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Volatility at World's End: Deflation, Hyperinflation and the Alchemy of Risk


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for you option geeks out there, this could have been written by bill gross if his gig were options instead of bonds. there's some interesting philosophical points raised:


<<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....

Today traders are irrationally exuberant for fear.




The VIX futures curve (a rough proxy for SPX forward volatility markets) has become unhinged breaking new boundaries in the price of fear. The cynicism of retail investors burned by a decade of phony bull-markets is driving the popularity of VIX exchange traded notes and introducing retail demand for vega on the front of the term structure. The largely retail buyer base of VIX ETNs seems to follow a one-dimensional playbook for purchasing vol based on anchoring biases with little regard for the intricacies of the asset class (e.g. "buy VXX when the VIX is low"). Farther out on the curve institutional investors are driving up the price of forward volatility by purchasing tail risk insurance even as investment banks have pulled back the supply of short vega due to reduced demand for structured products. Below is visual breakdown of different regimes in VIX futures and options from 2004 to 2012. The steepening of the VIX futures curve and higher volatility-of-volatility ("VOV") skew for VIX options demonstrates the rise of investor fear in the post-crash environment. VIX skew measures the volatility-of-volatility (VOV on y-axis) investors are willing to pay per given level of spot-VIX (on x-axis). The steeper the VIX skew the more premium it costs to hedge against a crash using VIX options. The chart that looks like it was drawn by a first grader (bottom left) shows raw VIX skew data and is hard to interpret. The chart to the bottom right uses a smoothing technique to show the rise in fear and sharply steeper VIX skews whether volatility is at 14 or 40...

There is no historical precedent to understand how modern derivatives market would perform in the hell of destructive inflation. Weimar Republic Germany did not have a market for options, CDS, or variance swaps for us to study. For me it is valuable to theorize how that reality may unfold in volatility markets and to do so we need to think creatively.




In hyperinflation everything we think we know about volatility will be backwards... literally it will be like watching options markets through the mirror. The traditional rule is that volatility will spike when the market crashes and vice versa. This is a rule of markets but not a law. In reality volatility is only a statistic indifferent to the direction of price movement. Volatility increases when an asset declines only because prices fall faster than they rise (the old adage that markets take the stairs up and the elevator down). To illustrate this concept the graphic below shows the 1-month realized volatility of the S&P 500 index deconstructed according to the percentage of variance derived from increases or decreases in the index price. On average 54% of SPX 1-month volatility comes from increases in stock prices but during crashes downside movements may comprise up to 99% of variance (thus far in 2012 increases in the SPX contributed between 80-90% of variance). The market for implied volatility anticipates the fat downside tails associated with market crashes. Since 1987 out-of-the-money put options have traded at a higher volatility level than out-of-the-money call options, a phenomenon otherwise known as negative volatility skew. The VIX index moves up and down the SPX volatility skew on the assumption that higher local volatility will result from a decline in the underlying index (see charts). The negative skew for SPX options became even more pronounced after the 2008 crash as tail risk hedging became fashionable. The problem is that this volatility paradigm, entirely valid in today's deflation fearing market, is completely wrong in a world where prices rise faster than they fall... like in hyperinflation...







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