Wednesday, February 7, 2018


Inside Wall Street's $8 Billion VIX Time Bomb (LINK)

The MacroVoices Podcast‏ discussion between Erik Townsend and Chris Cole that was released on January 25th (and related article and presentation) is a great overview of some of the things that have happened over the last few days (and the risks still inherent as a result of short-volatility trades) (Audio and Show Notes, Transcript)
Erik: There’s a lot of people that are very concerned just about the explicit part of this. The people that are essentially profiting from the contango and the VIX term structure by either the XIV ETF or similar strategy implemented by rolling forward short futures contracts. 
And a lot of people are very worried about the blowup of that trade. You know, I think the statistic is if the VIX doubles overnight that could completely wipe out the XIV ETF, or something like that. 
You’re saying that, really, that’s the least of our problems. So, aside from the Target manager who’s made a bunch of money by shorting the VIX, what is the full scope of what could go wrong here? And how would it likely go wrong? 
Would it start with, say, a change where the share buybacks dry up because the interest rates no longer support them? Or what do you think the catalyst might be? And what could the potential blowback be if this were to start to unwind in the other direction? 
Chris: There’s a lot to talk about on that topic. First of all, on the short VIX trade, I think it’s interesting, because now it’s become very popular to talk about that. I think if you go back and read Artemis’s research, dating back as far as 2014, we talked about how, really, just a 65% move in the VIX could be all that it would take to wipe out those products. We actually presented our numbers years ago on that. I think it’s become a very popular thing to talk about today. 
I think these short-vol products, these ETMs – you know, Artemis runs a hedge fund – the regulators are going to require you to be an accredited investor and pass all these tests to invest in a hedge fund that trades volatility in a risk-controlled and smart manner, and it’s largely going long-vol in an intelligent way. 
Meanwhile, anyone on the street can go out and buy a double-levered VIX ETN or a short-biased VIX ETN. So there’s a great irony to this. And I think that these products are a class-action lawsuit waiting to happen. It’s not a matter of “if” – it’s a matter of “when.”  
But, are they a systemic risk to the system? Not so much, compared to the larger short-volatility trade.
...Well, what common knowledge today will be proven wrong in the future? We only need to look into the past actually, empirically, to understand what that is going to be. It’s going to be the fact that stocks and bonds are anti-correlated with one another. 
In my entire life and trading career, and the trading career of almost anyone who is managing money today, stocks and bonds have experienced incredible anti-correlation. And when stocks  sell off, central banks ease and bonds perform. And risk parity funds have found ways to short that correlation in order to generate excess returns.
That’s all a risk parity strategy really is. A dispersion trading desk coupled with data exposure to the underlyings. It’s not that complex. The excess Alpha comes from a short correlation bet.
Well, the problem – and that has been a very good return in an environment where interest rates have dropped and dropped and dropped and dropped.
But what’s interesting is that, if you look at financial history – and I have a graph in “The Volatility and the Allegory of the Prisoner’s Dilemma,” which is a paper from 2015 and we talk about this at length – and also in the latest paper, “Volatility and the Alchemy of Risk” – if you look at the relationship between stocks and bonds over the past 120 years, they’ve actually spent more time correlative with one another than they’ve spent anti-correlative with one another.
What’s terrifying about this is that the entire modern asset management business is built on the short correlation trade of stocks and bonds. 

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