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ARTEMIS CAPITAL MANAGEMENT LP For Investment Professional Use. Not for Distribution
Unauthorized Reproduction Prohibited

Volatility and the Allegory of the Prisoner’s Dilemma

Volatility & Tail Risk Summit – London, April 16th 2015
Christopher Cole, CFA

Littlefield Building
106 East 6th Street, Suite 650
Austin, TX 78701
Phone (512) 467-4735
info@artemiscm.com
“Allegory of the Prisoner’s Dilemma” by Andy Diaz Hope & Laurel Roth. Reproduced with permission of artists. Unauthorized reproduction prohibited.
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
“The only thing “Peace is not the
that will redeem absence of
mankind is conflict”
cooperation”
Dorothy
Bertrand Russell Thompson

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Volatility & Tail Risk Summit 2015
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“Allegory of the Prisoner’s Dilemma” by Andy Diaz Hope & Laurel Roth. Reproduced with permission of artists. Unauthorized reproduction prohibited.
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
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 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 in the Prisoner’s Dilemma

VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA

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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Istockphoto.com
 Prisoner’s
Volatility
Dilemma
in the Prisoner’s
and Risk Suppression
Dilemma

VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA

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Volatility & Tail Risk Summit 2015
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Source: Artemis Capital Mgmt LP, FRED, MarketDataExpress
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
Volatility and Asset Prices in the Prisoner’s Dilemma

Regime of Prisoner’s Dilemma

(2009 to 2015)

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Source: Artemis Capital Mgmt LP, Global Financial Data
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
Volatility in the Prisoner’s Dilemma
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 Mgmt LP, Bloomberg

 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
Volatility in the Prisoner’s Dilemma
Total Debt-to-GDP by Country & World

282% 252% 286% 517% 401%

(+40% since 2007)

Great
Great Depression Recession?

WWI
WWII

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Source: Global Financial Data, Recent Debt-to-GDP data from McKinsey Global Institute
 Volatility in the Prisoner’s Dilemma

VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA

Is global deflation an economic or a demographic phenomenon?

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Source: Global Financial Data
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
We are all volatility traders
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

Sep-03
Dec-03

Sep-04
Dec-04

Sep-05
Dec-05

Sep-06
Dec-06

Sep-07
Dec-07

Sep-08
Dec-08

Sep-09
Dec-09

Sep-10
Dec-10

Sep-11
Dec-11

Sep-12
Dec-12

Sep-13
Dec-13

Sep-14
Dec-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-03

Apr-04

Apr-05

Apr-06

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
Source: Hedge fund monthly returns from HFRX, volatility returns from Artemis Capital.
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
Volatility is the Only Real Asset Class
In the real world… there are two asset classes… long and short volatility
What you think you are What you actually are
investing in0.4% 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
2.0%
Value Investing 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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Volatility & Tail Risk Summit 2015
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rates and/or;
2. Historical correlation (negative correlation) between equities and bonds
breaks down rendering traditional diversification useless

Sources: Special thanks to Drobny Global Macro for original visual conceptualization of this idea
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
Volatility is the Only Real Asset Class
Changing Correlations Between Fixed Income and Equity Prices
Correlation
Anti-correlation

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Source: Global Financial Data, Artemis Capital Management LLC
 CONFIDENTIAL
VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA Volatility & Tail Risk Summit 2015
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Volatility is the Only Real Asset Class

Source: Global Financial Data, Artemis Capital Management LP

 CONFIDENTIAL
VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA Volatility & Tail Risk Summit 2015
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What Will be the Outcome of the
Economic Prisoner’s Dilemma?

Source: The Tower of Babel / Pieter Bruegel the Elder

 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
What Will be the Outcome of the Economic Prisoner’s Dilemma?
Global War Cooperation + Hyper-
Growth + Asset
Austerity
Bubble

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Source: istockphoto.com, worldly
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
Volatility is your Only Escape from the Prisoner’s Dilemma
GLOBAL MACRO STRADDLE + BETA

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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.
 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
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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Illustration by Brendan Wiuff based on concept by Christopher Cole
 CONFIDENTIAL
VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA Volatility & Tail Risk Summit 2015
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One Last Thing…

Source: Financial Times / September 2014

 VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA
Christopher
Contact Information
Cole, CFA – General Partner and Founder
Artemis Capital Management – Contact Information

Artemis Capital Management, L.P.

106 East 6th Street, Suite 650
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 LLC. 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

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Volatility & Tail Risk Summit 2015
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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.
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