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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
www.artemiscm.com
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Illustration by Brendan Wiuff based on concept by Christopher Cole. Copyright Artemis Capital Management.
CO
NFID
ENTIA
L N
ot fo
r Distrib
utio
n
Volatility is an Instrument of Truth 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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“The only thing that will redeem
mankind is cooperation”
Bertrand Russell
“Peace is not the absence of
conflict”
Dorothy Thompson
“Allegory of the Prisoner’s Dilemma” by Andy Diaz Hope & Laurel Roth. Reproduced with permission of artists. Unauthorized reproduction prohibited.
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Volatility is the only real asset class Most active management strategies are short volatility in sheep's clothing
Volatility and the Allegory of the Prisoner’s Dilemma
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
Volatility is your only escape from the Prisoner’s Dilemma Hedge unknown unknowns and sell known unknowns
Global Macro Straddle + Asset Beta
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Source: Artemis Capital Management LP, Bloomberg 5
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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
Illustration by Brendan Wuiff based on concept by Christopher Cole
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DJI
A (l
oga
rith
mic
sca
le)
Rea
lize
d V
ola
tilit
y (%
)
Volatility at World's End DeflationDow Jones Industrial Index (RHS) vs. 1-month Realized Volatility of DJIA (LHS)
Volatility in World’s End Deflation Volatility shocks are rightfully associated with deflationary crashes
Financial media pundits called the 2008 crash an “unprecedented” period of volatility
VIX index reached 20+ year high of 80.86 on November 20th, 2008
2008 was only “unprecedented” if you assume data from the inception of the VIX index in 1990
Historical DJIA realized volatility data going back to 1929 shows volatility climbed to similar levels or higher a total of 6 times in the past 80 years! VXO, precursor to VIX, hit 150.19 on Oct 19, 1987 / 2008 was rare but not unprecedented!
Source: Artemis Capital Management LP, Global Financial Data 7
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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.
Volatility in Hellfire of Inflation Extreme volatility can also occur in hyperinflation
0000001101001,00010,000100,0001,000,00010,000,000100,000,000
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g-18
No
v-18
Feb
-19
May
-19
Au
g-19
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v-19
Feb
-20
May
-20
Au
g-20
No
v-20
Feb
-21
May
-21
Au
g-21
No
v-21
Feb
-22
May
-22
Au
g-22
No
v-22
Feb
-23
May
-23
Au
g-23
No
v-23
Pe
rfo
rman
ce in
pap
er
mar
ks (
mil
)
Pe
rfo
rman
ce a
dj.
fo
r fi
xed
exc
han
ge Performance of German Stock Market during Weimar Republic Hyperinflaton
Adj. according to USD exchange rate
Adj. according to wholesale index numbers
In paper marks, Weimar
0
500
1,000
1,500
2,000
Feb
-18
May
-18
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g-18
No
v-18
Feb
-19
May
-19
Au
g-19
No
v-19
Feb
-20
May
-20
Au
g-20
No
v-20
Feb
-21
May
-21
Au
g-21
No
v-21
Feb
-22
May
-22
Au
g-22
No
v-22
Feb
-23
May
-23
Au
g-23
No
v-23
Vo
lati
lity
(%)
Weimar VIX?(1)
Realized Volatility of German Stock Market during Weimar Republic Hyperinflation(monthly volatility data annualized)
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Cooperation
Volatility in the Prisoner’s Dilemma two purely rational entities may not cooperate, even if it is in their best
interests to do so
Coordinated Global Central Banking
De-Leveraging
Sustainable asset price gains Growing Middle Class Sustained growth cycle
Global central banks are in an arms race of devaluation resulting in suboptimal outcomes for all parties and greater systemic risk
Competition
Currency Wars & “Beggar Thy Neighbor”
Leverage and Excessive Risk
Asset Price Bubbles Massive Income Disparity Hyper Boom & Bust Cycle
Hyper-Asset Bubbles
Au
sterity
Sustainable Asset Prices
De
bt an
d
Leverage
Hyper-Asset Bubble
Cooperate Self-Interest
Co
op
era
te
Self
-In
tere
st
Co
op
era
te
Self
-In
tere
st
Cooperate Self-Interest
Co
op
era
te
Self
-In
tere
st
Cooperation
COOPERATION COMPETITION
Istockphoto.com
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Source: Artemis Capital Management LP, Global Financial Data 10
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Exchanges short term equilibrium for longer term tail risk
Suppress Tail Risk Suppress Tail Risk
Increase Peak of the Distribution
Short Volatility (most active strategies)
Crisis Alpha
Equity Beta
Deflation
Crisis Alpha
Deflation War Political Revolution
Inflation Currency Devaluation
Hyper-Asset Bubble
Stability
Deflation War Political Revolution
Crisis Alpha
Deflation War Political Revolution
Inflation Currency Devaluation
Hyper-Asset Bubble
Source: Artemis Capital Management LP, Bloomberg 11
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Source: Artemis Capital Management LP, Global Financial Data 12
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Only two types of institutions in this world, those that are short convexity, and those that are massively short convexity
Source: Artemis Capital Management LP, Bloomberg 13
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Source: CBOE Eurekahedge
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Source: CBOE Eurekahedge
Active Long Volatility + Equity Index Exposure Significantly Outperforms the S&P 500 index and Major Hedge Fund Indices
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Source: CBOE Eurekahedge
Volatility by Holding Period
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Lon
g V
ola
tilit
y+
Sho
rt Vo
latility +
Volatility Gamma
Volatility Vega
Short Volatility Risk Premia
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c-1
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Co
rre
lati
on
Relationship between Hedge Funds and Short Volatility3 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
0.93
1.43
De
c-0
2
Ap
r-0
3
Au
g-0
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De
c-0
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r-0
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g-0
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De
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De
c-1
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Hedge Funds vs. 10% OTM SPX Put (Growth of $1) Short S&P 500 Index Put Option
Cross-Section of Hedge Funds
Source: Hedge fund monthly returns from HFRX, volatility returns from Artemis Capital.
We are all volatility traders Most active management strategies produce alpha by being short volatility
or correlation
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In the real world… there are two asset classes… long and short volatility
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
20.0%
15.0%
5.0%
2.0%5.0%
2.0%
5.0%
10.0%
5.0%
3.0%
5.0%
3.0%
10.0%
5.0%
5.0%
0.4% 0.4% 0.4%0.4%
What you think you are investing in
Long/Short Equity Value Investing Special SituationsConvertible Arbitrage Currency Arbitrage 130/30 FundPrivate Equity Real Estate Risk ParityDistressed Directional Long Merger ArbitrageCredit Index Fundamental Value Fundamental GrowthSystematic CTA Global Macro Tail Risk
97%
3%
What you actually are investing in
Short Volatility, Correlation & Dispersion
Long Volatility, Correlation & Dispersion
Source: Special thanks to DROBNY Global Macro for original visual conceptualization of this idea 18
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Changing Correlations Between Fixed Income and Equity Prices
An
ti-c
orr
elat
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C
orr
elat
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Source: Artemis Capital Management LP, Global Financial Data, Robert Schiller 19
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Changing Correlations Between Fixed Income and Equity Prices
Danger
Zone
Source: Artemis Capital Management LP, Global Financial Data 20
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Bull Market in Fear is Defined by
VIX index Fire Danger is High – greater potential for Vol-of-VIX VIX Derivatives
1. Unbalanced Shadow Delta 2. Unbalanced Shadow Gamma 3. Shadow Theta
VIX Structured Product Inconsistent hedging ratios Vol-of-VIX derivatives driven by structured product flow rather than VIX
The new volatility regime is a reflection of investor neurosis generated by forced participation in risk assets by the financial oppression of global central banks
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
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
Runaway deflation/inflation drives higher volatility
Outperformance on the specific “tail” of the distribution OTM puts/calls re-priced
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-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
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Volatility as a Portfolio Substitute for Fixed IncomeReal Interest Rates (2yr UST - CPI) vs. Volatility Yield (SPX / 25% OTM Put)
1990 to Early 2014
Real Interest Rate (2yr UST - CPI)
1-year SPX Volatility Yield (-25% OTM Put / Notional)
Fear Regimes Explained by Portfolio Theory 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
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Source: Artemis Capital Mgmt LP, FRED, MarketDataExpress 23
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Allo
cati
on
fo
r 3
% R
eal
Re
turn
Nominal Expected Return on Stocks
Optimal Portfolio with Positive Real Rates(Stocks, Bonds, Cash & Vol) / Portfolio Target = 3% real return
Inflation = 3%
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)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Allo
cati
on
fo
r 3
% R
eal
Re
turn
Nominal Expected Return on Stocks
Optimal Portfolio in Financial Repression(Stocks, Bonds, Cash & Vol) / Portfolio Target = 3% real return
Inflation = 3%
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)
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!
Source: Calculations executed by Artemis Capital Management LLC . Covariance matrix based on data between 1990-2013.
Volatility-of-VIX microstructure is calmer in 2012 however the last 30 minutes of the trading day have become increasingly more violent than previous periods
Equity %
Long Volatility %
Fixed Income %
Fixed Income %
Cash %
Cash %
Cash %
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Source: Artemis Capital Mgmt LP, FRED, MarketDataExpress 25
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Dimensions of VIX optionality
VOV Term Structure (z-axis) & VIX Skew (x-axis)
Mar-13
Ap
r-13
May-1
3
Jun
-13
Jul-13
40%
60%
80%
100%
120%
140%
160%
-1.0σ
0.5σ
2.0σ
3.5σ
5.0σ
Maturity
Vo
l of
Vo
l
Moneyness (Sigma)
VIX Volatility Surface
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II. Monetary
I. Emotional
III. Macro
IV. Regulatory
Bull Market In Fear
Bear Market In Fear
Post-traumatic Deflation Disorder
Euphoria, Complacency, Greed
Forced participation in risk assets drives desire for hedging
Low risk premiums drive volatility shorting for yield hunt
Forced participation in risk assets drives desire for hedging
Low risk premiums drive volatility shorting for yield hunt
Theme
Gov. regulation (Dodd-Frank) constrains risk appetite
Dealers no longer able to inventory long volatility
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Low VIX index does not mean cheap volatility
You can’t trade the VIX – you can only trade the expectation of VIX
10
15
20
25
30
35
Spot Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8
Forw
ard
VIX
In
de
x (%
)
Lowest Volatility? Really?VIX Futures Curve Comparison
August 17, 2012 vs. September 2008
September 15, 2008 / Day after Lehman Bros. Bankruptcy
August 17, 2012 / Lowest VIX in 5 years (at the time)
November 4, 2014
!
Source: Artemis Capital Management LP, Bloomberg 28
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Note: Calculations based on monthly averages of VIX index and constant-maturity VIX futures
Bull and Bear Markets in Fear Forward volatility is a poor indicator for future movement of spot-vol
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-0.02x
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0.00x
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0.05x
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0.07x
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LONG RVOL RISK AND RETURN BY HOLDING PERIOD
Sharpe Sortino Ratio
2007 credit crisis
2008 financial crash
2010 flash crash
VIX Index and Forward Expectation of VIX Index
QE3 Flattening of Vol Term Structure
2011 US default crisis
Bear Market in Fear
Volatility Spikes
Bear Market in Fear
Volatility Falls and Bull Market in Fear
Spot Volatility (VIX)
Forward Expected Volatility (multiple color lines)
Moral Harzard Market
Historic Inversion shows expectation of central bank reaction
function!
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Shadow Short Convexity
Immeasurable risk introduced when market participants reorganize portfolios in way that contributes to feedback loops
Source: Walt Disney, Fantasia 30
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Yikes!
Source: Artemis Capital Management LP, Bloomberg 31
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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.
Short Interest in Volatility ETPs has exploded in the 2012-2014 period Nonlinear Rebalancing of Short VIX ETPs is disaster in making…
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)
r
1987 Black Monday
Crash
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Source: Artemis Capital Management LP, Bloomberg 33
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August 24th, 2015
Source: Artemis Capital Management LP, Bloomberg
Left Tail of Volatility
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SIA August Volatility Event – Fastest Mean Reversion in History
Source: Artemis Capital Management LP, Bloomberg
39 days only!
151 days
158 days
435 days
191 days
1557 days
515 days 544 days
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Source: Artemis Capital Management LP, Bloomberg
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SIA August Volatility Event – High Volatility of VIX
Source: Artemis Capital Management LP, Bloomberg 37
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Note: Artemis proprietary model based on financial stress conditions. Machine learning model utilizes learned conditions to approximate state of volatility
Conditions over Causation 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
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SIA Volatility Regime Shift in the Prisoner’s Dilemma
Source: Artemis Capital Management LP, Bloomberg 39
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SIA Volatility Regime Shift in the Prisoner’s Dilemma
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SIA 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?
Source: Artemis Capital Management LP, Bloomberg 41
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Source: Artemis Capital Management LP, Bloomberg
Left Tail of Volatility
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1987 Black Monday Crash
Buy the FEAR and you will always be protected from
the HORROR
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SIA Volatility is your Only Escape from the Prisoner’s Dilemma
GLOBAL MACRO STRADDLE + BETA
-80
-60
-40
-20
0
20
40
60
80
100
0%
5%
10%
15%
20%
-50% -45% -40% -35% -30% -25% -20% -15% -10% -5% +0% +5% +10% +15% +20% +25% +30% +35% +40% +45% +50%
Vo
lati
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P&
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Cu
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ve
Pro
ba
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We
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One Year Gain/Loss % in Equity Index
Monetize the Dormant Japan Volatility Monster Own both the Tails: Deflation vs. Hyperinflation
Deflation Equity Return Distribution
Inflation Equity Return Distribution
Nikkei Vol Curve P&L
Global Macro Straddle + Asset Beta
Short Volatility (most active strategies)
Crisis Alpha
Deflation Inflation
Crisis Alpha
Inflation Currency
Devaluation Hyper-Asset
Bubble
Stability
Inflation Hyper-Asset Bubble
Class Warfare
Growth & Stability
Equity Beta
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.
Short Volatility (most active strategies)
BU
Y
Sell
BU
Y
Deflation & Default Global War Asset Collapse
Long Vol Long Vol
-80
-60
-40
-20
0
20
40
60
80
100
0%
5%
10%
15%
20%
-50% -45% -40% -35% -30% -25% -20% -15% -10% -5% +0% +5% +10% +15% +20% +25% +30% +35% +40% +45% +50%
Vo
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One Year Gain/Loss % in Equity Index
Monetize the Dormant Japan Volatility Monster Own both the Tails: Deflation vs. Hyperinflation
Deflation Equity Return Distribution
Inflation Equity Return Distribution
Nikkei Vol Curve P&L
Global Macro Straddle
Equity Beta
Inflation Currency
Devaluation Hyper-Asset
Bubble
Growth & Stability
Short Volatility (most active strategies)
BU
Y
Sell
BU
Y
Deflation War Political Revolt Class Warfare
Short Volatility (most active strategies)
Buy Asset Beta
Asset Beta
Sell B
UY
BU
Y
Global Macro Straddle + Asset Beta Long Volatility Long Volatility
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Risk and Vol Returns in Fed BS Regimes
Crisis and Recovery (September 2008 to September 2012)
Period Average Weekly Change
SPX VIX 21d SV Fed BS
Fed Balance Sheet ↑ 0.6% -1.7% 0.0% 1.5%
Fed Balance Sheet > +1σ ↑ 3.2% -7.4% 0.0% 8.1%
Fed Balance Sheet ↓ 0.0% 1.3% -2.0% -0.9%
Fed Balance Sheet < -1σ ↓ 1.2% 2.7% -1.9% -4.7%
Post-Crisis Recovery Period (Mar 2009 to Sep 2012)
Period Average Weekly Change
SPX VIX 21d SV Fed BS
QEI con't (March09-Jun 09) 1.4% -2.6% -2.5% 0.6%
Post QEI (Jun09-Oct10) 0.2% -0.2% -0.8% 0.2%
QEII (Sep10-June11)(1) 0.5% -1.0% 0.0% 0.5%
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.
Sources: Federal Reserve Bank, ECB, Bloomberg
Source: Financial Times / September 2014
Are we too complacent?
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SIA Christopher Cole, CFA – General Partner and Founder
Artemis Vega Fund L.P. Artemis Capital Management, L.P.
98 San Jacinto, Suite 370 Austin, TX 78701
[email protected] www.artemiscm.com
Christopher Cole, CFA
CIO and Founder (512) 467-4735 phone
Artemis Capital Management – Contact Information
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.
Key Information/ Biography
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