VOLATILITY AND THE PRISONER’S DILEMMA
CONFIDENTIAL
For Investment Professional Use. Not for Distribution
CBOE Risk Management Conference Asia
Artemis Capital Management LP
Christopher Cole, CFA
December 1, 2015
98 San Jacinto, Suite 370
Austin, TX 78701
Phone (512) 467-4735
info@artemiscm.com
www.artemiscm.com
Confidential
Regardless of how it is measured volatility reflects the difference between the
world as we imagine it to be and the world that actually exist
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Volatility is an Instrument of Truth
CONFIDENTIAL
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2
Illustration by Brendan Wiuff based on concept by Christopher Cole. Copyright Artemis Capital Management.
Confidential
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“The only thing
that will redeem
mankind is
cooperation”
Bertrand Russell
“Peace is not the
absence of
conflict”
Dorothy
Thompson
CONFIDENTIAL
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3
“Allegory of the Prisoner’s Dilemma” by Andy Diaz Hope & Laurel Roth. Reproduced with permission of artists. Unauthorized reproduction prohibited.
Confidential
Investors are trapped in a Prisoner’s Dilemma
Global central banking “arms race” to fight deflation has trapped
investors in an equilibrium of excessive risk, debt, and false prosperity
CBOE RMC ASIA
Volatility and the Allegory of the Prisoner’s Dilemma
Volatility is the only real asset class
Most active management strategies are short volatility in sheep's clothing
Volatility is your only escape from the Prisoner’s Dilemma
CONFIDENTIAL
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Hedge unknown unknowns and sell known unknowns
Global Macro Straddle + Asset Beta
4
Confidential
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Volatility Regime Shift in the Prisoner’s Dilemma
CONFIDENTIAL
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Source: Artemis Capital Management LP, Bloomberg
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Confidential
Imagine the world economy as an armada of ships passing through a narrow and
dangerous strait between the waterfall of deflation and hellfire of inflation
Our resolution to avoid one fate may damn us to the other
CBOE RMC ASIA
Volatility at World’s End Deflation
CONFIDENTIAL
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6
Illustration by Brendan Wuiff based on concept by Christopher Cole
Confidential
Volatility shocks are rightfully associated with deflationary crashes
120
Volatility at World's End Deflation
Dow Jones Industrial Index (RHS) vs. 1-month Realized Volatility of DJIA (LHS)
50,000
Realized Volatility (%)
80
5,000
60
40
DJIA (logarithmic scale)
100
CBOE RMC ASIA
Volatility in World’s End Deflation
500
20
50
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
1958
1956
1954
1952
1950
1948
1946
1944
1942
1940
1938
1936
1934
1932
1930
1928
Source: Artemis Capital Management LP, Global Financial Data
CONFIDENTIAL
Not for Distribution
0
7
Confidential
Extreme volatility can also occur in hyperinflation
80
Performance in paper marks (mil)
100
Adj. according to USD exchange rate
60
Adj. according to wholesale index numbers
40
In paper marks, Weimar
20
Nov-23
Aug-23
May-23
Feb-23
Nov-22
Aug-22
May-22
Feb-22
Nov-21
Aug-21
May-21
Feb-21
Nov-20
Aug-20
May-20
Feb-20
Aug-19
May-19
Feb-19
Nov-18
Aug-18
May-18
Feb-18
0
2,000
Weimar VIX?(1)
Realized Volatility of German Stock Market during Weimar Republic Hyperinflation
(monthly volatility data annualized)
1,500
Volatility (%)
100,000,000
10,000,000
1,000,000
100,000
10,000
1,000
100
10
1
0
0
0
0
0
0
Performance of German Stock Market
during Weimar Republic Hyperinflaton
Nov-19
Performance adj. for fixed exchange
120
CBOE RMC ASIA
Volatility in Hellfire of Inflation
1,000
500
Nov-23
Aug-23
May-23
Feb-23
Nov-22
Aug-22
May-22
Feb-22
Nov-21
Aug-21
May-21
Feb-21
Nov-20
Aug-20
May-20
Feb-20
Nov-19
Aug-19
May-19
Feb-19
Nov-18
Aug-18
May-18
Feb-18
Source: “Economics of Inflation; A Study of Currency Depreciation in Post-War Germany" by Constantino Bresciani-Turroni Out of Print / 1968
(1) Based upon monthly realized variance from available stock price data.
CONFIDENTIAL
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0
8
Confidential
two purely rational entities may not cooperate, even if it is in their best
interests to do so
Global central banks are in an arms race of devaluation resulting in
suboptimal outcomes for all parties and greater systemic risk
COOPERATION
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Volatility in the Prisoner’s Dilemma
COMPETITION
Cooperation
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9
Istockphoto.com
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Volatility and Asset Prices in the Prisoner’s Dilemma
CONFIDENTIAL
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Source: Artemis Capital Management LP, Global Financial Data
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Confidential
Exchanges short term equilibrium for longer term tail risk
Suppress Tail Risk
Suppress Tail Risk
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Volatility in the Prisoner’s Dilemma
Increase Peak of the
Distribution
Source: Artemis Capital Management LP, Bloomberg
Inflation
Currency Devaluation
Hyper-Asset Bubble
CONFIDENTIAL
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Deflation
War
Political Revolution
11
Confidential
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Volatility and Asset Prices in the Prisoner’s Dilemma
CONFIDENTIAL
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Source: Artemis Capital Management LP, Global Financial Data
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Confidential
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Only two types of institutions in this world, those that are short
convexity, and those that are massively short convexity
Short Interest in Volatility ETPs has exploded in the 2012-2014 period
CONFIDENTIAL
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Source: Artemis Capital Management LP, Bloomberg
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Confidential
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Active Volatility Management
CONFIDENTIAL
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Source: CBOE Eurekahedge
14
Confidential
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Active Long Volatility + Equity Index Exposure Significantly Outperforms
the S&P 500 index and Major Hedge Fund Indices
CONFIDENTIAL
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Source: CBOE Eurekahedge
15
Confidential
Long Volatility+
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Volatility by Holding Period
Volatility
Gamma
Short Volatility +
Short Volatility Risk
Premia
Volatility
Vega
CONFIDENTIAL
Not for Distribution
Source: CBOE Eurekahedge
16
Confidential
Most active management strategies produce alpha by being short volatility
or correlation
3 year Rolling Correlation HRFX Hedge Composite to S&P 500 Short Put
(HFRX Absolute Return, Equity Neutral, Hedge Index, Merger Arb, RV Arb, Convertible Arb / Monthly)
1m ATM Put Sale on S&P 500 Index
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
(0.1)
(0.2)
Dec-02
Mar-03
Jun-03
Sep-03
Dec-03
Mar-04
Jun-04
Sep-04
Dec-04
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Sep-13
Dec-13
Mar-14
Jun-14
Sep-14
Dec-14
Correlation
Relationship between Hedge Funds and Short Volatility
CBOE RMC ASIA
We are all volatility traders
Hedge Funds vs. 10% OTM SPX Put (Growth of $1)
Short S&P 500 Index Put Option
Cross-Section of Hedge Funds
1.43
Dec-14
Aug-14
Apr-14
Dec-13
Aug-13
Apr-13
Dec-12
Aug-12
Apr-12
Dec-11
Aug-11
Apr-11
Dec-10
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Aug-05
Apr-05
Dec-04
Aug-04
Apr-04
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Aug-03
Apr-03
Dec-02
CONFIDENTIAL
Not for Distribution
0.93
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Source: Hedge fund monthly returns from HFRX, volatility returns from Artemis Capital.
Confidential
In the real world… there are two asset classes… long and short volatility
What you think you are
investing in
0.4%
0.4% 0.4% 0.4%
What you actually are
investing in
3%
5.0%
5.0%
20.0%
CBOE RMC ASIA
Volatility is the Only Real Asset Class
10.0%
3.0%
5.0%
15.0%
3.0%
5.0%
5.0%
10.0%
5.0%
Long/Short Equity
Convertible Arbitrage
Private Equity
Distressed
Credit Index
Systematic CTA
5.0%
2.0%
Value Investing
Currency Arbitrage
Real Estate
Directional Long
Fundamental Value
Global Macro
2.0%
Special Situations
130/30 Fund
Risk Parity
Merger Arbitrage
Fundamental Growth
Tail Risk
97%
Short Volatility, Correlation & Dispersion
Long Volatility, Correlation & Dispersion
Source: Special thanks to DROBNY Global Macro for original visual conceptualization of this idea
CONFIDENTIAL
Not for Distribution
WHEN DOES PORTFOLIO #1 turn into PORTFOLIO #2?
1. Deflationary collapse followed by financial repression and negative real
rates and/or;
2. Historical correlation (negative correlation) between equities and bonds
breaks down rendering traditional diversification useless
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Confidential
Source: Artemis Capital Management LP, Global Financial Data, Robert Schiller
CONFIDENTIAL
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Anti-correlation
Correlation
Changing Correlations Between Fixed Income and Equity Prices
CBOE RMC ASIA
Volatility is the Only Real Asset Class
19
Confidential
Changing Correlations Between Fixed Income and Equity Prices
Source: Artemis Capital Management LP, Global Financial Data
CONFIDENTIAL
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Danger
Zone
CBOE RMC ASIA
Volatility is the Only Real Asset Class
20
Confidential
Three Possible Macro-VIX regimes for the next decade
I. Bull Market in Fear (2009 to 2012)
 Post-2008 vol environment of steep term-structure
 High Implied Correlations and Forward Volatility
 Low to
CBOE RMC ASIA
The Next Volatility Regime
II. Bear Market in Fear = Japanization of US Vol (2012 to Now)
 Positive real rates lead to volatility as fixed income alternative
 Long-term volatility and skew collapse as investors short rich vol
 Rise of volatility short sellers builds systemic risk and high VOV
III. Deflationary or Inflationary Volatility Spiral
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 Runaway deflation/inflation drives higher volatility
 Outperformance on the specific “tail” of the distribution
 OTM puts/calls re-priced
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Confidential
Volatility Yields Should Rise (fall) when Real Interest Rates are negative (positive)
Diversification benefits of volatility become more valuable than extra yield (negative
real) earned on fixed income
Volatility as a Portfolio Substitute for Fixed Income
12.00%
Real Interest Rates (2yr UST - CPI) vs. Volatility Yield (SPX / 25% OTM Put)
1990 to Early 2014
10.00%
CBOE RMC ASIA
Fear Regimes Explained by Portfolio Theory
Real Interest Rate (2yr UST - CPI)
1-year SPX Volatility Yield (-25% OTM Put / Notional)
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
2014
2013
2012
2012
2011
2010
2010
2009
2008
2008
2007
2006
2006
2005
2004
2004
2003
2002
2002
2001
2000
2000
1999
1998
1998
1997
1996
1996
1995
1994
1994
1993
1992
1992
1991
1990
1990
CONFIDENTIAL
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-4.00%
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Confidential
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Prisoner’s
Dilemma
andFixed
Risk Suppression
Volatility
Yield vs.
Income
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Mgmt LP, FRED, MarketDataExpress
23
Confidential
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Bull Market in Fear and Modern Portfolio Theory
Bull Market in Fear is Explained by Markowitz Portfolio Theory
 Long volatility exposure extremely valuable to portfolio optimization in financial repression despite
substantial negative carry because it hedges forced over-allocation to equity
 5-12% is optimal volatility portfolio exposure in negative real interest rate environment!
Optimal Portfolio in Financial Repression
(Stocks, Bonds, Cash & Vol) / Portfolio Target = 3% real return
Inflation = 3%
(Stocks, Bonds, Cash & Vol) / Portfolio Target = 3% real return
Inflation = 3%
100%
90%
90%
Cash
%
80%
80%
Allocation for 3% Real Return
Allocation for 3% Real Return
100%
Optimal Portfolio with Positive Real Rates
Cash %
70%
60%
50%
40%
30%
20%
Fixed Income %
10%
Long Volatility %
70%
Cash %
Equity %
60%
50%
40%
30%
Fixed Income %
20%
10%
0%
0%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
7%
8%
9%
10%
11%
12%
13%
Nominal Expected Return on Stocks
Long Volatility (-3% nominal return, -6% real)
Cash (0% nominal return, -3% real)
Stocks (SPX, 3-10% nominal return, 0-7% real)
Bonds (10yr UST / 2% nominal return, -1% real)
14%
15%
CONFIDENTIAL
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Nominal Expected Return on Stocks
Long Volatility (-3% nominal return, -6% real return)
Cash (3.5% nominal return, 0.5% real return)
Stocks (SPX, 3-15% nominal return, 0-9% real return)
Bonds (10yr UST / 6% nominal return, 3% real return)
6%
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Source: Calculations executed by Artemis Capital Management LLC . Covariance matrix based on data between 1990-2013.
Confidential
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Prisoner’s
Dilemma
andFixed
Risk Suppression
Volatility
Yield vs.
Income
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Mgmt LP, FRED, MarketDataExpress
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Confidential
CBOE RMC ASIA
Understanding VIX options
Dimensions of VIX optionality
VOV Term Structure (z-axis) & VIX Skew (x-axis)
VIX Volatility Surface
Vol of Vol
160%
140%
120%
100%
80%
60%
40%
-1.0σ
0.5σ
2.0σ
CONFIDENTIAL
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Maturity
Jul-13
Apr-13
Mar-13
5.0σ
May-13
3.5σ
Jun-13
Moneyness (Sigma)
26
Confidential
Structural imbalances in supply-demand dynamics of volatility
Theme
Bull Market In Fear
Bear Market In Fear
 Post-traumatic
Deflation Disorder
 Euphoria,
Complacency, Greed
II. Monetary
 Forced participation
in risk assets drives
desire for hedging
 Low risk premiums
drive volatility
shorting for yield hunt
III. Macro
 Forced participation
in risk assets drives
desire for hedging
 Low risk premiums
drive volatility
shorting for yield hunt
IV. Regulatory
 Gov. regulation (DoddFrank) constrains risk
appetite
 Dealers no longer able
to inventory long
volatility
CONFIDENTIAL
Not for Distribution
I. Emotional
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What Effects the Price of Volatility?
27
Confidential
Low VIX index does not mean cheap volatility
You can’t trade the VIX – you can only trade the expectation of VIX
Forward VIX Index (%)
35
Lowest Volatility? Really?
VIX Futures Curve Comparison
August 17, 2012 vs. September 2008
30
!
CBOE RMC ASIA
Bull and Bear Markets in Fear
25
20
15
September 15, 2008 / Day after Lehman Bros. Bankruptcy
November 4, 2014
10
Spot
Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8
Source: Artemis Capital Management LP, Bloomberg
CONFIDENTIAL
Not for Distribution
August 17, 2012 / Lowest VIX in 5 years (at the time)
28
Confidential
Forward volatility is a poor indicator for future movement of spot-vol
VIX Index and Forward Expectation of VIX Index
Bear Market in
Fear
2008 financial
crash
Volatility
Spikes
Volatility Falls and
Bull Market in Fear
LONG RVOL RISK AND RETURN BY
HOLDING PERIOD
0.07x
Sharpe
Bear Market
in Fear
Moral Harzard
Market
Spot Volatility (VIX)
Sortino Ratio
CBOE RMC ASIA
Bull and Bear Markets in Fear
Forward Expected Volatility
(multiple color lines)
0.06x
0.05x
0.04x
0.03x
QE3 Flattening
of Vol Term
Structure
2551d
2101d
1951d
1651d
1801d
1501d
1201d
1351d
1051d
751d
901d
601d
301d
451d
151d
1d
-0.02x
2401d
0.00x
-0.01x
2251d
0.01x
2007 credit
crisis
Historic Inversion
shows expectation of
central bank reaction
function!
2011 US default
crisis
2010 flash crash
0.02x
CONFIDENTIAL
Not for Distribution
Note:
Calculations based on monthly averages of VIX index and constant-maturity VIX futures
29
Confidential
Shadow Short Convexity
Immeasurable risk introduced when market participants reorganize portfolios
in way that contributes to feedback loops
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Volatility protects you from Shadow Short Convexity
CONFIDENTIAL
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Source: Walt Disney, Fantasia
30
Confidential
Yikes!
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Everyone is short volatility = dangerous
Short Interest in Volatility ETPs has exploded in the 2012-2014 period
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Management LP, Bloomberg
31
Confidential
100% one day move in VIX could require $2 to $3 billion of vega buying pressure
from short and leverage VIX ETPs alone (XIV, SXVY, TVIX & UVXY)
1987 Black
Monday
Crash
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Nonlinear Rebalancing of Short VIX ETPs is disaster in making…
Short Interest in Volatility ETPs has exploded in the 2012-2014 period
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital, Bloomberg
* Assumes month 1 and month 2 VIX futures move simultaneously. Ratio as % change in vega notional from start. Assumes 1 day move in vol and no inflow or outflow from starting ETP AUM.
32
Confidential
CBOE RMC ASIA
Everyone is short volatility = dangerous
Short Interest in Volatility ETPs has exploded in the 2012-2014 period
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Management LP, Bloomberg
33
Confidential
August 24th, 2015
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Left Tail of Volatility
CONFIDENTIAL
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Source: Artemis Capital Management LP, Bloomberg
34
Confidential
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August Volatility Event – Fastest Mean Reversion in History
1557 days
544 days
515 days
435
days
191
days
158
days
151 days
39 days
only!
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Management LP, Bloomberg
35
Confidential
CBOE RMC ASIA
Left Tail of Volatility
CONFIDENTIAL
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Source: Artemis Capital Management LP, Bloomberg
36
Confidential
CBOE RMC ASIA
August Volatility Event – High Volatility of VIX
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Management LP, Bloomberg
37
Confidential
Much easier to see conditions that increase the probability of a forest fire than to predict
the exact spark that will ignite one
Volatility Wildfire Conditions





Financial Stress
Correlation Breakdowns
Volatility of Volatility
Currency Flows
Volatility Momentum





Equity Turbulence
High Leverage
Low Hedging
Autocorrelation
Inter-bank Lending





Credit Stress
FX Turbulence
Breakeven CPI
Expected Inflation
Liquidity Stress
CBOE RMC ASIA
Conditions over Causation
CONFIDENTIAL
Not for Distribution
Note: Artemis proprietary model based on financial stress conditions. Machine learning model utilizes learned conditions to approximate state of volatility
38
Confidential
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Volatility Regime Shift in the Prisoner’s Dilemma
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Management LP, Bloomberg
39
Confidential
CBOE RMC ASIA
Volatility Regime Shift in the Prisoner’s Dilemma
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Management LP, Bloomberg
40
Confidential
CBOE RMC ASIA
You would not drive cross-country using only your rear view mirror!!!
Financial markets do not always look like Nebraska!
So why does Wall Street mostly use past volatility to gauge future volatility?
CONFIDENTIAL
Not for Distribution
Source: Artemis Capital Management LP, Bloomberg
41
Confidential
1987 Black Monday
Crash
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Left Tail of Volatility
Buy the FEAR and you will
always be protected from
the HORROR
CONFIDENTIAL
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Source: Artemis Capital Management LP, Bloomberg
42
Confidential
CBOE RMC ASIA
Volatility is your Only Escape from the Prisoner’s Dilemma
GLOBAL MACRO STRADDLE + BETA
CONFIDENTIAL
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43
Note: Artemis created a model to simulate the behavior of the equity returns, volatility movement, and “greek” sensitivities of options. Volatility simulations are expected to represent real potential scenarios but there is
no guarantee as to accuracy of the model.
Confidential
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Are we too complacent?
CONFIDENTIAL
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Source: Financial Times / September 2014
44
Confidential
Artemis Vega Fund L.P.
Artemis Capital Management, L.P.
98 San Jacinto, Suite 370
Austin, TX 78701
info@artemiscm.com
www.artemiscm.com
Christopher Cole, CFA
CIO and Founder
(512) 467-4735 phone
c.cole@artemiscm.com
CBOE RMC ASIA
Artemis Capital Management – Contact Information
Christopher Cole, CFA – General Partner and Founder
Key Information/ Biography
CONFIDENTIAL
Not for Distribution
Christopher Cole, CFA
Managing Partner & Portfolio Manager / Artemis Capital Management LP
Christopher R. Cole, CFA is the founder of Artemis Capital Management LP and the portfolio manager of the
Artemis Vega Fund LP and affiliated institutional managed accounts. Mr. Cole’s core focus is systematic,
quantitative, and behavioral based trading of volatility derivatives. His decision to form a fund came after
achieving proprietary returns during the 2008 financial crash trading volatility futures. Mr. Cole's research
letters and volatility commentaries were influential in derivatives circles and thereafter widely referenced
and quoted by the mainstream financial media, academic, and institutional asset management communities.
He previously worked in capital markets and investment banking at Merrill Lynch. During his career in capital
markets and pension consulting he structured over $10 billion in derivatives and debt transactions for many
high profile issuers. Mr. Cole holds the Chartered Financial Analyst designation, is an associate member of
the NFA, and graduated Magna Cum Laude from the University of Southern California.
45