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
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Volatility is an Instrument of Truth

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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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2
Illustration by Brendan Wiuff based on concept by Christopher Cole. Copyright Artemis Capital Management.
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“The only thing “Peace is not the
that will redeem absence of
mankind is conflict”
cooperation”
Dorothy
Bertrand Russell Thompson

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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.
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Volatility and the Allegory of the Prisoner’s Dilemma

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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 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

Hedge unknown unknowns and sell known unknowns
Global Macro Straddle + Asset Beta

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Volatility Regime Shift in the Prisoner’s Dilemma

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Source: Artemis Capital Management LP, Bloomberg 5
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Volatility at World’s End Deflation

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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

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6
Illustration by Brendan Wuiff based on concept by Christopher Cole
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Volatility in World’s End Deflation

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Volatility shocks are rightfully associated with deflationary crashes
Volatility at World's End Deflation
120
Dow Jones Industrial Index (RHS) vs. 1-month Realized Volatility of DJIA (LHS)
50,000

100

80

DJIA (logarithmic scale)

Realized Volatility (%)

5,000

60

40
500

20

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0 50
1928
1930
1932
1934
1936
1938
1940
1942
1944
1946
1948
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Source: Artemis Capital Management LP, Global Financial Data 7
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Volatility in Hellfire of Inflation

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Extreme volatility can also occur in hyperinflation
120 100,000,000
Performance of German Stock Market
Performance adj. for fixed exchange

10,000,000

Performance in paper marks (mil)

100 during Weimar Republic Hyperinflaton 1,000,000
100,000
10,000
80 1,000
Adj. according to USD exchange rate 100
60 Adj. according to wholesale index numbers 10
1
40 In paper marks, Weimar 0
0
0
20 0
0
0 0
Feb-18

Feb-19

Feb-20

Feb-21

Feb-22

Feb-23
Nov-18

Nov-19

Nov-20

Nov-21

Nov-22

Nov-23
May-18

May-19

May-20

May-21

May-22

May-23
Aug-18

Aug-19

Aug-20

Aug-21

Aug-22

Aug-23
2,000
Weimar VIX?(1)
Realized Volatility of German Stock Market during Weimar Republic Hyperinflation
1,500
Volatility (%)

(monthly volatility data annualized)

1,000

500

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Feb-18

Feb-19

Feb-20

Feb-21

Feb-22

Feb-23
Nov-18

Nov-19

Nov-20

Nov-21

Nov-22

Nov-23
May-18

May-19

May-20

May-21

May-22

May-23
Aug-18

Aug-19

Aug-20

Aug-21

Aug-22

Aug-23
8
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.
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Volatility in the Prisoner’s Dilemma

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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 COMPETITION
Cooperation

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9
Istockphoto.com
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Volatility and Asset Prices in the Prisoner’s Dilemma

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Source: Artemis Capital Management LP, Global Financial Data 10
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Volatility in the Prisoner’s Dilemma

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Exchanges short term equilibrium for longer term tail risk

Suppress Tail Risk Suppress Tail Risk

Increase Peak of the

Distribution

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Deflation Inflation
War Currency Devaluation
Political Revolution Hyper-Asset Bubble

Source: Artemis Capital Management LP, Bloomberg 11

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Volatility and Asset Prices in the Prisoner’s Dilemma

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CONFIDENTIAL
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

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Short Interest in Volatility ETPs has exploded in the 2012-2014 period
convexity, and those that are massively short convexity

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Source: Artemis Capital Management LP, Bloomberg 13
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Active Volatility Management

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Source: CBOE Eurekahedge
14
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Active Long Volatility + Equity Index Exposure Significantly Outperforms

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the S&P 500 index and Major Hedge Fund Indices

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Source: CBOE Eurekahedge
15
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Volatility by Holding Period

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Long Volatility+

Volatility
Gamma

Short Volatility Risk

Premia Volatility
Short Volatility +

Vega

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CONFIDENTIAL
Source: CBOE Eurekahedge
16
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We are all volatility traders

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Most active management strategies produce alpha by being short volatility
or correlation

Relationship between Hedge Funds and Short Volatility

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)
0.8 1m ATM Put Sale on S&P 500 Index
0.7
0.6
0.5
Correlation

0.4
0.3
0.2
0.1
-
(0.1)
(0.2)
Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

Dec-14
Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

Sep-13

Sep-14
Mar-10
Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-12

Jun-13

Jun-14
Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-11

Mar-12

Mar-13

Mar-14
Hedge Funds vs. 10% OTM SPX Put (Growth of $1) Short S&P 500 Index Put Option
1.43 Cross-Section of Hedge Funds

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0.93
Apr-06
Apr-03

Apr-04

Apr-05

Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13

Apr-14
Dec-02

Aug-03
Dec-03

Aug-04
Dec-04

Aug-05
Dec-05

Aug-06
Dec-06

Aug-07
Dec-07

Aug-08
Dec-08

Aug-09
Dec-09

Aug-10
Dec-10

Aug-11
Dec-11

Aug-12
Dec-12

Aug-13
Dec-13

Aug-14
Dec-14
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Source: Hedge fund monthly returns from HFRX, volatility returns from Artemis Capital.
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Volatility is the Only Real Asset Class

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In the real world… there are two asset classes… long and short volatility
What you think you are What you actually are
investing in 0.4% 0.4% 0.4% 0.4%
investing in
5.0% 3%
5.0%
20.0%

10.0%

3.0%

5.0% 15.0%

3.0%

5.0%
5.0%
10.0%
5.0% 97%
5.0% 2.0%

Long/Short Equity Value Investing

2.0% Special Situations
Convertible Arbitrage Currency Arbitrage 130/30 Fund Short Volatility, Correlation & Dispersion
Private Equity Real Estate Risk Parity
Distressed Directional Long Merger Arbitrage
Credit Index Fundamental Value Fundamental Growth Long Volatility, Correlation & Dispersion
Systematic CTA Global Macro Tail Risk

WHEN DOES PORTFOLIO #1 turn into PORTFOLIO #2?

1. Deflationary collapse followed by financial repression and negative real

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rates and/or;
2. Historical correlation (negative correlation) between equities and bonds
breaks down rendering traditional diversification useless
Source: Special thanks to DROBNY Global Macro for original visual conceptualization of this idea 18
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Volatility is the Only Real Asset Class

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Changing Correlations Between Fixed Income and Equity Prices
Correlation
Anti-correlation

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Source: Artemis Capital Management LP, Global Financial Data, Robert Schiller 19
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Volatility is the Only Real Asset Class

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Changing Correlations Between Fixed Income and Equity Prices

Danger
Zone

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Source: Artemis Capital Management LP, Global Financial Data 20
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The Next Volatility Regime

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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

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 Outperformance on the specific “tail” of the distribution
 OTM puts/calls re-priced

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Fear Regimes Explained by Portfolio Theory

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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

12.00% Volatility as a Portfolio Substitute for Fixed Income

Real Interest Rates (2yr UST - CPI) vs. Volatility Yield (SPX / 25% OTM Put)
1990 to Early 2014
10.00%
Real Interest Rate (2yr UST - CPI)
8.00% 1-year SPX Volatility Yield (-25% OTM Put / Notional)

6.00%

4.00%

2.00%

0.00%

-2.00%

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CONFIDENTIAL
-4.00%
1990
1990
1991
1992
1992
1993
1994
1994
1995
1996
1996
1997
1998
1998
1999
2000
2000
2001
2002
2002
2003
2004
2004
2005
2006
2006
2007
2008
2008
2009
2010
2010
2011
2012
2012
2013
2014
22
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Prisoner’s Dilemma
Volatility andFixed
Yield vs. Risk Suppression
Income

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Source: Artemis Capital Mgmt LP, FRED, MarketDataExpress 23
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Bull Market in Fear and Modern Portfolio Theory

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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 with Positive Real Rates Optimal Portfolio in Financial Repression
(Stocks, Bonds, Cash & Vol) / Portfolio Target = 3% real return (Stocks, Bonds, Cash & Vol) / Portfolio Target = 3% real return
Inflation = 3% Inflation = 3%
100% 100%
Long Volatility %
90% Cash %
90% Cash %
80% 80%
Allocation for 3% Real Return

Allocation for 3% Real Return

Cash %
70% 70%
Equity %
60% 60%

50% 50%

40% 40%

30% 30%
Fixed Income %
20% 20%
Fixed Income %
10% 10%

0% 0%
6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

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Nominal Expected Return on Stocks Nominal Expected Return on Stocks
Long Volatility (-3% nominal return, -6% real return) Long Volatility (-3% nominal return, -6% real)
Cash (3.5% nominal return, 0.5% real return) Cash (0% nominal return, -3% real)
Stocks (SPX, 3-15% nominal return, 0-9% real return) Stocks (SPX, 3-10% nominal return, 0-7% real)
Bonds (10yr UST / 6% nominal return, 3% real return) Bonds (10yr UST / 2% nominal return, -1% real)

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Source: Calculations executed by Artemis Capital Management LLC . Covariance matrix based on data between 1990-2013.
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Prisoner’s Dilemma
Volatility andFixed
Yield vs. Risk Suppression
Income

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Source: Artemis Capital Mgmt LP, FRED, MarketDataExpress 25
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Understanding VIX options

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Dimensions of VIX optionality
VOV Term Structure (z-axis) & VIX Skew (x-axis)

VIX Volatility Surface

160%
140%
Vol of Vol

120%
100%
80%
60%
40%
-1.0σ
0.5σ
2.0σ

Jul-13
Moneyness (Sigma) 3.5σ

Jun-13
May-13
Apr-13

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Mar-13
5.0σ
Maturity

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What Effects the Price of Volatility?

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Structural imbalances in supply-demand dynamics of volatility

Theme Bull Market In Fear Bear Market In Fear

 Post-traumatic  Euphoria,
I. Emotional Deflation Disorder Complacency, Greed

 Forced participation  Low risk premiums

II. Monetary in risk assets drives drive volatility
desire for hedging shorting for yield hunt

 Forced participation  Low risk premiums

III. Macro in risk assets drives drive volatility
desire for hedging shorting for yield hunt

 Gov. regulation (Dodd-  Dealers no longer able

IV. Regulatory Frank) constrains risk to inventory long

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appetite volatility

27
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Bull and Bear Markets in Fear

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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
35
Lowest Volatility? Really?
VIX Futures Curve Comparison
August 17, 2012 vs. September 2008
30 !
Forward VIX Index (%)

25

20

15
September 15, 2008 / Day after Lehman Bros. Bankruptcy
August 17, 2012 / Lowest VIX in 5 years (at the time)

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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 28

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Bull and Bear Markets in Fear

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Forward volatility is a poor indicator for future movement of spot-vol

VIX Index and Forward Expectation of VIX Index

Bear Market in Volatility Volatility Falls and Bear Market Moral Harzard
Fear Spikes Bull Market in Fear in Fear Market
LONG RVOL RISK AND RETURN BY
HOLDING PERIOD
2008 financial 0.07x Sharpe Sortino Ratio Spot Volatility (VIX)
crash 0.06x Forward Expected Volatility
0.05x (multiple color lines)
0.04x
0.03x
2011 US default Historic Inversion
0.02x
crisis shows expectation of
0.01x central bank reaction
0.00x
2010 flash crash
function!
2007 credit -0.01x
QE3 Flattening
crisis -0.02x of Vol Term
1d
151d
301d
451d
601d
751d
901d
1051d
1201d
1351d
1501d
1651d
1801d
1951d
2101d
2251d
2401d
2551d
Structure

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Note: 29
Calculations based on monthly averages of VIX index and constant-maturity VIX futures
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Volatility protects you from Shadow Short Convexity

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Shadow Short Convexity
Immeasurable risk introduced when market participants reorganize portfolios
in way that contributes to feedback loops

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Source: Walt Disney, Fantasia 30
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Everyone is short volatility = dangerous

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Short Interest in Volatility ETPs has exploded in the 2012-2014 period

Yikes!

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Source: Artemis Capital Management LP, Bloomberg 31
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Nonlinear Rebalancing of Short VIX ETPs is disaster in making…

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Short Interest in Volatility ETPs has exploded in the 2012-2014 period
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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32
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.
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Everyone is short volatility = dangerous

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Short Interest in Volatility ETPs has exploded in the 2012-2014 period

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CONFIDENTIAL
Source: Artemis Capital Management LP, Bloomberg 33
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Left Tail of Volatility

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August 24th, 2015

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Source: Artemis Capital Management LP, Bloomberg 34
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August Volatility Event – Fastest Mean Reversion in History

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1557 days

544 days 515 days

435
days

191 158
days days
151 days 39 days
only!

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Source: Artemis Capital Management LP, Bloomberg 35
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Left Tail of Volatility

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Source: Artemis Capital Management LP, Bloomberg 36
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August Volatility Event – High Volatility of VIX

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Source: Artemis Capital Management LP, Bloomberg 37
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Conditions over Causation

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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  Equity Turbulence  Credit Stress
 Correlation Breakdowns  High Leverage  FX Turbulence
 Volatility of Volatility  Low Hedging  Breakeven CPI
 Currency Flows  Autocorrelation  Expected Inflation
 Volatility Momentum  Inter-bank Lending  Liquidity Stress

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CONFIDENTIAL
Note: Artemis proprietary model based on financial stress conditions. Machine learning model utilizes learned conditions to approximate state of volatility
38
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Volatility Regime Shift in the Prisoner’s Dilemma

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CONFIDENTIAL
Source: Artemis Capital Management LP, Bloomberg 39
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Volatility Regime Shift in the Prisoner’s Dilemma

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CONFIDENTIAL
Source: Artemis Capital Management LP, Bloomberg 40
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You would not drive cross-country using only your rear view mirror!!!

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Financial markets do not always look like Nebraska!
So why does Wall Street mostly use past volatility to gauge future volatility?

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Source: Artemis Capital Management LP, Bloomberg 41
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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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CONFIDENTIAL
Source: Artemis Capital Management LP, Bloomberg 42
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Volatility is your Only Escape from the Prisoner’s Dilemma

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GLOBAL MACRO STRADDLE + BETA

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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.
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Are we too complacent?

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44
Source: Financial Times / September 2014
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Artemis Capital Management – Contact Information

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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
info@artemiscm.com
www.artemiscm.com
Christopher Cole, CFA
CIO and Founder
(512) 467-4735 phone
c.cole@artemiscm.com

Key Information/ Biography

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.

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CONFIDENTIAL
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