Why Risk-Free Assets Are Risky

Tyler Durden's picture

Via Artemis Capital, “Volatility of an Impossible Object: Risk, Fear, and Safety in Games of Perception” by Christopher Cole

Why owning a UST bond is mathematically as risky as shorting an equity put option...

We all know shorting volatility is dangerous. We learned our lessons from the financial crisis. We all meticulously read “The Black Swan” and then watched the scary movie adaption of the book starring Natalie Portman. We all know that this method produces a steady stream of smooth returns making people think you are a genius until the inevitable disaster forces you to pawn off your Nobel Prize. We all know that shorting volatility will cause you to go insane with a twisted psycho-sexual obsession to master the art of ballet. It’s picking up pennies in front of a convexity steamroller. Don’t do it. Ever!! Worst of all... If you ever... ever... short volatility... Nassim Taleb will personally insult you and hurt your feelings.

Knowing these facts I would like to pose a question...

Which is riskier right now?

Shorting a collateralized far out-of-the-money S&P 500 index put or buying a “risk-free” US treasury bond? In the “bull market for fear” and “bubble in safety” the paradox is that these two vastly different investments have shockingly similar risk to return profiles (albeit to different risk factors). This goes against everything you have ever been taught in business school or on a CFA exam. In fact I will attempt to make a semi-compelling argument that the collateralized far-OTM put sale offers… gasp… a better risk to return profile than a long-dated UST. For the record I don’t recommend either.

First off measuring the risk to reward of a volatility short position is often a complex endeavor involving greeks like gammas, vegas, volgas, and vanna whites.

Let’s just simplify that entire process and “pretend” a put option is an alternative form of a bond. As an investor in this hypothetical “volatility bond” you receive an annualized “volatility  yield” represented by the premium of the option divided by the capital commitment required to fund the obligation.

In return for this yield you assume the risk of “default”, essentially meaning an obligation to buy the S&P 500 index at a pre-defined discount to current market value (say -25% or -50%). Now you will collateralize that option by setting aside the dollar amount of monies over the specified term needed to cover that purchase commitment. That collateral is equivalent to the “face value” of the bond and the “yield” is the option premium divided by that collateral and annualized. If the default event is a $100 stock falling to the -50% strike price in one year you would set aside $50 for the term of the commitment to cover mark-to-mark losses on the short option position. If you receive $2.5 in premium for selling the put option your yield is 5% (against a face value of $50).

We looked at several different types of hypothetical “volatility bonds”. The first requires you to purchase the S&P 500 Index at a -25% discount to the current price for the duration of a year. The second obligates you to  buy the S&P 500 index near the March 6, 2009 lows (650 strike price or -55% lower) for the duration of a year. We also obtained bank pricing on a 10-year over-the-counter put option at the 2009 low of 666. We can then compare these “volatility yields” to traditional fixed income yields. No complex greeks required.

(click for larger eligible version)



For the first time in history the volatility bond yield is consistently competitive with the yield on a wide variety of traditional fixed income investments (see above).What does it say when the market will compensate you more in annualized yield for the obligation to buy the S&P 500 index at the 2009 devil’s bottom of 666 (1.90% annualized yield for 10-year OTC put) than it will to own a government bond (1.87% yield for 10-year UST) of equivalent maturity? Consider that the 1-year volatility bond with a -25% SPX purchase commitment currently yields 2.69% annually or 82 basis point over the 10-year UST (chart below).


In periods of equity market duress the spread can go much higher hitting 454 basis points over the 10yr UST this past May. I know what you are thinking... what about the risks?

(click for larger eligible version)


The volatility bond and the UST bond have opposite risks factors as the first is exposed to deflation (stocks crashing) and the second inflation (higher interest rates). For the purposes of this analysis we assume a neutral macro-economic view. As a baseline for comparison our stress test uses historical bond and equity prices over multiple decades to match the equivalent probability of each stress event. It may feel as if a 325 basis point increase in rates is extraordinary but it is easy to forget that the historical probability of that occurring is much greater (13%) than that of a 2008 style crash in equities (2%). Of course this is backward looking. Ultimately the true future probability estimate is always left to the best judgment of the investor.

Mark-to-Market Risk: Fair comparison of risk includes analysis of potential unrealized losses for both investments when exposed to adverse market conditions as modeled by the stress tests above. The volatility bond will experience a mark-to-market loss if stocks decline and vol rises, however if the short put option remains out-of-the-money by maturity those losses will not be realized and the investor will keep the full premium. In a similar manner the UST bond will have negative price swings if rates increase but could still make all payments on time. The investor holding either instrument to maturity may be none the wiser if he received his principal back in full and never looked at mark-to-market prices (a retired broker once told me this was how client reporting of fixed income worked at his firm back in the rising rate environment of the 1970s). Important to note that both positions have convex return profiles and prices will not change linearly given shifts in volatility or rates.

Default Risk: I think it is funny when academics claim that the US government will never default because it can just print money to pay off its debt obligations. That is the logical equivalent of saying my house will never be burglarized because if someone tried to break in I could just light it on fire. For the UST bond inflation and currency devaluation are alternative forms of default. For the volatility bond the definition of default is not as complex. If the short put ended in-the-money at maturity the investor would be obligated to own the discounted SPX at the higher strike rate resulting in a loss on posted collateral. This “default” scenario may not be a bad thing if the investor doesn’t mind owning stocks at a -50% or -25% discount from today but it still counts for our purposes. Hence the volatility bond has much higher risk here. One unique attribute of the volatility bond is that it is a contractual obligation to ignore behavioral bias and purchase stocks only during periods of deep discounted value.

When the “bull market in fear” meets a “bubble in safety” a collateralized short volatility position and “risk-free’ UST bond have shockingly similar risk-to-reward payoffs. Of course you would rather own the UST bond in deflation or the volatility bond in inflation but we are assuming a risk neutral world. To this effect both investments suffer comparable losses to their worst case scenarios. Without endorsing either investment, when evaluated on a pure risk-to-reward framework the volatility bond (with embedded short optionality) is superior to UST bonds at current prices.

What kind of world do we live in where the risk-return pay-off of short selling equity volatility is equal or better to that of a supposedly “risk-free” government bond? The UST bond market is one of the most liquid markets in the world where investors look to first for preservation of capital during periods of crisis. Now the market for safety has an efficient frontier on par with the penny in front of the steamroller trade?

If you don’t find that scary then you’re not paying attention. It used to be that you would post margin against your tail risk options using risk-free UST bonds. Now those risk-free assets are the source of the tail-risk.


When risk-free is risky maybe it is time to buy volatility on safety itself (see chart above).

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Dr. Engali's picture

Meanwhile in China... Foxconn workers on the iPhone 5 line go on strike:


markmotive's picture

Just look at the duration and rates on US 10yr and 30yr bonds. If rates rise by a relatively small amount Treasuries would get pummeled.


GetZeeGold's picture



Double down on death and taxes......you can't lose. It's a lock.

Yen Cross's picture

 Artemus Gorden?


  Jim says that "corrugated" purple chart speaks for itself? I'm all experimental(and shit)<>

Ralph Spoilsport's picture

I'll admit it. I got lost halfway through this article.

holdbuysell's picture

Agreed. A dense read at the end of a day. So, many thanks to Tyler for bringing it back to highlight certain salient points such as this one that describes how pathetic the (non) market has become:

"Now the market for safety has an efficient frontier on par with the penny in front of the steamroller trade?"

LawsofPhysics's picture

Allow me to summarize. There are no "markets", it is a casino. Got Physical? You fucking better.

Lost Wages's picture

Speaking of physical, I was on Jim Sinclair's Mineset just now and he said, "Gold will protect you in this transition. Silver will give you a cheap thrill followed by a spiritual experience devoid of a teacher." I wonder what he meant by that...

Lost Wages's picture

I asked him what he meant. He said, "It depends what the economic conditions are at end game. Silver is industrial as well as precious. -Jim" The Doc said it means it'll have a blowoff top followed by a major correction.

Stud Duck's picture

Physical, uhhhhh, lets see, canned food, check, extra ammo, check, milk cow, check, horse, check, land, check, knowledge in how to grow food, milk cow, ride horse, small rural town, water for irrigation, check. methane gas supply for fuel in the ground below land ( 250 ft, 5 lbs pressure), wood for heat. small beef herd. no  debts, 50 K is maple leaf, exit plan if needed. check

Yea, think I'm lined up on the physical, could use more ammo, can never have enough of it!

samcontrol's picture

set up like you are you need some paper assets now.

AUD's picture

And I'll simplify. These 'risk free' assets are risky because they are junk. One day (I'm not predicting when), it will finally be accepted as such, or, closer to the mark, those who have them will find out the hard way.

Yen Cross's picture

sell the bumps. That bad boy is going to 95!

Number 156's picture

Watch as they put guys like Bernie Madoff behind bars for financial crimes but they exempt guys like Mozillo, Corizine et al. Wasn't the robosigning scandal enough? AIG backdoor bailout? Anyone?

Youve got Romney talking about the so called 47% who are dependent on goverment welfare while at the same time the banking fraudsters are taking raking in corporate welfare handouts to the tune of hundreds of billions of dollars. He's no different from Obama, Bush, Clinton, theyre all corporate sock puppets.

The casino youve invested in will rig the game every which way and will wipe you out. As things get worse and worse, the government and their cronies will panic and find ways to rob you blind.

You wont have a snowball's chance in hell.


dsg2003gt's picture

that was a clever article. well done.

FranSix's picture

TBT reverse split today.

Lost Wages's picture

That explains why Yahoo Finance said it was up 1525%.

DeadFred's picture

As did VXX. Do they set the splits to the pahse of the moon? Just curious.

Fecklesslackey's picture

I own both VXX and TBT - real losers, I should know better. VXX is like waiting for a lottery ticket to pay off and TBT will be good in 2022, if the don't reverse split it to 0 first.

MeelionDollerBogus's picture

Just time it right. I don't touch tbt, I've lost on TLT options because I didn't time it right but I'm happy with VXX. You can buy VXX puts when it goes up to a peak again too. I only paper-traded that one, was a good call though. I did in June (1st) get 60% on vxx calls despite it being a small move. I'm in for vxx as shares for now.

Just look at this and see:

2012 09 13 spy crash soon - http://flic.kr/p/daxu6H goldpricemodel

Even looking at 280-day ROC a spike to 20% tends not to hold (3 years back, take a look) and drops to 3% or 11%. No matter what that's a market drop and VXX goes up roughly 4x. Just dump it when it hits. Hold the cash (conservative) or roll some into vxx puts (daring)

palmereldritch's picture

FYI in a pending week expected to be filled with anticpation, speculation and concern, the IMF and World Bank Group are meeting in Tokyo.

Like Fukushima wasn't bad enough.


AUD's picture

From Doug Noland's latest;

Well, I’ve been ranting for awhile now about the “biggest Bubble in the history of mankind.” At this point, things increasingly remind me of 1999 and 2006.  Bubble Dynamics eventually reached a degree of excess that was too conspicuous to deny.  Yet the stakes are so much greater today.  The amount of global debt is so huge and the quality so poor.  It’s completely systemic and global.  Dangerous excesses have gravitated to the core of Credit and monetary systems.  Policymakers are now “all in” in a desperate gambit to hold financial and economic fragility at bay.  And, dangerously, highly speculative markets seem determined to extend their divergent path from economic fundamentals.  It’s frightening how enormous and enormously powerful dysfunctional global markets have become.


spanish inquisition's picture

I think the FED's only survival option at this point to blow up every other currency while consolidating actual assets under the umbrella of the owner banks. The big battles on the currency debasement war have yet to be fought.

magne13's picture

That is one of the best articles I have read on here in some time.  In fact you can simply sell SP Puts to fund your short 30yr basis positions.  I am quite confident the central planners have hit the breaking point and I am also quite confident that the SP500 will never truly go lower in price (nominal) at least not for a sustained period of time.  The 30yr treasury however is like an abandoned baby, the yield will spike and the US govt could care less because the FED will never raise short term rates, basically putting the current 30yr in the hot seat.  If you haven't seen the writing on the wall by now, you mine as well get out of the game, buy SPs, Sell SP puts, Sell 30yr OTM calls, Sell 30yr Treasuries vs every other treasury issue and of course long gold and silver. Enough said.

samcontrol's picture

any chance you could be more specific on those first three trades? thanks.

nofluer's picture

Short volatility? TREASURY bonds? Ummmm... I'll have neither please.

Last year we invested in some chickens.

This year I put my money into a couple of Jerseys and some alfalfa, and a salvage tractor - then got some tires for the shredder so I could mow the weeds on the tilable ground. 

Next year I'll be investing in a mower/conditioner, a side delivery rake, and a bailer and if I still have investment capital, I'll buy one of those fancy new bail baskets so I can mow and rake, then bail and pick up 130 bales at a time  and drive them to the storage area without getting off the tractor.

Then if there's STILL left-over capital, I'm gonna get me sum PIGS!!!


disabledvet's picture

"the only way you win is by not playing the game." Index funds so long as the Fed has a naked inflation creation policy. I CANNOT pick winners in the market place in general because i'm just adding complexity ("me"...the ultimate complexity in investing...or "you" in the case of you i might add) and that costs "the real me" money. A hobby probably isn't a bad idea either...

snowlywhite's picture

ugh, I say you're both wrong. Just look at the amount already owned by the Fed.


What's another 600bln or whatever's left in the market between friends? Beer money I say... Buy them all ;)

cjbosk's picture

Give me the treasury, long dated that is please!

I'll enjoy the "bubble" rhetoric from here to 2% yields, all the while clipping crappy coupons but making huge convexity on the investment. Don't believe it, look at Japan.....

JapanAmerica Bitchez! Any takers?

GOSPLAN HERO's picture

Buy silver on Ebay.

DowTheorist's picture

Bottom line: Get you some gold. Physical preferably.

The big picture is gold is in a primary bull market, here you have the details:


However, under Dow Theory October 4 was a relevant day because market action has clearly frustrated the incipient secondary reaction in the gold and silver markets. We are “in the clear” and it reaffirms the primary bullish trend and negates any secondary reaction.

Thus, now both the primary and secondary trend in gold and silver is firmly bullish.

Furthermore, this bullish breakout in gold and silver has also implications for the stock markets.

More on the breakout and its consequences here:


A_S's picture

ehm, this was in the artemis pdf you posted yesterday, didn't you read it?

I knew the retard commenters on this site don't read the content but even tyler doesn't???

A_S's picture

oh yeah, buy gold, it's going up, i'm smarter than bernanke