Volatility at World's End


If you are going to read one thing on Volatility, read this. Excellent as usual, courtesy of Artemis Capital Mangement.

Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation. The global fleet is tethered by chains of trade and investment so if one ship veers perilously off course it pulls the others with it. Our only salvation is to hoist our economic sails and harness the winds of innovation and productivity. It is said that de-leveraging is a perilous journey and beneath these dark waters are many a sunken economy of lore. Print too little money and we cascade off the waterfall like the Great Depression of the 1930s… print too much and we burn like the Weimar Republic Germany in the 1920s… fail to harness the trade winds and we sink like Japan in the 1990s. On cold nights when the moon is full you can watch these ghost ships making their journey back to hell… they appear to warn us that our resolution to avoid one fate may damn us to the other.

Volatility at World’s End symbolizes a new paradigm for pricing risk that emerged after the 2008 financial crash and is related to our collective fear of deflation. The metaphor encapsulates the unyielding sense of dread that the global economy will plunge into the dark abyss and is the source of major changes in volatility markets. Today the existential fear of world’s end deflation is so powerful investors are willing to pay the highest prices for portfolio insurance in nearly two decades. The market for forward volatility has become unhinged as the SPX variance and VIX futures curves sustain historically high premiums over low spot vol. My argument is not that this extreme fear is misplaced but that it is mispriced. Like Odysseus in the epic poem the global economy is trapped between the monsters of Scylla and Charybdis. We risk one to avoid the other. From one world’s end to the next sometimes I wonder if decades from now we will look back with the hindsight that we were all hedging the wrong tail.


The calm in volatility markets (realized and implied) since implementation of the recent wave of global stimulus has been nothing short of incredible. The microstructure of daily VIX movement (defined as minute-by-minute vol-of-vol annualized) has fallen dramatically since implementation of the ECB’s LTRO program. Volatility-of-volatility microstructure is now calmer than at any point over the past six years of data. The VIX index registered the lowest intra-day movement in history on January 11 with a daily high-low range of only 1.14%. The S&P 500 index has gained or lost only 0.46% a day in 2012 compared to 1.04% in 2011 representing the biggest reduction in eight decades going back to 1934 (shortly after Roosevelt devalued the dollar to end the Great Depression)(4). The low realized VOV has been countered by extreme levels of implied VOV reflected in VIX futures and options driven by large vega inflows from retail VIX ETN participation (more on page 16).


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