When an accident occurs, the insurance claims adjuster produces a report. What does said report tell us? The yen’s largely one way path lower took a dramatic turn that saw it rally by roughly 9% over just 3 weeks. The pricing fallout was everywhere – in curves, credit, correlation, convexity and carry. That’s a bunch of C’s, isn’t it. The cause of chaos: crowding. When markets misbehave, it’s natural to jointly evaluate two factors: the combination of “new news” and the “setup” going in. Over the course of this short podcast, I share some thoughts on this recent risk flare-up and what it tells us about market fragility. I hope you find it interesting and useful.
[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics
[00:00:06] in financial markets associated with managing risk, generating return, and the deployment
[00:00:12] of capital in the alternative investment industry.
[00:00:19] Good listeners, I welcome you back to another Dean-Narrated episode of the Alpha Exchange.
[00:00:24] I'm very fortunate to have such wonderful guests on this podcast.
[00:00:28] I learned a good deal through this interaction and it's a pleasure to make some small contribution
[00:00:33] to the financial community's understanding of risk through these conversations.
[00:00:37] I've also increasingly enjoyed sharing my own thoughts and the framework I've personally
[00:00:42] developed over the years to think about markets. And over the next 15 minutes,
[00:00:46] I'd like to reflect on the recent action and what I believe are the implications.
[00:00:51] The VIX closed at 14.8 on Friday, August 16th.
[00:00:54] It's closed 30 days earlier, 14.5. One would be forgiven for assuming that not much happened along
[00:01:01] the way. I mean, sure, the summer Olympics came and went. In politics, Biden dropped out via tweet.
[00:01:08] The RNC happened, gotta say, loved Hulk Hogan's rant. Industry season three got underway.
[00:01:15] But these aren't really of any relevance to the market. I like to say that nothing bad in
[00:01:20] markets happens when vol is below 15. So things were fine, right? We know, of course, that the
[00:01:26] point-to-point unchanged VIX fails to tell the story of dramatic disruption that recently beset
[00:01:31] the market. When an accident occurs, the insurance claims adjuster produces a report.
[00:01:38] What does said report tell us? The Yens largely one way path lower took a dramatic turn that
[00:01:44] saw it rally by roughly 9% over just three weeks. The pricing fallout was everywhere in curves, credit,
[00:01:52] correlation, convexity and carry. That's a bunch of Cs, isn't it? The cause of chaos?
[00:01:58] Crouting. When markets misbehave, it's natural to jointly evaluate two factors. First, new news.
[00:02:07] What did we learn and how might this new information have forced us to reprice the
[00:02:11] assumptions previously underpinning asset levels? Second, what was the setup going in?
[00:02:17] That is, was the market leaning considerably one way or another? Simple formula. Price reaction equals
[00:02:24] new news time set up. No differential equations required. Let's look at the yen quickly. It fell
[00:02:31] by 11.5% versus the dollar in 2021. It fell another 14% in 2022 and a further 7.5% in 2020
[00:02:41] It's as if the same folks who built the VXX had their hands in Japan's currency.
[00:02:47] In 2024 up until mid-July, the yen would depreciate by another 11% versus the dollar.
[00:02:54] It's a staggeringly consistent trend and sharp ratios on this currency carry are more than
[00:03:00] appealing. Bloomberg reports via its WCRS page that dollar yen carry yielded a sharp ratio
[00:03:07] of 1.75 from 2021 until July of this year. The yen mech sharp was even better north of two.
[00:03:15] I'm no expert on monetary policy, especially that in Japan. I do know the word Japanification
[00:03:21] though and it came to be for a simple reason. The extent to which the country embodied an
[00:03:26] almost permanent state of deflation and the policy initiatives put in place to cure it.
[00:03:32] Those two came to be viewed as nearly semi-permanent and suddenly it's not the Fed exporting tighter
[00:03:38] monetary policy around the world that creates the risk but the opposite. There are lots of
[00:03:43] takes out there on the extent to which the yen carry trade has been cleaned up. To the degree
[00:03:47] that interest rate differentials guide currency movements we can see from the Bloomberg MIPR
[00:03:53] page that Fed BOJ policy spread two years forward narrowed by 70 basis points in less
[00:03:59] than a month. That's a lot and stepping back to contemplate the cause of this narrowing,
[00:04:04] a simple chart of year over year CPI in the US versus that in Japan will show near perfect
[00:04:10] convergence with both series hovering right around 3%. It sure didn't used to look this way.
[00:04:17] Let's review the spillover. By now we know that a 65 pre-handle open on the VIX was reached
[00:04:23] on Monday August 5th and even during the traditional 930-4 trading session it was briefly in the
[00:04:30] mid 50s. It closed at 38 as the S&P fell by 3%. For some context there are 36 daily moves lower
[00:04:38] in the S&P since 2008 that are 4% or more. Five of those have been 8% or greater swoons.
[00:04:47] The average VIX move up on the down 4% days is 23.5%. On August 5th the S&P as mentioned fell by just
[00:04:56] 3%. The VIX moved up by 65%. Interesting stats to be sure but now for the serious part and why
[00:05:05] I'm quite concerned about the giant move in the VIX. The S&P is by far the global benchmark
[00:05:11] for risk. The S&P options market is also by far the most critical insurance market for assets.
[00:05:18] February 5th 2018 was a very unique day that was a relatively easy to see accident in the making.
[00:05:26] The ETP products built around the VIX were enormous and with a shock that was reasonably easy to
[00:05:32] imagine the capital base of the ETPs would be wiped out. It was pretty clear that the
[00:05:38] liquidity in VIX futures was not equipped to handle the mechanical demand from the ETPs that
[00:05:44] would result from a pop in the VIX future. March of 2020 is in a class by itself with regard to
[00:05:50] risk. We haven't tried to shut the U.S. economy down before in modern times. So what the bleep
[00:05:57] happened last week in the VIX? It's okay to say that the VIX wasn't out of line.
[00:06:02] It simply takes in price feeds of S&P options and does a bunch of calculations to get its level.
[00:06:10] But it is preposterous to suggest that what happened in the underlying S&P options market
[00:06:15] was okay or that it was consistent with the overall level of uncertainty. The most critical
[00:06:21] insurance market broke and this wasn't 2008 or 2020. I have to say this is really worth spending
[00:06:28] some time thinking about. The explanations for the VIX massively outsized move last week on August 5th
[00:06:36] range from the lazy, it must be zero DTE to the absurd, the SIBO saying a 65 VIX was consistent
[00:06:44] with the 4% down move in the S&P. Come on. I'm still trying to understand it. Were a bunch
[00:06:51] of S&P option market makers unvaxxed and caught COVID? How in the heck could that happen Fauci?
[00:06:56] And they didn't show up for work? Did the PPT, the plunge protection team accidentally buy puts
[00:07:02] instead of equities? We know that implied vols around the world tend to move in concert with one
[00:07:07] another. All right, fine. Vol on live cattle and lean hogs didn't really ramp last week,
[00:07:12] but in equities they certainly do move together. On August 5th however as the VIX got to 65,
[00:07:19] the Europe VIX, the V2X was at just 41. When the VIX opened around 55, the V2X was at around 39.
[00:07:29] Even more glaring during the actual trading hours of August 5th when the VIX opened at 55,
[00:07:35] the NASDAQ equivalent, the VXN was around 40. Even if we give the market time to
[00:07:41] sufficiently open and take a snapshot at 10 30 AM, we see the VIX at 43 and the VXN at 34.
[00:07:48] That's nine vols of difference. It means back at the envelope that a one month 10% out of the money
[00:07:55] put on the S&P costs twice that of the same on the NDX. A second relationship worth exploring is
[00:08:02] the rolling spread between the VXN and VIX. It's quite rare that VIX is greater than VXN.
[00:08:09] Monday, August 5th was comparable to the Feb 18 and March 20th,
[00:08:14] wide in that spread when the VIX actually exceeded the VXN. A very stable spread,
[00:08:20] consistently averaging five plummeted to between negative 5 and negative 15 for a few hours on
[00:08:27] August 5th. Just as soon it's now back to positive five. Some of this begs the question,
[00:08:34] how could NDX vol get so cheap to S&P vol? The daily returns of these two stock indices are
[00:08:41] 90 plus percent correlated. As discussed, the vol spread relationship on options is quite stable
[00:08:47] with VXN averaging about five over VIX. The obvious quote, ARB certainly not perfect
[00:08:54] would be to sell that 10% out of the money put on the S&P and buy twice as many on the NDX
[00:09:01] for around zero cost. A few caveats. First, nothing and I mean nothing in financial markets
[00:09:09] is obvious. Markets as fast as the one on August 5th are illiquid and vulnerable to sloppy execution.
[00:09:17] Second, and related, the dislocated VIX comes from the exorbitant premiums on out of the money S&P put
[00:09:24] options that underpin the calculation. These levels of the market makers saying we're not in
[00:09:30] any position to sell any vol. The prices get raised in order to strongly dissuade buyers.
[00:09:36] At the same time, the market makers absolutely don't want to buy vol either at those sky high levels.
[00:09:42] And lastly, a normally benign spread relationship like VXN to VIX doesn't become so dislocated
[00:09:47] without something being very wrong. The same instability that got the spread there is
[00:09:53] the instability that could also make it move even further away, a cascading failure.
[00:09:59] Think of LTCM's 29.5 versus 30 year bond
[00:10:03] ARB in US Treasuries. When something gets that wide, the fundamentals of convergence cease to
[00:10:10] matter. Quite a dislocation. And today, a 15 handle VIX again. Nothing to see here.
[00:10:16] Whenever there's a market events of consequence, it makes sense to review the performance of
[00:10:21] popular hedging strategies. I wanted to share some thoughts on put spread collars. First,
[00:10:26] if you haven't already, check out the recent pod I dropped Cubans Collar is Jensen's Alpha,
[00:10:31] in which I break down the factors that drive pricing in zero cost collars.
[00:10:35] The put spread collar is the long put short call hedge, but using a put spread instead of
[00:10:41] an outright put. The trade off is simple. The put spread costs less and thus it allows
[00:10:46] the end user to pair it with a higher straight call option to make the package zero cost.
[00:10:51] Of course, the put spread provides some, but not all of the protection that a straight put does.
[00:10:56] S&P index put spread collar strategies have been money good as a point to point hedge overlay for
[00:11:02] a long time. Val underperformed by a great deal in 2022. And even though the S&P fell by 90%
[00:11:09] in the year, the Val and resulting lofty price of outright puts really compromise the
[00:11:14] protection by selling off the lower strike put and the upper strike call in combination
[00:11:20] with buying a closer to the money put option. The put spread collar has worked well.
[00:11:25] For example, in 2022, the SIBO put spread collar index ticker symbol CLLZ lost just 13% in 2022.
[00:11:36] Let's use a stylized example to review the recent sell off using a 9580 put spread
[00:11:41] with a short call overlay out to September regular that's September 20th expiration,
[00:11:47] initiated at zero cost as of the June expiration. The hedge performed well last week,
[00:11:53] adding some value on a modest S&P pullback. Next we can decompose the legs of the options package,
[00:12:00] the long top strike put, a short bottom strike put and a short call. The Monday, August 5th
[00:12:05] sell off came at an ideal time as the top strike put was just 3% out of the money based
[00:12:11] on the Friday, August 2nd close. That left it with a negative 31 delta that went to negative 44
[00:12:17] as of the August 5th close. By contrast, the lower strike put saw its delta go from negative 5
[00:12:24] to negative 11. The call delta went from 10 to 7. No strategy hedges all scenarios,
[00:12:31] at least efficiently. The put spread collar is short Vega, meaning sensitivity to implied
[00:12:37] vol and that can be a negative should vol get marked up a good deal. That is in the put spread collar,
[00:12:42] you are long a put but short a strangle, a scenario in which the index continued to fall
[00:12:48] lower towards the lower strike and vol got further bid in the process would be detrimental
[00:12:53] to the mark to market of a put spread collar. Options are notoriously expensive over the
[00:12:58] long haul so finding combinations that helped defray the premium can provide some sleep at
[00:13:03] protection without breaking the premium bank. I've reached my 2000 word limit but I am reminded
[00:13:10] of an old adage hedge when you can not when you have to the recent spike in vol tells us
[00:13:15] something about an underlying fragility about unwelcome tales and the system's capacity to
[00:13:21] lurch from very low to very high vol in this context the rapid decline in option premiums post
[00:13:27] August 5th feels like a gift to me. I wish you a prosperous week and I'll catch you next time.
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