The Hidden Risk of Unknown in Financial MarketsVincenzo Riflesso
Risk Specialist
SUMMARY
• THE UNKNOWN UNKNOWNS
• THE CONVEXITY FRAMEWORK
• THE GLOBAL SHORT VOLATILITY STRADDLE
• 1937-2019 : WHY 1937 STOCK MARKET CRASH MATTERS TODAY?
UNKNOWN UNKNOWNS
UNKNOWN UNKNOWNS
The Relativity
of Knowledge
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This Room(Scale 1)
The World(Scale 10)
The Universe(Scale 1000)
Audience
Me
Tony
Albert Einstein
CONVEXITY
Most of the Financial Institutions in the World run a short convexity position: the distingue is between light shortand heavy short convexity. The phenomenon has been amplified in the last 7 years by Central Banks that artificiallycreated incentives for Investors to double down on any venture that is negatively exposed to change.
A Short Convexity choice derives small incremental gains on the assumption of stability in exchange for the risk ofsubstantial loss in the event of change. A Long Convexity choice is the opposite, requiring a small upfront cost, inexchange for robust and significant positive exposure to change. Many Investments and Life choices reflect on formor the other
Source: Volatility and the Allegory of the Prisoner’s Dilemma – Artemis Capital
CONVEXITY AND HEDGEHOGS
Convexity is more than a financial concept and represents a construct for life. We are short convexity in oureveryday lives without being conscious of it and rationalize our exposure through cognitive dissonance. For exampleconsumer debt and taking a job for salary rather than for growth are both examples of short convexity behavior. Fewindividuals pursue a course of long volatility that requires upfront cost or conflict in the short term for positive andnot-linear exposure to change. We are long convexity when we seek to improve ourselves through self-study,exercise, healthy eating, networking, surrounding ourselves with those who are smarter than us. As an Institutiongets increasingly larger and more complex it becomes more sensitive to change and falls into a short convexity trap.Small is beautiful because it is adaptable and defensive. This is one reason why hedgehogs, which have ancestorsback 80 million years, managed to outlive dinosaurs.
The human psyche has difficulties to comprehend nonlinearity and convexity. While few people can evencomprehend convexity exposure, what is even less transparent is the HIDDEN CONVEXITY that exists in the waycomplex systems self-organize. We call it SHADOW CONVEXITY and it is much harder to understand and measure. Inlife shadow convexity exists when fragility or robustness is incentivized to such a degree that it becomesunknowingly institutionalized within a system of interactions.
Source: Volatility and the Allegory of the Prisoner’s Dilemma – Artemis Capital
FIRST AND SECOND ORDER EFFECT
A first order move is a change in position that is probable, standard, and easily predictable.Higher order movements are non-linear shifts in a position that are rare and not easily conceived.
Success in Life and Investing is often about sacrificing first order effects (linear) for the power of higher order effects(non-linear). Name a single billionaire entrepreneur that didn’t sacrifice a safe and linear salary to achieve untoldwealth. Name a single long-lasting marriage where sacrifice didn’t precede higher order trust and love.
From the begin of time early humans were hard wired to search for predictable patterns and to identify consistentfirst order cause and effect to support survival. To our ancestors, losing a day of food, or mistaking a predator for arock, could spell death. We developed a strong linear perception skills and we didn’t develop non-linear patternsrecognition.
For this reason we should start to “UNLEARN WHAT YOU HAVE LEARNED…”
GEORGE LUCAS THE LONG CONVEXITY TRADE
In 1976, 33-year old George Lucas was negotiating the fees for directing and writing an ambitious new movie. Lucasdid something that seemed highly irrational at the time. Although the market for his directing and writing servicewas between $500K and $1 Million, Lucas accepted a much lower upfront fee of $150K (30%). In exchange, hewould retain all merchandising, licensing, and sequel rights to this new film.
Fox Studios was more than happy to relinquish these higher order rights for a lower upfront salary because theexecutives had painful memories writing down $200 million in unsold toy inventory on the failed 1967 release ofDoctor Dolittle.
The common knowledge at the time was that merchandising tie-ins for wide release films were a failed concept, andthe studio thought Lucas was either too young or brash to know it. Lucas perceived his new film as a franchise fromthe start and saw massive value in retaining legal and creative control of the property.
Source: Star Wars Convexity – Artemis Capital
MORGAN STANLEY THE SHORT CONVEXITY TRADE
Howie Hubler is an American former Morgan Stanley bond trader who is best known for his role in the secondlargest trading loss in history. He made a successful short trade in risky subprime mortgages in the U.S., but to fundhis trade he sold insurance on AAA-rated mortgages that market analysts considered less risky, but also turned outto be worthless, resulting in a massive net loss on his trades. His actions directly resulted in the loss of roughly $9billion during 2008-08 financial crisis.
The trade worked in this way: Hubler bought $2 billion in CDS on extremely risky mortgages. To finance theoperations he sold $16 billion in AAA-rated CDOs (Collateralized Debt Obligations). Because of the opaque nature ofthe CDOs on which they were selling CDS, Hubler and his group did not realize that the CDOs they were insuringcontained similarly risky subprime mortgages to the bonds they were shorting. In other words it committed a bigmistake in value the correlation between the 2 categories assets.
More important for us it’s the perception of the events in building the trade: in order to avoid to pay the short-termprice, he sold fat tails events leveraging his bet, so he didn’t consider the non-linear effect coming from a higherorder event, that at the end happened.
TOP 10 TRADING LOSSES
Short Vega and Long Convexity
Long Volatility Hedge Funds havehistorically generated positive alpha andpositive exposure to regime change byselling first order movements to financeexposure to higher order movements.
Source: Star Wars Convexity – Artemis Capital
CONVEXITY AND SHADOW GREEKS
Where is Convexity
Source: Star Wars Convexity – Artemis Capital
The Financial Market today
THE GLOBAL SHORT VOLATILITYTRADE
Source: Volatility and the Alchemy of Risk – Artemis Capital
THE BUYBACK GROWTH
CAPITAL SPENDING AND BORROWING
EPS AND BUYBACK
Correlation between Bonds
and Equity Yields
Source: Volatility and the Alchemy of Risk – Artemis Capital
The Central Bank Put
CENTRAL BANK EFFECT
VOLATILITY AS AN ASSET
CLASS
Short Volatility ETP
Leverage Volatility ETP
1937-2019: A new Market Crash?
Reason 1: Business Cycle
Reason 2: Inequality and Raise of Populism
Reason 3: Late Stages of the Long-Term Debt Cycle
Reason 4: A Rising Power
Gold Reserves are increasing