BULL MARKET IN FEAR GRANT’S FALL CONFERENCE / NEW YORK CITY - OCTOBER 23, 2012
For Investment Professional Use. Not for Distribution Christopher Cole, CFA Artemis Capital Management LLC Artemis Vega Fund LP
520 Broadway, Suite 350 Santa Monica, CA 90401 (310) 496-4526 phone (310) 496-4527 fax [email protected]
BULL MARKET IN FEAR 1
Zinn - Jon Kabat Jon Volatility is the market price of uncertainty market is the Volatility
We live in uncertain times… a bull market fear in market a bull times… uncertain in live We Webster - “You cannot stop the waves, but you can learn to surf” to learn can butyou waves, the stop cannot “You Merriam
from
fear
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Definition
BULL MARKET IN FEAR 2
hellfire of hellfire inflation
and and
waterfall of deflation of deflation waterfall What is Volatility?is What
Cole
Volatility at World’s End Deflation End World’s at Volatility Christopher
by
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Imagine the world economy as an armada of ships passing through a narrow and and a narrow through passing ships of armada as an economy world the Imagine Illustration
Volatility in World’s End Deflation B ULL
Volatility shocks are rightfully associated with deflationary crashes
M
Volatility at World's End Deflation ARKET 120 Dow Jones Industrial Index (RHS) vs. 1-month Realized Volatility of DJIA (LHS)
50,000
IN
100 F
EAR
80 5,000
60 Realized Volatility (%) Volatility Realized 40 scale) (logarithmic DJIA 500
20
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1928 1930 1936 1938 1944 1946 1952 1954 1960 1962 1968 1970 1976 1978 1984 1986 1992 1994 2000 2002 2008 2010 1932 1934 1940 1942 1948 1950 1956 1958 1964 1966 1972 1974 1980 1982 1988 1990 1996 1998 2004 2006
3
BULL MARKET IN FEAR 4 Performance in paper marks (mil) marks paper in Performance
100,000 10,000 100,000,000 1,000 10,000,000 1,000,000 100 10 1 0 0 0 0 0 0
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23 - Aug 23 - Aug
23 - May 23 - May
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22 - Nov 22 - Nov
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22 - Feb 22 - Feb
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21 - Nov 21 - Nov
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21 - Aug 21 - Aug
Bresciani 21 - May (1) 21 - May
21 - Feb 21 - Feb
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20 - Nov 20 -
Nov by
20 - Aug 20 - Aug
Weimar VIX? Weimar
Germany"
20 - May 20 - May
War .
-
20 - Feb 20 - Feb Post data
(monthly volatility (monthlyvolatility data annualized)
in
Volatility in Hellfire Hellfire of Inflationin Volatility
19 - Nov 19 - Nov price
Performance of German Stock Market Market Stock of German Performance during Weimar Republic Hyperinflaton Republic Weimar during
stock 19 - Aug 19 - Aug
Depreciation
19 - May 19 - May
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19 - Feb 19 - Feb Currency Extreme volatility can also occur in hyperinflation inoccur also can volatility Extreme
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18 - Nov 18 - Nov Study
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;
Realized Volatility Germanof Volatility Market StockRealized duringWeimar RepublicHyperinflation 18 - Aug 18 - Aug
realized
18 - May May 18 - Inflation
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18 - Feb 18 - Feb monthly
upon
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:
20 40 80 60 500
100 exchange fixed for adj. Performance 120 Volatility (%) 1,000 Volatility 2,000 1,500 Based
) 1 ( Source Everything you need to know about trading volatility B
volatility) are associated with lower equity returns ULL
“There are known knowns; there are things we know that we know. There are known unknowns; Many people who trade volatility do not realize they that is to say there are things that, we now know we don't know. But there are also unknown M unknowns – there are things we do not know, we don't know.” ARKET
Donald Rumsfeld, United States Secretary of Defense
IN
F
Known Unknowns Unknown Unknowns EAR
Regimes of Volatility-of-Volatility (2007 to 2012)
Period Average SPX Return Volatility Regime Vol of VIX VIX index . US Fiscal Cliff . European Crisis (annual) Total 87.5 24.8 +1% . . (2007 to Sep 2012) China hard landing Global Recession Bull Market 81.7 13.8 +5% (2006 to July 2007) . War with Iran . Fiscal Austerity Credit Crisis Onset ? 82.7 23.0 -11% (Aug 2007 to Aug Market2008) Crash 95.7 49.6 -71% (Sep 2008 to Feb Recovery2009) to Flash 80.8 26.7 +35% Volatility Volatility of Volatility Crash (MarPost-Flash 2009 to Crash May 90.5 23.2 +10% Steepening (MayLTRO 2010Steepening to Oct 97.7 20.3 +16% . Vanilla Options . Realized Volatility . Forward Volatility . Tail Risk Hedging (Nov 2011 to Sep . VIX Index . Variance Swap . Convexity . Vol Curve Trades 2012)
Risks that you Risks that you Risks that you Risks that you know and can know but can’t don’t know but don’t know and quantity quantify could quantify can’t quantify
5
Everything you need to know about trading volatility B
ULL
M
Two very different styles of crash depending… ARKET
Known Unknowns Unknown Unknowns IN
F EAR
Regimes of Volatility-of-Volatility (2007 to 2012)
Debt-Cycle Crash Existential Flash Crash Period Average SPX Return Volatility Regime Vol of VIX VIX index (annual) (2008 Crash, Great Depression) (Black Monday 1987, 2010 Crash) Total 87.5 24.8 +1% ? (2007 to Sep 2012) Bull Market 81.7 13.8 +5% . Crash occurs over time (months) . Hyper-speed crash (days, seconds) (2006 to July 2007) Credit Crisis Onset 82.7 23.0 -11% (Aug 2007 to Aug . Slow recovery . Fast recovery Market2008) Crash 95.7 49.6 -71% (Sep 2008 to Feb Recovery2009) to Flash . Natural end of leveraging cycle . Market fragmentation 80.8 26.7 +35% Crash (MarPost-Flash 2009 to Crash May 90.5 23.2 +10% . High volatility for long period . Extreme volatility for shorter period Steepening (MayLTRO 2010Steepening to Oct 97.7 20.3 +16% (Nov 2011 to Sep . Elevated volatility-of-volatility . Extreme volatility-of-volatility 2012) . Start of a recession or depression . Omen of future recession (often)
Predictable Unpredictable (in retrospect) (even In retrospect)
6
BULL MARKET IN FEAR 7
Correlation - Structure -
Bull Market in Fear Market Bull What is the “Bull Market in Fear”? is the “Bull Market What related to our collective fear of the next deflationary crash of next fear the collective our to related
ExpensiveInsurancePortfolio Spikes Hyper Volatilityand Violent fromMonetary PolicyinVolatility Distortions Abnormally Steep Volatility Term Steep VolatilityAbnormally
New paradigm for pricing risk that emerged after the 2008 financial crisis crisis as financial emerged 2008that after risk the pricing for paradigmNew
4. 3. 2. 1.
Bull Market in Fear is Definedis by inFear Market Bull
Bull Market in Fear B ULL
Structural imbalances in supply-demand dynamics of volatility markets M
ARKET
I. Emotional
. Post-traumatic Deflation Disorder IN
. Desire for safety and security at any cost F EAR
II. Monetary Greater . Forced participation in risk assets drives desire for hedging Demand for . Unspoken feeling that gains in financial assets are “artificial” Volatility
III. Macro-Risks . Debtor-developed economies face structural headwinds . Unrest in Middle East
IV. Regulatory . Government regulation (Dodd-Frank, Volcker rule) has Less Supply constrained risk appetite for banks to supply volatility of Volatility . Lower demand for structured products by investors
8
BULL MARKET IN FEAR 9
M6 Expiry M3
VIX
12 - Jul
12 - Feb
11 - Dec
11 - Sep
11 - Jun
11 - Apr
11 - Jan
10 - Oct
10 - Jul
10 - May
10 - Feb
09 - Nov
09 - Sep
09 - Jun
09 - Mar
08 - Dec
2004 to Presentto 2004
08 - Oct
08 - Jul
08 - Apr
08 - Feb
07 - Nov
07 - Aug
07 - May
07 -
structure measures the anticipation volatility of future the anticipation measures structure Mar
-
06 - Dec
06 - Abnormally Steep Volatility Term Structure Term VolatilitySteep Abnormally Sep
06 -
Bull Market in Fear / VIX Futures Curve (normalized by spot VIX) spotVIX) (normalized by Futures Curve VIX / Fear in Market Bull Jun
06 - Apr
06 - Jan
05 - Oct
05 - Aug
05 - May
Volatility term Volatility
05 - Feb
04 - Nov
04 - Sep
04 - Jun
Mar 04 - "There is no terror in the bang, only in the anticipation of it." Alfred Hitchcock Alfred of it." anticipation the bang,in in the only nois terror "There
0.50x 0.70x 0.90x
1.10x 1.30x 1.50x 1.70x 1.90x Vix Futures/Spot Vix Futures/Spot Vix
Abnormally Steep Volatility Term Structure B ULL
The most extreme term-structure for S&P 500 index volatility in two decades
reflects continued anticipation of a deflationary collapse M ARKET Ratio of Expected Future Volatility as Ratio to Spot Volatility 2.4x
S&P 500 options IN
2.2x F EAR
2.0x VIX Index 1.8x
1.6x
1.4x Expected Volatility Volatility as Expected Ratio a to Volatility Spot 1.2x 0.08 0.17 0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92 1.00 1.08 1.17 1.25 1.33 1.42 1.50 Expiry (1=year) Cumulative Average (1990-Mar 2012) 2012 YTD (avg.) Bull Market of 1990s (avg.) 2000 to Feb 2009 (avg.) 2009 to 2012 Bull Market in Fear
10
Volatility is cheap and expensive at the same time B
ULL
Low VIX index does not mean cheap volatility M ARKET
35 Low Volatility? Really?
VIX Futures Curve Comparison IN
August 2012 vs. September 2008 F
30 ! EAR
25
20 Forward VIX index (%)index VIX Forward August 17, 2012 / Lowest VIX in 5 years 15 September 15, 2008 / Day after Lehman Bros. Bankruptcy
10 Spot Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8
11
Volatility Regimes Defined by Central Banking B ULL
Volatility spikes consistently occur after the end of central bank balance sheet expansion
M
130% Fed Balance Sheet Expansion and VIX index 50 ARKET
No Fed Action LTRO (ECB), QEI Op Twist (Fed) & QEIII (Fed) 120% Aug 2011 Crash 45 QEII IN
Op. Twist+LTRO(ECB) F
QEIII EAR 110% VIX QEII 40
Risk and Vol Returns in Fed BS Regimes Flash Crash 100% 35 Crisis and Recovery (September 2008 to September 2012) Period Average Weekly Change SPX VIX 21d SV Fed BS
90% 30 Fed Balance Sheet ↑ 0.6% -1.7% 0.0% 1.5% VIX Index VIX (%) Fed Balance Sheet > +1σ ↑ 3.2% -7.4% 0.0% 8.1%
Fed Balance Sheet ↓ 0.0% 1.3% -2.0% -0.9% 80% 25 Fed Balance Sheet < -1σ ↓ 1.2% 2.7% -1.9% -4.7%
Post-Crisis Recovery Period (Mar 2009 to Sep 2012)
Fed BS % % BSChange Fed since September 2008 70% 20 Period Average Weekly Change SPX VIX 21d SV Fed BS QEI con't (March09-Jun 09) 1.4% -2.6% -2.5% 0.6%
60% 15
May May May May
Mar Mar Mar Mar
Sep Sep Sep Sep
Nov Nov Nov
Jul Jul Jul Jul
Jan Jan
Jan Post QEI (Jun09-Oct10) 0.2% -0.2% -0.8% 0.2%
- - -
- (1)
- - -
11 09 10 12
- - -
- 0.5% -1.0% 0.0% 0.5%
11 12
10 QEII (Sep10-June11)
- - -
- - - -
09 10 11 12
- - - -
10 11 09
09 10 11 12
09 10 12 11 Post-QEII (July11-Nov11) -0.2% 2.2% 2.3% -0.1%
LTRO (Dec11 to Sep 0.3% -1.5% -2.7% 0.0%
(1) period following announcement of QEII at Jackson Hole August 2010. Since 2008 global central banks have expanded their balance sheets by $9 trillion - enough fiat Sources: Federal Reserve Bank, ECB, Bloomberg money to buy every person on earth a 55'' wide-screen 3D television 12
Post-Traumatic-Deflation-Disorder (PTDD) B ULL
Tail Events are now priced as if they are standard risks
Highly unlikely events are either ignored or vastly over weighted based on our collective experiences M ARKET Lifetime odds of Dying 25% Implied Odds of % Returns for S&P 500 index
from these causes is 1 in 4.7(1) SPX Options (1year)
Black Swan? IN
20% F Heart Disease Actual from Sep 2008 to Sep 2012 EAR 1 in 6 Implied from Jan 1990 to Sep 2008 Implied from Sep 2008 to Sep 2012 15% September 2012 (average) Stroke 1 in 28 10%
Car Crash Cumulative Probability Cumulative 1 in 88
5%
0%
5%
0% 5%
-
45% 40% 30% 25% 15% 10% 50% 35% 20%
10% 15% 20% 25% 30% 35% 40%
------Implied 12m %G/L in S&P 500 Index A “black swan” is not dying because your parachute didn’t open while skydiving…. it is dying because the guy whose parachute didn’t open landed on you while you were golfing
Note: Artemis calculates the implied probability distribution using interpolated weights from variance swap pricing. This methodology may occasionally give higher weightings to tails in down markets than other 13 methods like taking the second derivative of call prices, fitting mixture of normal PDFs to recover prices, or fitting vol models (SVI,SABR). (1) "Lifetime Odds of Death for Selected Causes, United States, 2007" / National Safety Council 2011 Edition
Note :
Artemis Cumulative Probability methods 50%
40% 30% calculates 20% 10% like 0% taking
the
You are not smart for hedging what everyone else already knows! already Youelse everyone what hedging for smart notare the
implied
S&P 500 Index 12 S&P Index 500 second 1995 1995
probability derivative 1996 1996 Fear ofdeflation is notbutit MISPRICED MISPLACED is
1997 of distribution call 1998 prices, 1998
using fitting 1999
interpolated 2000 mixture -
2000 Model to Contribution % month of
2001 normal
weights
2002 High of Tail Cost Risk Insurance
PDFs
from 2002 to
variance recover 2003 prices,
(1995 to March 2012) March (1995 to swap 2004
or pricing
2004 fitting 19952012to .
This vol 2005 models methodology 2006
(SVI,SABR) 2006
may .
occasionally 2007 - Free Variance by Expected Returns Returns Varianceby Expected Free
2008 give
higher 2008
weightings
2009
to
tails
2010 in
down
markets -50.0%
than -35.0%
other -20.0% Implied 12m %G/L in in S&P 500 index -5.0%
10.0%
25.0% 0% 10% 20% 30% 40%
-
10% - - - - 20% 30% 40% 50%
F M B EAR IN ARKET ULL 14
1 HIGHER CORRELATIONS lead to...
Extreme Volatility-of-Volatility and Hyper-Correlations B S&P 500 Sector Correlation (60 day)
ULL 0.8 2000 to 2012 1)
Fire Risk is High Today in the Forest -
Higher correlations are kindling for violent volatility fires (spike) M 0.6 ARKET 0.4 HIGHER CORRELATIONS lead to...
1 S&P 500 Sector Correlation (60 day) (0 Correlation 0.2
2000 to 2012 IN
1) 0.8
-
2000 2001 2004 2005 2009 2010 2011 2003 2003 2006 2007 2008 2012
0 2002
F EAR 0.6
0.4
Correlation (0 Correlation 0.2
2000 2001 2002 2003 2003 2004 2005 2006 2007 2008 2009 2011 2012
0 2010
205 More VIOLENT VOLATILITY SPIKES 185 Volatility of VIX index (60 day) 165 2000 to 2012 145 125 105 Volatility (%) Volatility 85
65
2000 2001 2002 2003 2008 2009 2010 2011 2005 2006 2007 2012 45 2004
15
Hedge Fund Strategies 12m Correlation to ATM Short Straddle on SPX 1.00 (HFRX Absolute Return, Equity Nuetral, Hedge Index, Merger Arb, RV Arb, 0.80 Convertible Arb / Monthly) 0.60 0.40 0.20 - (0.20) (0.40) (0.60)
(0.80)
03 04 05 06 07 08 12 09 10 11
04 05 06 07 08 09 12 10 11
------
------
Feb Feb Feb Feb Feb Feb Feb Feb Feb
Aug Aug Aug Aug Aug Aug Aug Aug Aug Aug
Extreme Volatility-of-Volatility and Hyper-Correlations B ULL
Volatility is a Shadow Currency in the Bull Market for Fear M
$USD currency index strength = Higher Volatility ARKET
Correlation of $USD Index to VIX Index 0.6 (1986 to 2012) IN
F
EAR
0.4
0.2
0
-0.2
-0.4
1987 1989 1990 1992 1995 1996 1997 1998 2002 2003 2004 2005 2010 2011 2012 1986 1988 1991 1993 1994 1999 2000 2001 2006 2007 2008 2009
Note: Prior to 1990 there was not VIX index. We have substituted the CBOE VXO index, the precursor to the VIX, which was available starting in 1986. 16
BULL MARKET IN FEAR 17
Itself! buy the the right buy
fundamentals known unknowns known Volatility on Safety Safety on Volatility and sell sell and the more should more you the … buy … Risky is Volatility of Impossibleof Object an Volatility
Free - How to beat a “Bull Market in Fear” a “Bullto beat Market How fear the left tail the tail left fear is a better than buy reason to is a better unknown unknowns unknown
Risk
Fear Hedge Hedge
Tail risk pricing (both left and right) has been consistently late to game the to late has and (both been pricing consistently right) left risk Tail Volatility (fear) (fear) an iseffective leading inform asset allocation to indicator Volatility When the market identifies a risk it is usually overpriced in volatility markets overpriced involatilityusually is it risk a identifies When the market When
when a “bull market in fear” meets a “bubble in safety” bet on interest rate volatility rate fear”in “bubble a safety”inon meets interest bet market a “bull when
The more we we more The
Bet on unknown unknowns… don’t hedge known unknowns B ULL
Volatility markets are surprisingly bad at predicting future risk M
When markets identify a ‘known unknown’ that risk traditionally is overblown or at ARKET
the very minimum over-hedged
Fiscal Cliff or Volatility of Volatility Cliff? IN
240 Predicted Volatility of VIX vs. Realized Vol of VIX F EAR October 2012 220 Volatility of VIX was 200% on Oct 13, 2008 Maximum was 265% on Aug 29, 2011 200
180
160 Very 140 Cheap Expensive Fear Fear
120 Volatility of VIX (%)ofVIX Volatility 100 Market Expected Volatility of VIX (local) US Fiscal Cliff 5yr Average Realized Vol-of-VIX 80 1yr Average Realized Vol-of-VIX 60 6mo Average Realized Vol-of-VIX
40 11-Oct-12 6-Nov-12 3-Dec-12 28-Dec-12 25-Jan-13 21-Feb-13 19-Mar-13 15-Apr-13 9-May-13 Forward Period
18
Bet on unknown unknowns… don’t hedge known unknowns B ULL
Sell “known unknowns” and Buy “unknown unknowns”… M
…monetize the bull market in fear by playing the term structure ARKET
1.6x Fear Arbitrage
(Volatility futures & Options, SPX Vol Term Structure) IN
F
1.5x EAR
1.4x
1.3x
1.2x Forward Volatility Term Structure Structure Term Volatility Forward 1.1x Unknown Known-Unknown Crash Unknown Crash 1.0x Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Forward Volatility (October 2012) Historical Average Forward Volatility (since 2004)
19
The more people fear the LEFT TAIL the more you should buy the RIGHT… and vice versa B
ULL
Role of the trader is not so much to predict the future but to identify mispriced risk M
The options market is consistently late to the game in pricing both the right and left tails ARKET financial crash options market is marked by the transfer of risk premium from the right of the return distribution to the left tail
Cross Asset Implied Probability Distribution Comparison (2008 pre-crisis to 2012)
Variance Swap Weighting { SPY, EFA, EEM, TLT, IEF, HYG, USO, GLD } IN
F EAR Pre-Crisis 2008 2012
60% 60% 60% Right Left 50% 50% Tail 50% tail Bias bias 40% 40% 40%
30% 30% 30%
Probability Of Return Of Probability 20%
20% Of Return Probability 20% Probability Of Return Probability Gold Gold Oil GoldOil HY Bonds 10% OilHY Bonds 10% UST 10yr 10% HYUST Bonds 10yr UST 30yr USTUST 10yr 30yr Intl. Equity (Emerg) USTIntl. 30yr Equity (Emerg) Intl. Equity (Dev) Intl.Intl. Equity Equity (Emerg) (Dev)
0% Intl.US Equity Equity (Dev)
------
+0.0σ +0.5σ +1.0σ +2.0σ +2.5σ
US Equity +1.5σ
2.5σ 2.0σ 1.5σ 1.0σ 0.5σ
3.0σ US Equity
- - - - -
0% -
+0.0σ +1.5σ +2.0σ +2.5σ +1.0σ
+0.5σ 0%
------
+0.0σ +0.5σ +1.0σ +2.0σ +2.5σ +1.5σ
3.0σ 2.5σ 2.0σ 1.5σ 1.0σ 0.5σ
3.0σ 2.5σ 2.0σ 1.5σ 1.0σ 0.5σ
Expected 1yr Asset Return Distribution Expected 1yr Asset Class Return Distribution Expected 1yr Asset Return Distribution by Standard Deviation (Historical) by Standard Deviation (Historical) by Standard Deviation (Historical)
Note: Artemis calculates the implied probability distribution using interpolated weights from variance swap pricing. This methodology may give higher weightings to tails in down markets than more traditional methods 20 like taking the second derivative of call prices, fitting mixture of normal PDFs to recover prices, or fitting vol models (SVI,SABR).
The more people fear the LEFT TAIL the more you should buy the RIGHT… B ULL
Maybe it is correct to buy tail risk insurance ... but is everyone just hedging the
wrong tail? M ARKET
Mirror Reflection: Deflation vs. Hyperinflation
20% S&P 500 Probability Distributions in different Regimes of Risk IN
1-year Gain-Loss% F
EAR
15% Implied from March 2012 SPX options …but it is a valuable exercise to theorize! … Volatility markets turn Simulated from in 2013-2022 Hyperinflationary Model (1 scenario of 10k)
10% Future? Double Convexity in Inflation Boom SPX 10yr OTM Call - 10K Strike 2,500 5 yrs to expiry/ SPX @ 3,000 (16% annual gain) 2,000 5% 1,500
1,000 ProbabilityWeighting Cumulative
Value of CallOptionof Value 500 40.0% 0 30.0% 0% 15% 20.0% 20% 25% 10% 30% -50% -43% -35% -28% -20% -13% -5% +3% +10% +18% +25% +33% +40% +48% 5yr implied vol 35% 5% 40% 5yr UST Yield One Year Gain/Loss % in S&P 500 index 45% 0% 50%
Note: Artemis created a model to simulate the behavior of the S&P 500 index and volatility during an inflationary shock. The model is not intended to be a prediction of the future but is merely a rudimentary stochastic- based method to understand what modern markets may look like in rampant inflation. The simulation runs 10,000 price scenarios for the S&P 500 index over 10 years modeling daily stock price behavior using a generalized Wiener process (Wiener.. not Weimar) and a drift rate that assumes linkages between annual CPI and equity performance. We assume inflation rises sharply from current levels of 2.87% in 2012 to 26% by 21 2015 and stays elevated at that level until 2017 (20% a year overall). The average volatility shifts are based upon assumptions regarding equity return to variance parameters observed in prior inflationary episodes (1970s US & 1920s Germany). The simulation shows annualized SPX returns for the decade at +9.94% but adjusted for inflation this drops to -9.8%.
Fear over Fundamentals B ULL 50 Cyclically Adjusted PE Ratio It is hard to have a bear market in a bull-market for fear 45 (Price to Average Inflation Adjusted Earning from past 10-years)
M 40 1881 to 2012 Volatility term-structure is an effective indicator to inform equity exposure 35
ARKET 30 25 20 It pays to have exposure to stocks when markets are hedged! 15 10
S&P 500 index portfolio exposure based on Vol Slope 5 IN
600 1996 to 2012 0
1884 1891 1901 1907 1917 1924 1934 1941 1951 1957 1967 1974 1984 1991 2001 2007 1881 1887 1894 1897 1904 1911 1914 1921 1927 1931 1937 1944 1947 1954 1961 1964 1971 1977 1981 1987 1994 1997 2004 2011
------
F
5 1 1 9 9 5 5 1 1 9 9 5 5 1 1 9 1 9 5 9 5 1 5 1 9 1 9 5 9 5 1 5 1 9 1 9 5 9 5 1 EAR 550
Period of Steep Vol Slope (1yr VarK / VIX > 1.10)
500 S&P 500 Index Tactical Allocation to S&P 500 during periods with Steep Vol Slope 450
400 575 350 Period of Steep Vol Slope (1yr VarK / VIX > 1.10) 2 Volatility Term Structure 300 S&P 500 Index
1-year Volatility / 1-month Volatility of Growth$100 475 1.5 Tactical Allocation to S&P 500 during periods with Steep Vol Slope 250 Ratio 1 0.5 200 375 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 150
275 100 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 of Growth$100
175 22
75 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 65% - 55% - 45% - 12 - May 1yr Volatility Bond (short OTM SPX Put Option Collateralized) Option Put SPX OTM (short Bond Volatility 1yr Bonds UST Dated Lond 11 - 35% - May 10 - May 09 - 25% - May 08 5% OTM Vol Skew Vol OTM 5% - - May 07 - May 15% - 06 - May 05 - May 5% - TLT 20+ US Treasury Bond ETF ETF Bond Treasury US 20+ TLT 04 - May 03 - 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% May 0.80x 0.60x 0.40x 0.20x 0.00x
BULL MARKET IN FEAR 23
Bond 30yr UST UST 30yr
the 500
of
S&P
the period
Risk to Risk to Risk 0.081x 0.034x 0.045x 0.050x
Reward Reward
for
% 2012
purchase
600bps 50 to
- the ↑ Bond
% % reward payoffs! reward 2% 2% 2% 2% to 1950
-
50% 10yr UST UST 10yr a short equity option option a short equity - and SPX ↓ SPX Historic Prob. Historic Prob. Historic close
Stress Test #4 Test Stress to - UST Rate Rate UST bonds occur
25% 25% OTM) to -
SPX ↓ SPX Loss Loss UST 2% probability 2% ↑ to320bps 600bps -33% -15% -41% -62%
Est. MTM MTM Est. MTM Est. the
13% to 2% probability2% to 13% for assumed
SPX Short Short Put SPX are Rates
2012
-
Risk to Risk to Risk 0.242x 0.176x 0.074x 0.070x tests Reward Reward (Strike @ (Strike
1960
of stress
325bps All
-25% . ↑ period % %
↓ 13% 13% 13% 13% on
SPX SPX Prob. Historic Prob. Historic Stress Test #3 #3 Test Stress depending 1yr OTM Puts(collateralized) Short 1yr OTM based
UST Rate Rate UST “Bubble “Bubble in Safety” data crash
vs. -3% Loss Loss -11% -25% -44% real
Est. MTM MTM Est. MTM Est. a
probability
during
Risk to Risk to Risk Historic 0.616x 0.588x 0.113x 0.099x
Reward Reward
.
meets a meets estimates
25% Risk / Unrealized Loss in Stress Test Scenario Test Stress in Loss / Unrealized Risk Scenario in Stress Test Loss / Unrealized Risk - scenario 200bps from
-14% ↑ % % Risk Free Assets are are Risky Assets Free Risk test
↓ 39% 39% 39% 39% differ
stress SPX SPX Prob. Historic Prob. Historic 13% chance 13% may
Stress Test #2 #2 Test Stress SPX ↓ SPX free’ UST bond have similar risk similar have bond UST free’ UST Rate Rate UST - given Long Dated UST Bond LongUST Dated shifts
-4% Loss Loss -17% -31% -0.9% actual Est. MTM MTM Est. MTM Est.
position
Efficient Frontier / Risk to Reward Comparison Comparison Reward / to Risk Frontier Efficient on
loss however
Risk to Risk Risk to Risk 1.373x 1.319x 0.214x 0.176x . Reward Reward ↑ to100bps 200bps 14% shifts,
- unrealized 68% to 33% probability33% to 68%
maturity 100bps
volatility -9% to Rates
↑ 9% to 9% % % ↓ - 68% 68% 68% 68% local Estimated
. closer
SPX SPX Historic Prob. Historic Historic Prob. Historic “Bull Market in Fear” Market “Bull Stress Test #1 #1 Test Stress 2012
differ ,
UST Rates Rates UST 14 estimated
SPX ↓ SPX may
68% to 33% probability33% to 68% on
position and “risk and position -2% -9% Loss Loss -18% -0.4% Est. MTM MTM Est. Est. MTM MTM Est. losses
based
September
of
as
pricing
Unrealized
. Return / Yield / Return year 1 year 1 data Maturity Maturity 10 years 10 years 30
Option All
. When the the When : SPX Put Put SPX UST Bond BondUST Stress Test Stress Stress Test Stress instrument Note index Yield Yield 1.87% 3.09% 2.69% 0.51% Yield to Risk / UST Bond vs. "Volatility Bond" (Collateralized Short Put on S&P 500 Bondto Bond" Risk(Collateralized UST index) vs.Yield / "Volatility SPX Put (Strike @-25%) (Strike Put SPX lows) @2009 (Strike Put SPX Bond Treasury US 10-year / Bond Treasury US /30-year Bond Treasury US Investment Collateral + Put SPX Short / Bond Volatility
Risk Free Assets are Risky B ULL
When risk-free is risky … it is time to buy volatility on safety itself M
Higher interest rate volatility can be realized in deflation and inflation ARKET
Interest Rate Volatility is Low
250 ... and a better bargain on a forward basis than equity vol IN
3.5% F
Merrill Lynch MOVE Index = VIX for UST Bonds EAR 3.0% Weighted Volatility of 2yr,5yr,10yr & 20yr UST 2.5% 200 2.0% 1.5% 1.0% 1yr Volatility Bond (short OTM SPX Put Option Collateralized) 0.5% Lond Dated UST Bonds 0.0% 150 -5% -15% -25% -35% -45% -55% -65%
100
50
Oct Oct Oct Oct Oct
Dec Dec Dec Dec
Apr Apr Apr Apr
Aug Feb Aug Feb Feb Aug Feb Aug
Jun Jun Jun Jun
- - - -
- - - - -
- - - -
- - - -
- - - -
- - - -
10 11 12 09
08 09 10 11 12
09 10 11 12
10 11 09 12
09 10 08 11
09 10 11 12
Source: Bloomberg 24
Yield to Risk / UST Bond vs. "Volatility Bond" (Collateralized Short Put on S&P 500 index) Investment Stress Test #1 Stress Test #2 Stress Test #3 Stress Test #4 Volatility Bond / Short SPX Put + Collateral SPX ↓ -9% SPX ↓ -14% SPX ↓ -25% SPX ↓ -50% Est. MTM Historic Prob. Risk to Est. MTM Historic Prob. Risk to Est. MTM Historic Prob. Risk to Est. MTM Historic Prob. Risk to Yield Maturity Loss % Reward Loss % Reward Loss % Reward Loss % Reward SPX Put (Strike @-25%) 2.69% 1 year -2% 68% 1.373x -4% 39% 0.616x -11% 13% 0.242x -33% 2% 0.081x SPX Put (Strike @2009 lows) 0.51% 1 year -0.4% 68% 1.319x -0.9% 39% 0.588x -3% 13% 0.176x -15% 2% 0.034x US Treasury Bond UST Rates ↑ 100bps UST Rate ↑ 200bps UST Rate ↑ 325bps UST Rate ↑ 600bps Est. MTM Historic Prob. Risk to Est. MTM Historic Prob. Risk to Est. MTM Historic Prob. Risk to Est. MTM Historic Prob. Risk to Yield Maturity Loss % Reward Loss % Reward Loss % Reward Loss % Reward US Treasury Bond / 10-year 1.87% 10 years -9% 68% 0.214x -17% 39% 0.113x -25% 13% 0.074x -41% 2% 0.045x US Treasury Bond /30-year 3.09% 30 years -18% 68% 0.176x -31% 39% 0.099x -44% 13% 0.070x -62% 2% 0.050x
BULL MARKET IN FEAR 25
Volatility of Impossibleof Object an Volatility
Cole
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BULL MARKET IN FEAR 26
” Crash… ”
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BULL MARKET IN FEAR 27
the
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BULL MARKET IN FEAR 28
Fiat Currency
modern asset class for our existential ourexistential for asset class modern - Volatility
economic future… economic Markets Volatility Volatility Volatility can be more FEAR than more just be can Volatility Volatility is the perfect post perfect the is Volatility
BULL MARKET IN FEAR 29
Scholes input, or any any or input, Scholes
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We will only prosper if we relentlessly search for nothing but the truth, otherwise the truth, but nothing for search relentlessly we if prosper only willWe Regardless of Regardless measuredit how reflects differenceis volatility the the between world VIX index. Volatility is not a statistic or a standard deviation, Black deviation, a standard or statistic a is not Volatility index.VIX Volatility as a concept is widely misunderstood. Volatility is not fear. Volatility is not the the not is Volatility fear. not is Volatility misunderstood. is widely conceptas a Volatility
BULL MARKET IN FEAR 30 Quantitative Quantitative
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Staus Gatheral
Vol 2012 Bank 23, Higher" DeutscheFebruary Dzekounoff - of - / Farrar, Farrar, /
Kahneman General Partner andFounder Partner General
Vol and the Cross Section of Stock Returns" Guido Vol Returns" Guido Baltussen, Sjoerd Van Stock Section of the and Cross - – of -
The Problem of the Volatility Volatility Smile" Emanuel the by Problem of The
volatility, sleeping and risk, tail volatility, elephants, 2011 4, January
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Definition "Impossible Wikipedia Definition of / Object" http://en.wikipedia.org/wiki/Impossible_object / "UnknownVol Unknowns: 2012 30, July Strategies/ "Deflation: making sure 'it' doesn't happen here" by Ben S. Bernanke (speech) / US Federal Reserve November 2002 Reserve happen doesn't Federal US 'it' (speech) making Bernanke Ben here" / by S. sure"Deflation: Explosion Vol Drives TVIX Options Strategy "US “The Performance of VIX Option Pricing Evidence Models:PerformanceOption Empirical Beyond of VIX Simulation” “The Zhiguang Wang; International Florida Uni Exchange Traded Products” VIXDevelopments in “Recent “More than you Ever Wanted to Know About Volatility Swaps” Kresimir Demeterfi, Emanual Derman, Michael Emanual Michael JosephDerman, About & Zou;Demeterfi, Volatility Kamal Wanted Go Swaps”Know than Ever Kresimir you to “More "Laughter in in Dark the "Laughter Columbia Financial Peter Carr; Lee 2004 / & Engineering RogerSeptember HedgingDerivatives” Seminar of “RobustVolatility "Economics of Inflation; Inflation; Depreciation Postof Currency in Study of "EconomicsA November 2006 Morgan / JPSecurities Allen, Stephen Swaps”Einchcomb, Granger; Peter Nicolas “Variance "Dying of Money: Lessons of the Great German and American Inflations" and German Inflations" American Money: Great of the O. Lessonsof "Dying Jens by "Lifetime Odds of Death for Selected Causes, United States, 2007" / National Edition National / Council 2011 Safety Causes, 2007" United of Odds Selected States, for Death "Lifetime Evan Sinclair, Trading”“Volatility TradingWiley 2008 "Think Fast and and Fast Slow" Daniel by "Think Hall Hull, 2003 Edition; JohnC. Derivatives” Fifth Prentice Other and Futures, “Options, “The Volatility Guide.” Practitioner’s Jim A Volatility Surface: “The “VIX Derivatives: A Poor Practitioner’s Model” Model” Poor Practitioner’s A Maneesh DeshpandeDerivatives: 2011 May / 19 “VIX and Futures Options” Dennis “Understanding VIX “Simulacra and Simulation” and “Simulacra Simulation” Jeanby Baudrillard Michigan / of University 1994 / 2005 22, & DecemberCarr Liuren Wu Tale of Peter Indices" by Two "A Reference Material: Reference Ocean wave pictures provided wave provided pictures istockphoto.com Ocean by "Penrose Triangle, Devil’s Turning Fork & Necker’s Cube” Derrick Coetzee / Public Necker’s /Coetzee & Triangle, Domain Derrick Cube”Devil’s"Penrose TurningFork / public domain People" the Leading Delacroix Eugène"Liberty 1830 by "Odysseus facing the choice between Scylla and Chrybdis" by Henry Fuseli 1794 / public public / facing betweenand choice Scylla the "Odysseusdomain Chrybdis" 1794 Henry Fuseli by “Jack usedbasedpurchaseonWaves”/of rightsIstock photo “Ocean "Volatility at World's End" by Brendan Wiuff 2012 / copyright owned by Artemis Capital copyright World's Capital ownedArtemis / by Management End"at BrendanLLC Wiuff by "Volatility 2012 ownedby C Artemis copyright / 2012 Cole by Christopher /Wiuff ConceptbyObject" Brendan Impossible of an "Volatility Artwork: Unified Risk TheoryUnified Is Volatility Broken? Normalcy Bias and Abnormal Variance, March 30, 2011 30, March and Bias Variance, Abnormal Broken? Normalcy Volatility Is Vega Short Great The Fighting Greek Fire with Fire: Volatility 2011 Volatility 30, Correlation, with Truth, September and Fire Fire: Greek Fighting Volatility of an Impossible Object: Risk, Fear, and Safety Perception and Games of Risk, Fear, in an Safety of Impossible Object: Volatility World’sDeflation, Hyperinflation End:at Volatility March 2012 and of Alchemy 30, Risk,the Artemis Research: Artemis Christopher Cole, Information CFA Cole, Christopher Contact
BULL MARKET IN FEAR 31
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Christopher Cole, CFA Cole, Christopher (310) 496(310)
focus [email protected] Artemis Vega Vega Fund L.P. Artemis
Santa Monica, CA 90401Monica, Santa 520 Broadway, 350Suite Broadway, 520 financial of options University
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LEGAL DISCLAIMER 32
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ACCURATE, BUT WETHEOF CANNOTSUCHGUARANTEEINFORMATION. ACCURATE, ACCURACY CERTAIN DATA CONTAINED HEREIN IS HEREIN IS BASED DATAON CONTAINED INFORMATION OBTAINED FROM BELIEVED SOURCESCERTAIN TO BE INVESTMENT RESULTS INVESTMENTSUBSTANTIALLYMAYVARY OVER GIVEN ANYTIME PERIOD. THAT AN INVESTOR WILL RECEIVE A RETURN OF ALL OR ANY PORTION OF HIS OR HER INVESTMENT IN THE IN INVESTMENTANY OF OR OF FUND. HIS RETURN HERALL PORTION WILL OR INVESTOR A AN RECEIVE THAT EXPECTED TO DEVELOP. BE EXPECTEDGIVEN CANTHATNO ASSURANCE THEINVESTMENT OBJECTIVE WILL BE OR ACHIEVED WITHDRAWAL, REDEMPTION AND TRANSFERABILITY OF TRANSFERABILITY REDEMPTIONAND WITHDRAWAL, SO AREINTERESTS INVESTORS RESTRICTED, MAYNOT HAVE TO CAPITAL WHENIT ACCESSIS NEEDED. THEFOR THERE IS NO SECONDARYMARKET ANDINTERESTS NONE IS AN INVESTMENT IN ANTHEFUND IS SPECULATIVE INVOLVES AAND HIGH DEGREE OF OPPORTUNITIESRISK. FOR THE MEMORANDUM. THE THE FUND’S MEMORANDUM.THE IS QUALIFIED THEIN INFORMATION HEREIN ITS BY ENTIRETY THE INFORMATION IN JURISDICTIONS WHERE PERMITTEDWHERE BY JURISDICTIONS INVESTMENTLAW. ANSHOULD ONLY BE MADEAFTER REVIEW OF CAREFUL L.P. (THE “FUND”). ANY SUCH OFFER OR SOLICITATION WILL WILL (THE“FUND”). L.P. SOLICITATION SUCH OFFER OR BE ANYONLY MEANSTOBY MADEINVESTORS QUALIFIED PLACEMENTPRIVATEA OF CONFIDENTIAL(THEMEMORANDUM “MEMORANDUM”) AND ONLY THOSEIN THIS IS IS NOTOFFERING THIS AN THEOR OF SOLICITATION AN OFFER TOINTEREST ANFUND, PURCHASEVEGAARTEMIS IN
DISCLOSURE 33 ED ED TURN TURN A FOR FOR
MAY BE MAY
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ING R DIFFERENT DIFFERENT R E THE NET ARY EL THE THE EL ETS. ETS. THE POOL. POOL. FFECT YOUR YOUR FFECT FFE YOU TY TY ASS DUC Y Y A OMP th their own advisers before advisers before their own th wi
presented in this document includes includes this document in presented
rmance is not indicative rmance future ofindicative not is ies. Proprietary ies. Proprietary results for trading nce rfo rtion of or potentially potentially rtion their entire or of ffr me, an investment in the Partnership may the Partnership in investment me, an ll as those of close family members. Note Note family members. close of ll asthose ti po
pal of the General Partner, Christopher pal R. Partner, the General of we
legal advisors regarding the suitability this suitability of the advisors regarding legal t of potential risk factors please review the t review please factorsrisk potential of
nci lis and
UNITED STATES STATES TRANSACTIONS WHERE THE POOL FOR JURISDICTIONS UNITED -
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SUBSTANTIAL NECESS BE TO MAY CHARGES SUBJECT IT FEES. BE ADVISORY MANAGEMENT, MAY FOR POOLS BROKERAGE AND COMMODITY FURTHER,
YOU SHOULD CAREFULLY CONSIDER WHETHER YOUR FINANCIAL CONDITION PERMITS YOU TO PARTICIPATE IN A COMMODITY POOL. IN SO INDOING, POOL. COMMODITY IN A TO PERMITS PARTICIPATE YOU CONDITION FINANCIAL YOUR WHETHER CONSIDER CAREFULLY SHOULD YOU Commodity PoolCommodity DisclosureOperator Statement All 2009 performance numbers quoted within this document are derived from financial statements that were audited by Spicer Spicer audited Je by were that financial from derived statements are this within document quoted numbers performance All 2009
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