0.204 -0.018 0.517 -0.116 0.476 0.077 -0.160 0.330 VIX close on last trading day and VIX open on settle day 0.85** 0.22 -0.44* -0.53** -0.32* 1.13** 0.01 0.00 -0.13 -0.15 0.46* 0.57** 0.17 -0.30* 0.01 0.48* -0.71** -0.18 -0.09 -0.12 -0.48* 0.02 0.12 0.73** 0.23 0.37* 0.03 0.00 -0.16 0.15 0.00 -0.34* -0.01 VIX open and Futures settle price 0.125 0.833** 1.766** 0.061 0.155 0.763** 0.356* -0.302* 0.107 -0.326* 0.246 0.208 0.531** 0.458* -0.086 0.535** 0.005 0.387* 0.565** -0.421* -0.195 -0.615** 0.615** 0.405* 0.461* -0.074 0.202 0.247 0.194 0.236 0.287 0.450* 0.390* (7) (8) Last Trading Day Contract Month May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Jan-05 Feb-05 Mar-05 May-05 Jun-05 Aug-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Cash VIX close 19.33 15.05 14.46 17.02 13.56 15.05 13.21 12.47 11.27 13.15 14.57 11.79 13.52 15.33 12.23 11.19 11.91 12.25 11.62 11.40 13.35 16.69 17.74 13.42 11.98 11.73 10.50 10.30 10.74 10.34 13.27 12.14 14.01 Futures settle price 18.36 14.00 13.13 17.49 13.73 13.16 12.84 12.77 11.29 13.63 13.86 11.01 12.82 15.17 12.31 10.18 12.62 12.04 11.15 11.94 14.03 17.29 17.01 12.29 11.29 11.43 10.27 10.05 10.71 9.95 12.98 12.03 13.63 At the Futures Settlement Cash VIX at the open 18.48 14.83 14.90 17.55 13.88 13.92 13.20 12.47 11.40 13.30 14.11 11.22 13.35 15.63 12.22 10.71 12.62 12.43 11.71 11.52 13.83 16.67 17.62 12.69 11.75 11.36 10.47 10.30 10.90 10.19 13.27 12.48 14.02 Futures price** 18.355 13.997 13.134 17.489 13.725 13.157 12.844 12.772 11.293 13.626 13.864 11.012 12.819 15.172 12.306 10.175 12.615 12.043 11.145 11.941 14.025 17.285 17.005 12.285 11.289 11.434 10.268 10.053 10.706 9.954 12.983 12.03 13.63

* different by >0.30, ** different by >0.50 ** The procedure to represent futures prices and settlement prices in March 2007.

Table II Summary Statistics of Differences for the VIX Cash and Futures Contracts
The table presents summary statistics of the differences between the cash VIX and VIX futures prices on the last trading day and the settlement day.

(1)

(2) Difference Between:

(3)

(4)

Statistic

VIX close and Futures close/ on last trading day 0.20 0.16 0.28 -0.50 0.87 30% 15%

Futures close on last trading day and Futures settle price 0.11 -0.03 0.70 -1.08 1.84

VIX close on last trading day and VIX open on settle day 0.05 0.00 0.40 -0.71 1.13 39% 18%

VIX open and Futures settle price 0.26 0.25 0.43 -0.61 1.77 55% 24%

Mean Median St. deviation Min Max % of times dif is above |.3| % of times dif is above |.5|

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Table III Options Trading Volume at the Special Opening on the Futures Settlement Date
The table presents summary statistics regarding the average volume of options per strike traded at the opening of the futures settlement day. Only out-of-the-money options are considered for the settlement. The average of the difference between the VIX and futures prices are absolute averages.
(1) (2) Average volume per strike Contract Calls Jan-05 Feb-05 Mar-05 May-05 Jun-05 Aug-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug -06 Sep-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 Average Average if difference >|.3| 202 1,038 131 510 647 745 114 312 263 112 277 96 8 209 92 155 1,062 403 2,368 400 365 868 824 1,672 536 402 Puts 175 1,622 279 768 1,160 1,173 163 514 548 303 455 261 31 670 124 283 1,454 544 2,941 335 586 2,625 1,218 1,280 813 521 1,534 3,214 2,223 4,074 2,598 6,653 897 6,094 1,548 831 7,409 611 921 7,196 2,796 2,122 4,423 2,753 15,458 3,347 3,878 8,693 5,900 7,745 4,288 3,203 (3) Futures open interest on settlement day (4) Difference between VIX open and Futures settle prices 0.30* 0.11 0.33* 0.25 0.21 0.53** 0.46* 0.09 0.54** 0.00 0.39* 0.57** 0.42* 0.20 0.61** 0.61** 0.41* 0.46* 0.20 0.25 0.19 0.24 0.29 0.45* 0.34 0.47 (5) Average Option volume per strike as a percentage of Futures open interest (%) 12.29 41.38 9.22 15.68 34.78 14.41 15.44 6.78 26.20 24.97 4.94 29.21 2.12 6.11 3.86 10.32 28.44 17.20 17.17 10.98 12.26 20.09 17.31 19.06 15.73 14.40

* different by >0.30, ** different by >0.50

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Table IV Alternative Settlement Procedures for VIX Futures

This table shows the results from employing the average of the one-minute cash VIX values as the settlement value for the futures contract.
(1)
Expiration Months

(2)
Difference between:

(3)

(4)

(5)

Standard Deviation of:

Close of the VIX Open of the VIX VIX open and and Average VIX and Average of VIX on the last VIX on the the VIX on Futures settle price on the last trading trading day settlement day day settlement day

May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Jan-05 Feb-05 Mar-05 May-05 Jun-05 Aug-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Average

0.13 0.83 1.77 0.06 0.16 0.76 0.36 -0.30 0.11 -0.33 0.25 0.21 0.53 0.46 -0.09 0.54 0.00 0.39 0.57 -0.42 -0.20 -0.61 0.61 0.40
0.46 -0.07 0.20 0.25 0.19 0.24 0.29 0.45 0.39

-0.03 0.03 -0.12 -0.01 -0.11 -0.24 -0.15 -0.09 -0.20 0.41 -1.12 0.05 0.48 0.25 0.10 -0.02 -0.24 -0.24 0.10 -0.53 0.12 -0.22 -0.88 0.87 -0.28 -0.04 -0.44 -0.40 0.01 -0.29 -0.70 0.32 0.23 -0.10

0.48 0.15 1.08 1.06 -0.53 -1.10 0.14 -0.21 0.11 -0.18 0.45 -0.49 0.20 0.47 -0.22 0.09 0.16 -0.12 0.33 0.06 -0.99 1.25 2.39 0.29 0.25 -0.21 0.10 0.13 0.29 0.25 0.22 0.25 0.26 0.19

0.10 0.17 0.13 0.15 0.09 0.16 0.12 0.20 0.18 0.23 0.52 0.13 0.34 0.17 0.24 0.09 0.18 0.25 0.20 0.31 0.12 0.26 0.43 0.20 0.26 0.14 0.26 0.25 0.08 0.26 0.49 0.15 0.22 0.21

0.35 0.11 0.39 0.22 0.19 0.37 0.13 0.16 0.11 0.15 0.18 0.17 0.16 0.61 0.10 0.18 0.11 0.16 0.07 0.11 0.74 0.39 0.52 0.12 0.08 0.12 0.12 0.07 0.14 0.14 0.68 0.11 0.16 0.22

0.24

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Exhibit I: Arbitrage Transactions with VIX Futures

A. When VIX futures price > options time value (forward cash VIX) Futures Transactions Options Transactions At time t Sell (short) VIX futures Buy a portfolio of out-of-the-money options At futures expiration Cover short futures position by Sell portfolio of options at the bid price at settling (buying) at expiration ROS settlement B. When VIX futures price < options time value (forward cash VIX) Futures Transactions Options Transactions At time t Buy VIX futures Sell (short) a portfolio of out-of-the-money options At futures expiration Cover long futures position by Buy back the portfolio of options at the ask settling (selling) at expiration price at ROS settlement

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Figure 1 Average Convergence of Cash VIX and VIX Futures

12% 10% 8% 6% 4% 2% 0% 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 -2% -4% (fut-cash)/cash

Average Convergence

Figure 2 Convergence of the Two Contracts with the Largest Difference between the VIX Open on Settlement Day and the Futures Settlement Price
40%

30%

10%

0% 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 -10%

(fut-cash)/cash

20%

Jun-04 Jul-04

-20%

Figure 3 Convergence of the Two Contracts with the Smallest Difference between the VIX Open on Settlement Day and the Futures Settlement Price
40%

30%

10%

0% 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 -10%

(fut-cash)/cash

20%

Aug-04 Jan-06

-20%

Note: In the last two graphs the open VIX is used on the settlement day to compare the VIX open and the futures settlement price; on the days before expiration the VIX close and futures settlement price are used.

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Figure 4 Out-of-the-Money Put Options

1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00
10 25 10 75 11 25 11 60 11 70 11 80 11 90 12 00 12 10 12 20 12 30 12 40 12 50 12 60 12 70 12 80 12 90 13 00

Ask - Bid Open - Bid

Figure 5 Out-of-the-Money Call Options

2.10 1.80 1.50 1.20 0.90 0.60 0.30 0.00
0 0 0 0 0 0 0 0 0 0 0 13 9 14 0 13 4 13 5 13 6 13 7 12 9 13 1 13 2 13 3 13 8 14 2 5

Ask - Bid Open - Bid

Figure 6 Average VIX Futures Open Interest

7000 6000 5000 4000 3000 2000 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 Average Open Interest

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