Market uncertainty, expected volatility and the mispricing of S&P 500 index futures

• Expected volatility adversely affects the willingness to engage in arbitrage.
• We employ the VIX and VIX innovation as proxies for expected volatility.
• Large expected volatility results in large and persistent futures mispricing.
• The impact of expected volatility on futures mispricing is non-linear.
• Concurrent volatility outweighs expected volatility during the crisis period.

An association between increased index futures mispricing and concurrent index volatility has been reported within several prior studies; in the present study, we argue that expected volatility over an arbitrage horizon also has an adverse effect on the ability and willingness of traders to engage in arbitrage, leading to greater and more persistent futures mispricing. Using the CBOE VIX and its innovation on the concurrent spot volatility as proxies for expected volatility, we present evidence of an increase in S&P 500 index futures mispricing with expected volatility. The impact of the VIX grows exponentially across the distribution of conditional mispricing levels, which suggests that the expectations of heightened future volatility become increasingly detrimental to arbitrage activities when the futures price deviations are enlarged; however, the influence of expected volatility is found to have been reduced during the global financial crisis period, a period during which concurrent volatility overwhelmingly dominated the magnitude of mispricing.