False Peace, Moral Hazard and, Shadow convexity
Dorothy Thompson once said “peace is not the absence of conflict”. Never forget there is a form of peace and stability reinforced by a foundation of underlying volatility. Game theorists call this the paradox of the Prisoner’s Dilemma, and it describes a dangerously fragile equilibrium achieved only through brutal competition. The Prisoner’s Dilemma is the most important paradigm for understanding shadow risk in modern financial markets at the pinnacle of a multi-generational debt cycle unparalleled in the history of finance. Global Capitalism is trapped in its own Prisoner’s Dilemma; forty four years after the end of the Bretton Woods System global central banks have manipulated the cost of risk in a competition of devaluation leading to a dangerous build up in debt and leverage, lower risk premiums, income disparity, and greater probability of tail events on both sides of the return distribution. Truth is being suppressed by the tools of money. Market behavior has now fully adapted to the expectation of pre-emptive central bank action to crisis creating a dangerous self-reflexivity and moral hazard. We are nearing the end of a thirty year “monetary super-cycle” that created a “debt super-cycle”, a giant tower of babel in the capitalist system. As markets now fully price the expectation of central bank control we are now only one voltage switch away from the razors edge of risk. Do not fool yourself - peace is not the absence of conflict – peace can exist on the very edge of volatility.
The next great crash will occur when we collectively realize that the institutions that we trusted to remove risk are actually the source of it. The truth is that global central banks cannot remove extraordinary monetary accommodation without risking a complete collapse of the system, but the longer they wait the more they risk their own credibility, and the worse that inevitable collapse will be. In the Prisoner’s Dilemma, global central banks have set up the greatest volatility trade in history.
To download the full article published in October 2015, click here. Opens in a new window.
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. Opens in a new window.
RISK, FEAR, AND SAFETY IN GAMES OF PERCEPTION
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.
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. 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 of risk.
To download the full article published on October 4, 2012 click here. Opens in a new window
DEFLATION, HYPERINFLATION AND THE ALCHEMY OF RISK
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 Opens in a new window
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. 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.
To download the full article published on March 30, 2012 click here. Opens in a new window.