CFA Institute Conference Proceedings Quarterly
January 2014 | Vol. 31 | No. 1
The following is the abstract from the article “Volatility: The Market Price of Uncertainty” by Christopher Cole from Artemis Capital Management LLC.
Today’s securities markets are pricing in yesterday’s crash, the known unknown, rather than tomorrow’s unknown unknown. To understand volatility as an asset class is to value the forward expectation of uncertainty, which is as much a function of human psychology as it is an expression of mathematics. Since the financial crisis, the pricing of volatility derivatives has undergone wide-scale changes that reflect classic behavioral biases. Not only is volatility an asset class, but in fact, it may end up being the most important asset class for institutional portfolios over the next decade. A strategy of “crisis alpha,” defined as the strategic acquisition of mispriced volatility, is a powerful way to navigate future uncertainty.
To download the full article published in January 2014, click here.
The following is an excerpt from the research article “Volatility of an Impossible Object: Risk, Fear, and Safety in Games of Perception” from Artemis Capital Management LLC. Click for PDF Download
The global financial markets walk on the razors edge of empiricism and what you see is not what you think, and what you think may very well be impossible anyway. The impossible object in art is an illustration that highlights the limitations of human perception and is an appropriate construct for our modern capitalist dystopia. Famous examples include Necker’s Cube, Penrose Triangle, Devil’s Tuning Fork, and the artwork of M.C. Escher. The formal definition is “an optical illusion consisting of a two-dimensional figure which is instantly and subconsciously interpreted as representing a projection of three-dimensional space even when it is not geometrically possible” (1). The fundamental characteristic of the impossible object is uncertainty of perception. Is it feasible for a real waterfall to flow into itself; or for a triangle to complete itself in both directions? The figures are subject to multiple forms of interpretation challenging whether our naïve perception is relevant to understanding the truth. The impossible object is of vast importance to mathematics, art, philosophy and as I will argue… modern pricing of risk.
Modern financial markets are a game of impossible objects. In a world where global central banks manipulate the cost of risk the mechanics of price discovery have disengaged from reality resulting in paradoxical expressions of value that should not exist according to efficient market theory. Fear and safety are now interchangeable in a speculative and high stakes game of perception. The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.
The volatility of an impossible object is your own changing perception.
Our cover illustration pays homage to M.C. Escher’s 1961 masterpiece Waterfall and is intended to be an artistic abstraction of the self-reflexive mechanics of modern monetary theory. In a capitalist cityscape the aqueduct begins at the waterwheel of monetary expansion churning out a torrent of boundless fiat currency that streams through the dense metropolis. The river of money flows from the edge of the aqueduct into the waterfall of deflation and then over the waterwheel suspended in a never-ending cycle of monetary expansion and crisis. Beneath the city the fires of inflation burn threatening to one day consume the monetary mechanism. Is the reflexivity of flowing fiat currency the solution or the very source of the paradox? We don’t know.
Likewise how certain are we that the elevated two-dimensional prices of risk assets and low spot volatility have anything to do with fundamental three-dimensional reality? In this brave new world volatility is an important dimension of risk because it can measure investor trust in the market depiction of the future economy. The problem is that the abstraction of the market has become an economic reality unto itself. You can no longer play by the old rules since those rules no longer apply. I know what you are thinking. You didn’t get your MBA to be an amateur philosopher – your job is to make cold-hard decisions about real money – not read Plato. You are out of luck. For the next decade this market is going to reward philosophers over students of business. Why? Because the modern investor must hold several contradictory ideas in his or her head at the same time and none of them really make any sense according to business school case studies. Welcome to the impossible market where…
Knowledge is not what you know but certainty in what you do not
Volatility is cheap and expensive at the same time
Fear is a better reason to buy than fundamentals
Risk-free assets are risky
Common sense says do not trust your common sense
The following is an excerpt from the research article “Volatility at World’s End: Deflation, Hyperinflation and the Alchemy of Risk” from Artemis Capital Management LLC.Click for PDF Download
Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation. The global fleet is tethered by chains of trade and investment so if one ship veers perilously off course it pulls the others with it. Our only salvation is to hoist our economic sails and harness the winds of innovation and productivity. It is said that de-leveraging is a perilous journey and beneath these dark waters are many a sunken economy of lore. Print too little money and we cascade off the waterfall like the Great Depression of the 1930s… print too much and we burn like the Weimar Republic Germany in the 1920s… fail to harness the trade winds and we sink like Japan in the 1990s. On cold nights when the moon is full you can watch these ghost ships making their journey back to hell… they appear to warn us that our resolution to avoid one fate may damn us to the other.
Volatility at World’s End symbolizes a new paradigm for pricing risk that emerged after the 2008 financial crash and is related to our collective fear of deflation. The metaphor encapsulates the unyielding sense of dread that the global economy will plunge into the dark abyss and is the source of major changes in volatility markets. Today the existential fear of world’s end deflation is so powerful investors are willing to pay the highest prices for portfolio insurance in nearly two decades. The market for forward volatility has become unhinged as the SPX variance and VIX futures curves sustain historically high premiums over low spot vol. My argument is not that this extreme fear is misplaced but that it is mispriced. Like Odysseus in the epic poem the global economy is trapped between the monsters of Scylla and Charybdis. We risk one to avoid the other. From one world’s end to the next sometimes I wonder if decades from now we will look back with the hindsight that we were all hedging the wrong tail.
In the face of foreboding undercurrents our US-economic ship seems to have turned course toward calmer waters. The S&P 500 index had its best first quarter in 14 years, volatility fell to a 5 year low, and bond yields rose sharply on the trade winds of better than expected economic and jobs data. Risk assets were buoyed by an orderly Greek default with the ECB’s three year bank lending program (LTRO) succeeding in reducing dangerously high sovereign yields in the Euro-zone. While I admit I don’t understand why further leveraging the Euro-banking system to the same sovereign debt that caused the crisis will fix anything in the long-run it definitely has succeeded in calming markets in the short-term. Unfortunately this has been a recurring theme and once again there is no shortage of eager financial and political middle men cheering that the worst is now over. The conventional wisdom says “do not fight the Fed” so by extension of that logic it is madness to fight every central bank in the world by fading this rally. The pace of global monetary stimulus has been astounding reaching almost $9 trillion in total expansion over the past three and a half years in the greatest period of fiat money creation in human history(1). Let me put these numbers into perspective. Collectively global central banks have created enough fiat money to buy every person on earth a 55” wide-screen 3D television (do the math).
Artemis Capital Management LLC is pleased to present “Volatility at World’s End: Two Decades of Movement in Markets” a unique visualization of implied and realized stock market volatility from 1990 to 2011. The video was originally shown as part of Christopher Cole’s speech at the 2012 Global Derivatives and Risk Management Conference in Barcelona Spain on April 17th.
The movement of stock prices has been an obsession for generations of speculators and traders. On a higher level mathematicians believe that modern markets are an extension of the same fractal beauty found in nature. Visualized these stock markets may take the shape of a turbulent ocean with waves made of human hopes, dreams, greed, and fear. Merging the world of high-finance and high-art Artemis Capital Management LLC is proud to present a creative visualization of stock market volatility over the last two decades.
Volatility at World’s End: Two Decades of Movement in Markets is a depiction of real stock market volatility using trading data from 1990 to 2011. The visuals are designed from S&P 500 index option data replicating the implied volatility wave (or variance swap curve) extending to an expiration of one year. The front of the volatility wave contains the same data used to calculate the CBOE VIX index. The movement of this wave demonstrates changing trader expectations of the future stock market volatility. As the wave moves through time the expected (or implied) volatility surface transforms into a realized volatility surface derived from historical S&P 500 index movement. The transition represents what professional traders call “volatility arbitrage”. The color variation in the volatility waves show the volatility -of-volatility or internal movement of the wave. The track underneath the volatility wave represents underlying S&P 500 index prices.
Volatility at World’s End: Two Decades of Movement in Markets Concept and Creative Direction by Christopher Cole, CFA
Visual Animation and Programming by Jayson Haebich
Title Design by Nataliya Vakulenko
Artemis Capital Management LLC, All Rights Reserved 2012
The following is an excerpt from the research article “Fighting Greek Fire with Fire: Correlation, Volatility, and Truth” from Artemis Capital Management LLC.Click for PDF Download
The world economy is fighting a fearsome wildfire as the European sovereign debt crisis burns its way closer toward the tinderbox of a second global recession. The insolvency inferno has no prejudice and will fuse to the flesh of any asset class fueling a blistering spiral of correlation and volatility. The third quarter of 2011 was characterized by explosive movements in equity markets as the S&P 500 index declined -14% in the worst performance since the crash of 2008. Global indices officially entered bear market territory with the MSCI All-Country World Index down more than -20% since peaking in May. The 10-year US Treasury yield reached the lowest level on record in September as credit markets braced for an economic slowdown. Over the quarter implied volatility increased +96% as the VIX index climbed to 42.96. If you heeded the omens of variance markets earlier this year you were richly rewarded by this increase in volatility.
A wildfire is blind and cruel in violently transforming the essence of any material to ash. In this sense the end-effect of fire is always correlation and volatility. The common method to extinguish a wildfire is by dousing it with water but what if this is not enough? Is it possible for fire to resist or spread through the addition of liquidity? Ironically in recorded history there is one such type of flame… Greek Fire. Greek Fire was the most feared weapon of the Byzantine Empire because water alone was powerless against its flames. The composition of the weapon is an ancient secret but modern scientists believe it was made with calcium phosphide (heating lime, bones, charcoal) which, upon contact with water, ignites spontaneously. Greek Fire was so difficult to extinguish that it was known to continue to burn even underneath bodies of water. The fire could fuse to any surface, including the sea, explode and spread uncontrollably. For this reason the ancient napalm was very effective in naval warfare and saved Constantinople from two Arab sieges. The guardians of the formula were so afraid it would fall into enemy hands that its secrets were eventually lost to time(1). For those who fought against Greek Fire a liquidity trap became a liquidity grave.
In the new era of global interconnectedness liquidity alone is not enough to extinguish Europe’s Greek Fire. The smoldering flames of default are spreading impervious to fiat money creation. The unintended consequences of unprecedented intervention in markets are culminating in higher cross-asset correlations and violent price gyrations. All we left have to show for our three year liquidity orgy is the most correlated period in modern finance. The propensity for erratic movements in DJIA daily lagged returns is at the most extreme levels in over nine decades of recorded data. We are trapped in a binary market governed by the flip of a macroeconomic coin with deflation on one side and government bail-outs on the other. In this hyper-correlated market many alpha generating strategies resemble directional volatility trades.
The more global asset classes move in lockstep the more haphazardly the international response to the crisis has become. A currency war is raging as central banks alternate dousing sovereign insolvency flames with uncoordinated currency devaluation. Whether this is Brazil unexpectedly cutting rates by 50 basis points despite the highest inflation in six years or Switzerland pegging the Franc to the Euro to protect exports it is every man, woman, and central bank for itself. Every day we see new kinks in the armor of prior economic and political alliances that lay vulnerable to surrender in a vicious self- reinforcing cycle of devaluation. While public opposition grows to bail-out economics the Federal Reserve has very few credible stimulus options remaining to battle the inferno.
Greek Fire in Europe threatens to ignite a global recession and if you haven’t already noticed, your alpha is burning. There are no safe havens and to survive the flames of the next decade we must embrace and harness their nature.
Note: The following article is an excerpt from the First Quarter 2011 Letter to Investors from Artemis Capital Management LLC published on March 30, 2011. PDF Download
The financial markets have endured a flock of geopolitical “black swans” including the devastating earthquake and nuclear crisis in Japan, widespread revolution and violence in the Middle East and North Africa, and escalation of the European sovereign debt crisis. Incredibly domestic markets shrugged aside fear from each transformational event as stocks registered their best first quarter in over a decade led by a recovery in corporate earnings and job growth. The absence of sustained price volatility despite several global shock events is interpreted as a bullish omen by many investors. In regard to geopolitical risk it feels like volatility should be perched above 30%, but surprisingly, after increasing in mid-March, the VIX index registered its second largest drop in history (and the third longest) falling -40.86% over seven days and ending the month below historic averages.
The passive mood of spot volatility is masking a dramatic revolution in the structure and behavior of the volatility curve that has wide-ranging ramifications for anyone who trades variance or uses portfolio insurance. The timing of recent volatility distortions has coincided with the implementation of the Federal Reserve’s second quantitative easing program and is likely an unintended consequence of loose monetary policy.
In an increasingly volatile world many investors are talking about how to protect their portfolios against the black swan event. What may be more relevant is to explore the psychology of a market that fears the black swan but refuses to acknowledge its presence upon arrival. In behavioral psychology this is called a “normalcy bias” and the concept provides a framework to understand the current volatility market. Continue reading →
Note: The following article is an excerpt from the Fourth Quarter 2010 Letter to Investors from Artemis Capital Management LLC published on January 4, 2011. PDF Download
In the eyes of this volatility trader the current paradigm of monetary and fiscal stimulus may best be understood as the greatest leveraged volatility short in economic history. The current stimulus program is analogous to continuously rolling “naked” put options on the global economy, backed by margin provided by the US taxpayer, generating short-term growth at the expense of long-term systematic risk. The reinvestment of the vol premium into risk assets by the investor class ensures the Fed’s naked put is not exercised. Although policy makers have been rolling the great vega short for the past 30 years it has never been more levered than today. At present bullishness is pervasive as the government has succeeded in artificially suppressing asset volatility with the new stimulus. To be fair the economy is improving with corporate profits increasing for seven consecutive quarters and credit spreads narrowing. Many economists are revising their 2011 GDP projections upward. Nobody should be afraid to attend this stimulus party or the fledging recovery but before agreeing to ride home on the risk bandwagon I’d prefer to make sure there is a designated driver. In the future we may look back at this period of unanimous euphoria as the best opportunity since mid-2007 to purchase ‘tail risk’ insurance in the form of long-dated volatility.
In Q4 2010 the volatility markets were fully sedated by a massive dose of fiscal and monetary methadone. In the wake of weakening economic data this summer and near 10% unemployment the US government wasted no time in applying new rounds of stimulus.
Immediately prior to the start of the quarter the Federal Reserve signaled its intention to renew its Treasury bond purchase program and subsequently purchased $168 billion of debt on route to a planned $600 billion total by the end of June 2011. In November the Fed passed China as #1 largest holder of US Treasury Bonds and now has $1.2 trillion of holdings as of December
Not to be outdone Congress piled on its own supply side stimulus in a bi-partisan “compromise of excess” by extending the Bush era tax cuts for all classes, providing a payroll tax cut, and extending unemployment benefits. This should increase the deficit by approximately $900 billion over the next two years. Government liabilities have expanded over $4 trillion in nine quarters.
Note: The following article is an excerpt from the Third Quarter 2010 Letter to Investors from Artemis Capital Management LLC published on September 30, 2010. PDF Download
The summer of investor discontent was made glorious by the sun of quantitative easing as the equity markets finished their best September since 1939, largely due to expectation for further monetary stimulus. Earlier this month the Federal Reserve signaled its intention to renew its Treasury bond purchase program (known as Quantitative Easing 2 or QE2) sending the markets up, the dollar down, and our trading partners into a frenzy. In this brave new normal our monetary policy has somehow managed to make any asset yielding above 1% look sexy while sparking a global race to depreciate every globally traded currency. While the noble intention is stabilization and job growth the Federal Reserve is inadvertently throwing the global monetary world into complete disarray. The correlations (implied and realized) of asset classes are at multi-decade highs negating the benefits of diversification and mystifying even the most seasoned investors. In addition volatility surfaces steepened significantly over the quarter with the high volatility skew emblematic of a growing distrust of the prevailing equilibrium. There is a definitive connection between current monetary policy, unusually high correlations, and the historically steep volatility surface. Even as the domestic equity markets rise, the volatility and correlation markets are flashing signals of increased systemic risk seething under an innocuous surface. The following letter uses detailed quantitative analysis to make this case, but as you will see, the simple metaphor of selling pineapples in a Hawaiian farmer’s market may suffice to understand why risk is increasing exponentially in today’s global economy.
Rise of the Correlations: The paradox of the economic recovery is a phenomenon whereby different asset classes are moving in sync at highest levels in decades, making diversification futile for professional and retail investors alike. Correlation is a statistical measurement used to determine how closely the prices of different securities move in tandem and is directly related to volatility. Correlations are an important tool to test our trust in the market simulacrum because they provide a way to measure randomness. High correlation in markets can be described as a representing a lack of randomness in the price discovery mechanism. When markets become less random, paradoxically, they become riskier but also attractive for arbitrage opportunities.