25 Sayings on Vol and Risk…Part 3 of 5

[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry. Our journey to 25 sayings on vol and risk continues folks and as UFC's Bruce Buffer

[00:00:25] is known to emphatically tell us, it's time for our third segment sayings 11 through 15. We've got some good ones ahead of us and as always I aim to share some of my thinking on markets, overlay a dose of history in pop culture and perhaps give you a chuckle in

[00:00:45] the process. We'll be in and out in under 30 minutes i.e. shorter than a pal presser, a five block cab ride from the east side to the west side and no doubt less time it takes windows to update the drivers on your PC.

[00:00:59] So as successions Logan Roy would say, let's get into it. As by now you may be aware my fondness for anniversaries leaves me always looking back at when iconic songs came to be. In part one of our series we started 50 years back in 74 with Steely Dan's Ricky

[00:01:16] Don't Lose That Number, Eric Clapton's I Shot the Sheriff and Pink Floyd's Time. In part two we highlighted songs from 1984 turning 40 this year, Steve Perry's Oh Sherry, Twisted Sisters We're Not Gonna Take It and Bon Jovi's Runaway were selected.

[00:01:33] We turn now to 1994 looking back 30 years, Green Day's Dukie album hit the scene and along with it a bunch of hits my personal favorite Longview. Pearl Jam released Better Man. There's some debate as to the meaning of the lyrics as there usually is for songs but in

[00:01:51] modern day US politics, Better Man is the public's cry for help on the political front for something other than the Trump-Biden cage match again. And lastly I want to highlight the song Zombie by the Cranberries what a haunting, serious

[00:02:06] and consequential song written entirely by Dolores O'Reardon as a call out against terrorism in Ireland. Sadly she would pass away in 2018. Days seem like years and years feel like days. The world moves fast. Every year is meaningful in terms of global events and 1994 was certainly no different.

[00:02:26] Kurt Cobain died. Nancy Kerrigan was attacked. A player strike in Major League Baseball canceled the World Series. Bezos found that Amazon and who could forget the low-speed Bronco Blanco chase featuring OJ Simpson. A devastating earthquake struck San Francisco in January 1994 tragically killing 57.

[00:02:46] On the market's front 1994 was drama filled. The Bond Market Massacre, a result of Greenspan's aggressive tightening cycle certainly brought relevance to Buffett's You Don't Know Who Swimming Naked Till the Tide Goes Out. Orange County Treasurer Robert Citron was one of the castaways.

[00:03:03] Overseeing public funds he bought leveraged inverse floaters you know the ones in which the coupon is a function of LIBOR squared. These structured products left him with duration risk multiples of the state of maturity of the bonds conjured by the Wall Street digit heads.

[00:03:19] With the Fed funds target moving expeditiously from three to six in about a year Citron's bonds bought using repo blew up from unwelcome calls from mark to market collateral. The fund lost 1.5 billion one of the more spectacular and earliest derivatives debacles.

[00:03:36] As you might imagine the bond market ruptures sponsored an extremely high move index reaching 150 in May of 1994. All the while the VIX comfortably rested at 12 or so. Perhaps back then equities were not as short the straddle on rates as one of our saying suggests.

[00:03:52] The linkages today between risky and risk free markets are far more pronounced. One can't help but wonder if the Fed's enormous presence in post GFC markets has something to do with this. Well just like Marty McFly we took the time machine back 30 years.

[00:04:09] It's time to consider the here and now and critically make progress on our 25 sayings. So let's get underway with number 11 and that is quote if history is a foreign country, the history of risk is another planet.

[00:04:22] I built this one around the timeless phrase that quote the past is a foreign country which comes from LP Hartley's 1953 book go between the full opening sentence of the book is quote the past is a foreign country. They do things differently there. What an interesting metaphor.

[00:04:40] A review of the book by Natasha Horey says the go between wistfully condenses the problems inherent to memory and history distant intangible unreliable lost our histories as the levels of personal and national are at best half remembered and at worst actively misrepresented amen.

[00:05:01] It is most interesting to consider this in light of special counsel's report on Joe Biden's memory. I mean classified documents handling sometimes we fail to remember things. Sometimes we decide to forget them and more often than not we stitched together a historical

[00:05:17] sequence of events that helps us make sense of it all. How many times have you heard a friend tell a story that somehow combined two unique occurrences perhaps it was for special effect seeking higher impact to make the

[00:05:29] story more entertaining but it certainly may be the way he or she actually remembers it. If your friend has done it you probably have as well. In markets I say that the history of risk is indeed another planet.

[00:05:44] They don't just do things differently there events that occurred some time ago are more difficult to appreciate 15 years ago city bank traded below $8 a share. You could own a share of Bank of America for 250 a little more than a gallon of gas or

[00:05:59] a tall latte from Starbucks by the way and I know you know this tall is small at Bucky's and that same latte will cost you a fiver now. And that's before you entertain all the bells and whistles you know two pumps

[00:06:12] of Chai a drizzle of Carmel or a dusting of cinnamon. We look back on the financial crisis and think well that can't ever happen again. Morgan Stanley CEO James Gorman said quote the chances of another financial crisis is as close to zero as I can imagine.

[00:06:29] Come on James I don't think we ought to ever be close minded on matters of systemic risk maybe Ronald Reagan should have responded well James there you go again some version of it most surely will in the 2015 movie The Big Short Greg Lipman's Jared Venette

[00:06:46] tells us that quote no one's paying attention not the banks the investors the regulators or the ratings agencies. While we all get the point the reality was that the world watched the credit bubble inflate in real time along the way we learned of and embraced new acronyms like

[00:07:02] SIVS, Ninja Loans and CPDOs. We knew that the banks were leveraged more than 30 X to one but the VIX was at 10 and risk hid in plain sight. We were told forcefully that financial innovation helped disperse credit risk moving it

[00:07:17] away from the traditional banking system channel strengthening the system in the process. Did I mention that IG credit spreads were in the low 20s? It's working. It's really difficult to truly remember the past and in markets because we finance

[00:07:31] types generally embrace order we are inclined to stitch things together such that events make sense to us comforting us in the process. The ultimate S&P low of 666 in March of 09 is something we experienced differently now than we did then.

[00:07:47] It felt much riskier at that time than it does now with the benefit of staring at the chart for the last 15 years. That's when the Fed did QE. It put a floor underneath the market. One trader can be heard saying with confidence all the sellers were exhausted.

[00:08:02] The market couldn't have fallen further said his buddy Jack and diet Coke in hand. Really? If we look at one year index fall on the S&P at that low point, the implied probability that the S&P could touch 500 in a year was more than 50%.

[00:08:17] Remember the joke about the S&P 500? That it wasn't the number of stocks in the index. It was the index value? Well that actually was more likely than not an outcome according to market pricing. If we think about vol levels as some representation of the market's

[00:08:32] distribution of possible outcomes, it's clear that nothing was off the table back then. But as we look now with the S&P at 5000, that sense of uncertainty is next to impossible to recreate. Let's move on to saying number 12. I love this one.

[00:08:48] It's quote by definition there's a winner to every back test. We decide a certain set of criteria to test and we see what outcomes the data yields. Let's start with an absurd set of criteria.

[00:09:01] Suppose I told you that when the S&P is up on the first Wednesday of the year and it happens to rain on that Wednesday and a Democrat is in the office of the presidency, the S&P is up 10 out of 10 times. Powerful!

[00:09:14] Would you be waiting with your interactive broker screen loaded up ready to plow into the spy should that first Wednesday be a soaker? The back test is perfect. How could you not? If we look long and hard enough some tasty results will emerge.

[00:09:28] Now of course my first example is as suggested absurd. The point is that back tested results are a handle with care item. Let's dive in further. You are a pension fund trying to protect the hard earned capital of your retirees.

[00:09:43] You are contemplating a hedging program during 2016 and when Trump shocks the world in November, you become more determined to play defense through optionality. Your very friendly sell side derivatives fellow pays you a visit armed with lots of stats on how owning convexity could provide explosive

[00:10:00] gains that offset portfolio losses in a risk off. Trump is set to unleash chaos on the world and markets, he declares. But that same fellow was not yet aware that 2017 would be the lowest realized vol year in the S&P in more than five decades and

[00:10:16] one during which the VIX closed below 10 more than 50 times. Conversely, what if that fellow's colleague, a most brainy black Scholes enthusiast and backgammon expert sitting in the banks nearby alternative risk premium group met the same pension fund in late 2019 under the premise of harvesting carry.

[00:10:35] I mean, if Trump's presence in the White House couldn't sponsor volatility, what could? With a thick chart book in hand, the eager structuring guru presents gorgeous back tests making it clear that even in the inevitable wobbles and risk assets these carry trades hold up.

[00:10:51] But it's 2019, who could have known that the VIX would reach a new all time high just a few months later, certainly not AIMCO or Malachite and certainly not the folks at Allianz. The back tested results as presented at the end of 2019 are going to look quite

[00:11:07] a bit different than the back tested results presented at the end of 2020. If you were sizing for stress up until 2019, you almost certainly got wiped out in 2020. If you were sizing for stress that materialized during the COVID crash,

[00:11:22] your back test is going to have to find a way to take less risk. Instead of selling the 80% put outright, maybe it's the 80-50 put spread. Ah, the benefit of hindsight. There's always a winner to a back test. We are solving for something. Think about it.

[00:11:38] I want to find the hedge that is most convex to a market vol event but bleeds the least during the lean periods. Is it VIX or SPY? Do I use credit options? Am I better off with a cheaper put spread?

[00:11:50] Do I buy a gazillion units of the very low strike option? Or do I buy many fewer of something closer to the money? What's my protocol for rolling the option? How about monetization? These are all decisions we can program into the back test on an ex-anti basis.

[00:12:06] Out of the exercise, definitionally will be one winner. That's just the reality. It doesn't mean we should not engage in back tests. It just means that we must handle with care to say the least. There is a related saying around back tests I want to share with you.

[00:12:22] And that comes from Calster's risk officer, Chris Dietrich. He once said, quote, you'll never see a bad back test ever. I'm not sure he realized just how good this was when he said it. As hack comedian Kenny Banya said in Seinfeld, gold, Jerry, gold.

[00:12:39] Every single bad back test is simply disregarded, thrown away. It's as if the exercise was never undertaken. Ignored, the bad back test knows he'll be summoned to the dustbin of irrelevance. Why would you ever present a bad back test?

[00:12:54] Imagine for a moment, I'm a whiz kid starting a new hedge fund. I've got a cap intro team chomping at the bit for my execution business, eager to take me on the road to meet some family offices and raise some dough for my launch.

[00:13:07] Over a breakfast in a hotel room complete with scrambled egg wraps and maple scones, I give them the pitch. I show them the back test. It shows a 16% negative annualized return with a 16 vol.

[00:13:19] Ditch the risk free rate for a second, this back test runs about a negative one sharp ratio I say with a strange sense of self assurance. The family office CIO coughs on his maple scone.

[00:13:31] To be sure, the scone is a pretty dry pastry but he's flummoxed by my back test. It's time for me to make my pitch. It's simple, I say. The future will look different from the past.

[00:13:42] This back test will completely turn around and you'll make a lot of money with me. Imagine for a moment that you are armed with a litany of reasons why this will be so. You present them confidently, staring at your negative one sharp.

[00:13:55] Do you think the CIO would pony up for your launch? You'll never see a bad back test ever. Saying 13 comes to us by way of passports, John Burbank. I can't begin to estimate the number of times I've used this one over the years.

[00:14:10] John said succinctly, abruptly that quote price is a liar. I think but can't be entirely certain this is some high finance example of anthropomorphism. Staring at a price dislocation. There goes price lying again, the miffed macro maven mumbled.

[00:14:28] Frustrated at first he came to accept that price is simply that magic number that brought buyer and seller to the table. Clearing prices are a funny thing. The market price of one month S&P options is cleared at 6 vol in October 2017 and 76 vol in March of 2020.

[00:14:45] Same exact contract but vastly different prices. Let's consider each of these. Recall that late 2017 the short vol trade was increasingly successful. Realized vol in the S&P was less than six in the fourth quarter and the AUM of products like the XIV was ballooning.

[00:15:03] The clearing price of insurance in the single digits would tell us in the words of Kevin Bacon from Animal House that all is well. We'd find out just a month into 2018 that the stream roller was headed for those

[00:15:15] picking up nickels at least as far as the short vol trade goes, all was not well. And how about March of 2020? A new all time high in the VIX. Paradoxically the cost of hedging is peaking at just the time when the

[00:15:28] Fed is about to embrace a limitless version of QE. The playbook is kind of familiar. The risk gets to an intolerable level. The price of insurance reflects it and for that very reason as the market is about to break the Fed backstops it.

[00:15:42] The central bank's mandate ceases to be growth and inflation. It becomes firefighter. Its giant hose of money aimed directly at risk premium levels trying to soak them before they burn out of control. Price is a liar. She's all we have but she lies.

[00:15:58] Sort of like Joe from say anything. You remember Joe lies. I digress. No more Lloyd Dobler references. Burbank was telling us that we can learn a lot by studying price but we should also accept that price can communicate in ways that can be misconstrued, sometimes dangerously so.

[00:16:16] In the year or so before June of 2007 the Bear Stearns high grade structured credit fund never saw marked to market levels on their CDOs that moved outside of a percent or so. A wiggle here, a wiggle there.

[00:16:29] But as we learn from the big short in April of 2007 Ralph Chaffee was shocked to see Goldman suddenly mark his gold plated AAA rated paper in the 60s. Goodness. There's a great academic paper by MIT's Andrew Lowe who devised a fictitious head

[00:16:44] shun which he cheekily called capital decimation partners. This two and 20 or so fund has an eight year track record plenty of time to get on the radar screen of the consultants. It's got an annualized sharp of 2.15 with just six down months.

[00:17:00] It turns out the fund has been selling out of the money puts in good size during a bull market when delivered volatility has been low. By the way, I like saying delivered vol versus realized vol every now and again. It sounds kind of smart.

[00:17:14] But then boom, a 1987 or LTCM or 911 GFC or 2020 hits your entire stack of hard earned carry disappears in weeks. The sharp ratio north of two and the more than 90% positive monthly returns optically appealing belied the deeply negative skewness of the return profile.

[00:17:36] You wouldn't know it based on the performance up until one of these market blowups. When I think about John Burbank's statement that prices are liar, I'm thinking that clearing prices can stray far away from economic value when a supply demand imbalance becomes significant.

[00:17:51] In 2010, the long dated S&P variance market simply broke. File sellers were vastly off sides needing to cover shorts put on at the wrong price. There was no supply. One of Goldman's favorite trades that year was to sell forward starting long dated S&P vol.

[00:18:07] Buffett was rumored to be interested in covering his enormous portfolio of written index puts. The fallout 10 year variance traded at levels right near 40% in mid 2010. To lose money on that traded expiration, the S&P would have to move 2.5% a day every day for 10 years.

[00:18:26] As Sam Rothman said in Casino, it could not happen. It would not happen. But that was the price that sufficiently coaxed both buyer and seller to transact at that unstable time. All right, we are moving to number 14 which I can credit Chris Cole of Artemis Capital with.

[00:18:43] Chris has said that quote volatility is an instrument of truth. Price is a liar, but vol is an instrument of truth. Interesting contrast there. Perhaps Andrew Lowe's stylized hedge fund captures both sayings at once. The high sharp ratio and strong consistency of success is price lying.

[00:19:03] It's only when the market turbulence event hits leading the hedge fund to demise that we see that volatility is an instrument of truth. Volatility results from the adjustment process to finding truth in asset prices and investor positioning. Vol events occur when this process happens in a compressed timeframe.

[00:19:21] Peg breaks come to mind. We might consider the Euro Swiss peg that came undone on January 15th of 2015. Abandoning its campaign to hold the line at 1.2, the S&B allowed the dam to break. Wrecking havoc on the carry trade set up on the premise that

[00:19:38] Tom Jordan's promise was money good. Euro Swiss variant swaps could have been bought for a strike price of two leading into this. Always a convex instrument, variant swaps are breathtakingly convex at incredibly low strike prices. Let's walk through this quickly by comparing the payouts on a low versus

[00:19:55] high strike swap. Let's use 20 for the high one and two for the low one. 100K Vega per point is our size. To translate that to variance units, we need to divide by twice the strike price for each one.

[00:20:09] Our swap struck at 20 vol is 420 squared in variance with 2500 units. That is arrived at by dividing 100K by twice the vol strike. Our second swap carries a variant strike of four, two squared. Its units are 25,000, i.e., 100K divided by twice the vol strike of two.

[00:20:30] Suppose each swap realizes five vols more than its strike price. For the high strike swap, the profit is 562,500. For the low strike swap, the profit is double that at 1.125 million. The value of one vol point is far more for the low strike swap than it is for

[00:20:49] the high strike. When I think about Chris Cole's notion that volatility is an instrument of truth, I think about it as an outcome that emerges from the market's confrontation with mistakes. Prices reflected a consensus view on the world which turned out to be wrong. Happens all the time.

[00:21:05] When the facts change, a change by mind might be one way to put it. The shattering of this consensus, especially when deeply held by market participants, is apt to bring with it a healthy dose of vol. There's nothing more destabilizing than the undoing of a peg.

[00:21:21] And that gets us to our last saying in part three of our series. And here we must thank Mr. Mark Twain. Born on November 30th, 1885, Wikipedia tells us that Twain was a writer, humorist, essayist, entrepreneur, publisher, and lecturer.

[00:21:37] There's no account that he actively traded volatility or owned Bitcoin. Of course, he wrote The Adventures of Tom Sawyer and The Adventures of Huckleberry Finn. Lots of quotes are attributed to Mark Twain. For our purposes, he gets number 15 of our 25 sayings on vol and risk.

[00:21:54] He may or may not have actually said that quote, it ain't what you don't know that gets you in trouble. It's what you know for sure that just ain't so. There's so much to consider here. Big picture, I'd argue that overconfidence is a psychological

[00:22:08] shortcoming of humans that often makes its way into market prices. In options markets, low implied volatility is a reflection of the precision with which the market believes it understands probabilities. The Euro Swiss Cross that we covered earlier carried a six month implied vol of two as of August 2014.

[00:22:28] It reached 25 months later as the S&B walked away from that FX ceiling it had promised to markets. Assumptions get baked into asset prices. In late 2020, post Pfizer vaccine mind you, I recall being bewildered at the coexistence of two prices.

[00:22:44] First, the five year note yielded less than 40 basis points. And second, option implied volatility on five year note futures was around 1.5. In words, this price in combination can be read as quote, rates are low, they're gonna stay low and we are sure of it.

[00:23:01] Such is the force of Fed forward guidance during an especially fraught time period. It's what you know for sure that just ain't so. Just ask Joe Casano, the mastermind behind AIG's financial products disastrous foray into selling CDS on subprime.

[00:23:19] In 2007 in reviewing the risks in the portfolio, Casano told analysts quote, it is hard for us and without being flippant to even see a scenario within any realm of reason that would see us losing $1 in any of those transactions, my goodness.

[00:23:38] By the way, I've read most books on the GFC and one that I believe does not get enough attention is called fatal risk by Roddy Boyd. In careful detail, the rise and fall of the financial products unit is documented.

[00:23:52] One shocking or perhaps not so shocking piece of information we learn is that when the unit was downgraded from AAA, it was forced to post mark to market collateral or variation margin in Isda Parlins. It's reported that the back office folks at AIGFP didn't know what that was.

[00:24:12] Insert OMG emoji here. Friends, it appears that I am soon to cross the 4000 word threshold and assuming I speak such words at a pace consistent with parts one and two part three should also be around 25 minutes. That means it's time for me to say goodbye for now.

[00:24:30] Fret not however saying 16 through 20 are soon to follow. Until next time, be well. You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend. And before we leave, I wanted to invite you to drop us some feedback.

[00:24:46] As we aim to utilize these conversations to contribute to the investment community's understanding of risk, your input is valuable and provides direction on where we should focus. Please email us at feedback at alphaexchangepodcast.com. Thanks again and catch you next time.