A recent paper by the Variant Perception group provides a fascinating historical perspective on currency breakups and devaluations in addition to a review of the current Eurozone situation. By their count 69 countries have exited currency areas in the last 100 years and rather than catastrophe the overwhelming result was that they were much better off just a few years after the transition.

By reviewing the historical patterns the writers came up with a typical recipe for an exit:

1. Over a weekend / bank holiday declare that there is a new currency in force in the country. All accounts held in the country are converted to the new currency, typically at a 1:1 ratio. For example,  if Spain used this approach all Euro holdings in the country would be converted over to new Pesetas.
2. The government defaults on its debt or unilaterally redenominates all of its debt in the new currency.
3. Paper currency is stamped to indicate that it is legal tender in the new currency.  As soon as possible new bank notes are printed and the old notes are no longer accepted
4. Currency controls are put in place to restrict the flow of capital outside the country.

These changes have immediate effects:

1. The exchange rate between the new currency and the old drops to a value that significantly devalues the new currency
2. Companies with large debts outside the country take huge losses that often bankrupt them unless they get support from the government
3. Export oriented companies get an almost immediate boost as the local currently devalues / inflates—making their products more competitive.
4. Freed from external monetary constraints, governments can boost stimulus spending, bootstrapping their economies—and further devalue their new currency.
5. Foreign Banks that hold large amounts of the country’s debt take massive losses.
6. Savers that haven’t managed to get their currency based assets out of the country suffer an immediate loss in buying power compared to stable currencies.

The dissolution of the USSR and the breakup of Czechoslovakia in the early 1990s were fairly recent currency transitions, but they predate the highly interconnected financial networks of today.  The software impact of switching from the Euro to a local currency is probably daunting, but software is not a fundamental barrier. Since surprise is an important part of a currency transition it seems very unlikely that updated software would be ready when the change is announced.  Instead, networks would probably be shutdown to prevent electronic funds transfer and functionality restored a piece at a time.

From an investment standpoint the dissolution of the Euro reminds me of the USA mortgage bubble.  It seemed pretty obvious that it was unsustainable, but timing the bust was difficult.  Many people were years early with their moves.

It’s a no-brainer that Eurozone companies should hedge their exposure to a Euro breakup. The Variant Perception paper suggests that companies in the weaker countries are already shifting their deposits to safe countries like Germany. Shifting debt from foreign countries to local holders might be tough, but hedging that debt against a big move like a currency exit might not be too expensive.

It’s just a matter of time before the Eurozone governments admit they have created a monster that needs to be at least partially dismantled. The quick economic recoveries that followed recent defaults and devaluations (e.g., Asia 1997, Russia 1998, Argentina 2002) show that currency exits provide a fresh start—not the catastrophes that some predict.

It’s time to cook up some new currencies.

A few comments about the current contents of the Volatility Landscape. It’s located on the sidebar, under the custom search dialog.

• TVIX is still struggling with a persistent premium to its NAV value, which is often as high as 10%.  ProShares’ UVXY is an equivalent ETF product that closely tracks its NAV.

• On the news front CBOE announced that it plans to offer futures on variance swaps.  This white paper provides a nice tutorial on the differences between volatility and variance contracts.

• Also in the news Barclays’ announced that they will be offering two volatility ETNs to be listed on the Canadian Stock exchange.   These are essentially the US listed VXX and XVZ ETN with a US dollar to Canadian dollar currency hedge thrown in.   Unfortunately Barclays is listing the VXX equivalent with the ticker symbol of “VIX”, which I’m sure will go a long ways towards educating the Canadian investors that this ETN does not in fact track the CBOE’s VIX index, instead tracking a rolling index of  short term VIX futures…

• On the predictions front, I predict that TVIX and VXX will do reverse splits in the next couple of months.    I suppose it’s possible that TVIX will be allowed to sink well into single digits if its share creation issues are not resolved, but I doubt Barclays will allow VXX to trade in the single digits for long.  The VXX prospectus calls out a 4:1 reverse split, so look for VXX back in the forties.

• Currently I think people should avoid XXV and TVIX.  The problem with TVIX is its share creation problem.  See the links in the Volatility Landscape for more details.

• I would like to see options offered on both XIV and VQT.   With ProShare’s SVXY now having options there is at least an inverse volatility solution, but XIV has superior spreads and liquidity. With a market cap of over $300 million it seems like VQT is long overdue for optionability.  What’s the problem here?

• The first white paper is an extensive discussion on volatility ETNs and VIX futures from the University of Reading.  They cover the existing constant maturity funds, the dynamic funds like XVZ, and propose a class of funds that dynamically switches investments in the dynamic funds—where will it end?   The next two, which I highly recommend are from Artemis Capital Management.  The video on 20 years of volatility is very interesting.  The lower stair step is the SPX, and the wave like curtain above it is the VIX, including its term structure.

Below investment grade bond funds like SPDR’s JNK or iShares HYG are yielding in the 7% range.   The interest rate risk of these “junk” bond ETFs is less than investment grade instruments because their yield is dominated by default risk rather than prevailing interest rates.   If interest rates on highly rated bonds climb due to improved macro economics the non-investment grade yields stay relatively stable because corporate defaults decline during good economic times.

The prices of high yield ETFs tend to follow the general equity market because stocks prices are well correlated with the risks of corporations defaulting on their debt.  The chart below shows the performance of $1000 invested in SPY (S&P 500) and JNK over the last few years.

SPY vs JNK including dividends

During the 2008/2009 crash JNK bottomed out with a  38% decline.   SPY declined 51%.

Volatility based tail risk funds like Barclays’ XVZ provide a way protect the principal of high yield bonds against severe market declines without giving up their interest rate advantages.  For more information on XVZ see under the hood and backtest to 2004. The chart below shows the performance of $1000 invested in SPY, XVZ, JNK, and a hedged investment where 28%  is put in XVZ and the rest in JNK.

High Yield Backtest

The respective compound annual growth numbers including dividends for this 4 year period were 2.6% (SPY), 28.5% (XVZ), 6.5% (JNK) , and 15.7% for the hedged approach.

You might ask, why not just put it all in XVZ?  It had the best overall return, but the drawdowns (peak to trough) of 16% and 25% during the backtest time period would be hard for me to live with.    The hedged portfolio on the other hand never dropped substantively below the starting level and its worst case drawdown was 9.2%.    In the simulation I rebalanced the XVZ / JNK position quarterly and invested any accumulated dividends.

Risk factors include the fact that XVZ has only been trading since August of 2011, so its demonstrated track record is short.   The high yield bond funds themselves are highly diversified, with JNK currently holding 227 different investments and HYG holding 504, but there are concerns that their current surge in popularity ($12 billion in inflows in the last 6 months), will result in increased risk and potential liquidity problems.  That’s something I will be monitoring, but currently the overall sub-investment grade bond market is around $1 trillion, so the all the high yield ETFs together comprise less than 2% of that.

First about the money, SPX/SPXpms are:

• 10X the size of SPY options,  reducing commission costs if you are trading positions of that size.  Their price is roughly 10X the equivalent SPY option.
• Considered taxable as section 1256 contracts—generally 60% of your gains are treated as long term, regardless of how long you hold them
• Cash settled so there is no need to close out a trade just to eliminate the risk of an option being exercised

SPX/SPXpms reduce aggravation because:

• They eliminate pin risk, and any other scenarios where you end up long or short securities when your options expire in the money
• They can only be exercised at expiration (European style), so there is no risk of early assignment unbalancing a spread position.   You don’t have worry about ex-dividend dates.
• For SPXpm options there are no delays in settlement—the opening price of SPX can sometimes be delayed because of order imbalances, the market close is inherently more orderly.

I’ve traded SPX/SPXpm options for a while now, and there’ve been a few surprises, some good, some bad.

•  There are four flavors of SPX options:

  * The standard AM settled options that expire on the morning of the third Friday of the  month (SPX).  These are floor traded and usually have wide spreads bid/ask spreads.

  * Three PM settled flavors: the Weeklies (SPXW), the Quarterlys (SPXQ), and the PM version of the SPX (SPXPM)  that settles the day after the monthly options.  The first two show up under the SPX symbol in option chains, the SPXPM options show up in their own chain.   I’m assuming the Quarterlies will trump the Weeklys and the PMs if they all fall in the same week.Could the CBOE have made this more confusing?

• If you want Friday PM settlement on the traditional monthly expiration week you must use the SPXPM symbol, for the other weeks use SPX.  User beware.
• Fidelity’s Active Trader Pro does not support cash settled index option spreads for IRAs—there is no good reason.  I suspect it is a software thing.
• The minimum increment on prices, even spreads is $0.10
• Close to the money strikes are offered at 5 point intervals (e.g., 1395 / 1405),the equivalent on SPY options would be 139.5 / 140.5—not available .   These 5 point intervals enable tighter credit / debit spreads and better resolution in placing positions.
• While the bid / ask spreads on AM settled SPX options are always huge, the PM settled options are much better. For SPX options a  limit order halfway between the bid and ask will usually fill.  Never use a market order—you are leaving money on the table.

This is not good.

If things were working well, authorized participants (APs) would be able to short TVIX, walk over to Credit Suisse’s doorstep, purchase TVIX shares at the IV price to cover their short, and pocket a cool $1.18 per share with no risk. They would if they could.

So where is the problem?   Are there no shares available to short?   I doubt it, although I think TVIX shares were exceeding hard to borrow right before Credit Suisse made their limited creation announcement March 22nd.

I suspect the problem is on the share creation side.  Credit Suisse can require the APs to supply swaps instead of cash as part of the share creation process—likely with challenging conditions.   In their press release Credit Suisse takes carte blanche in their ability to specify the deliverables:

“..will be on terms acceptable to Credit Suisse, including the counterparty meeting Credit Suisse’s creditworthiness requirements, margin requirements, minimum size and duration requirements and such other terms as Credit Suisse deems appropriate in its sole discretion.”

If these terms are onerous enough to create a significant premium on the appropriate swaps then TVIX’s price behavior starts to make sense.  The chart below shows the recent relationship between TVIX’s market price and its indicative value.

TVIX Premium at Close

If expensive swaps are the problem this chart suggests TVIX’s premium will top out in the 5% to 10% range when TVIX is flat or declining.   If volatility is climbing then the premium will drop, and never go very far negative because the share redemption process is still working well.  Credit Suisse is happy to give the APs cash at the IV price in exchange for TVIX shares…

Open Interest and Volume on Short Term VIX futures

The data doesn’t look as dramatic if we change the vertical axis to a logarithmic scale—a scale that makes it easier to see if the rate of growth is changing.  The chart below shows the short term VIX futures growth in open interest from the beginning of trading in 2004 compared to the VIX index.

Open Interest using logarithmic scale

The open interest has doubled pretty consistently every year and a half since inception, and doesn’t show any signs of slowing down.  In the early years institutions drove growth, but the current growth in VIX futures is dominated by the volatility ETFs.  The largest, Barclays’ VXX with $1.8 billion in assets under management, only needs to grow another 15% to become one of  the top 100 biggest ETFs.

What will happen as the demand for volatility increases?

When demand for a physical commodity like gold increases the price goes up.   The increased price helps satisfy that demand in two ways: current owners sell their holding to take their profits, and producers are motivated to obtain/make more of it.  If the price increases enough previously uneconomic sources (e.g., lower grade ores) might become profitable.  On the other hand, increased production might strain the ability of suppliers to provide required materials and create supply disruptions and price increases in other areas.

Even though volatility can’t be eaten, alloyed, burned, or worn the same thing happens when demand goes up.  The price increases, some holders sell, and producers (futures market makers in this case) make more of it.  In some cases historic price relationships might start changing.

Volatility comes in lots of flavors and timeframes—for example, historical, intra-day, projected, and implied, but no one had figured out how to buy or sell it until the CBOE created the VIX index in 1993, and tweaked it specifically so that it was suitable for the futures market in 2003.   The key to creating this market was the ability of market makers to sell futures tied to the VIX index and cost effectively hedge their positions with S&P 500 (SPX) options.

The VIX index is an ongoing estimate of volatility 30 days from now derived from SPX option implied volatilities.  It’s not without its warts.  It does a crappy job of estimating big volatility changes even a day or two in advance and it has Friday/Monday distortions that have nothing to do with volatility 30 days out.  The VIX futures market ignores the VIX’s dumber quirks, and forms its own opinions about what the future holds.

VIX futures are only guaranteed to synchronize with the VIX index on the day they expire.  The rest of the time the prices for volatility futures shift according to the laws of supply and demand and often do not track the VIX.     During panics, near month futures prices have traded $23 below the VIX and during calm times $4 above it.  The longer dated futures diverge even more from the daily VIX index values depending on market expectations.

Talking about the “right” price for volatility is like talking about the right price of gold or gasoline—ultimately it only matters what the market says.

There is some evidence that the increased demand for volatility futures is changing historic price relationships across the various markets—even during this quiet phase of the market.   Volatility is still tiny compared to the overall market (less than $5 billion vs.  the $12 trillion market cap of the S&P 500 ), but we can’t ignore the possibility that volatility might have a very high leverage effect on the market.  It only takes one person yelling “fire” to panic a crowd.

VIX futures are highly interconnected with the S&P 500.  In times of panic will increased demand for VIX futures dampen volatility swings, or will it feed the flames of fear?

Our intuition tends to support the later, but I think the reality is that demand for VIX futures has a neutral impact on S&P 500’s prices.  Below I trace a nominal chain of events that occur when a VIX future is purchased:

1. Someone buys a VIX future contract
2. The futures market maker that sold the contract is now short volatility.  Market makers usually don’t want to take a directional position, so unless there is an offsetting trade they will hedge themselves by taking a long volatility position, buying the appropriate set of SPX options and hedging the delta with SPX futures (I missed the SPX futures part of this in the first version of this post)
3. The option market makers that sold the options are now short delta–among other things.  They hedge their delta exposure by buying the appropriate number of SPX futures.
4. Since the VIX futures market makers and the SPX options makers are both delta hedging the same set of options (on different sides of the trade)  the net of their actions on the SPX futures market  should cancel each other out.
5. So, for  at least for a first level of approximation the creation of VIX futures contracts should have a neutral impact on S&P 500 prices.

What the market maker actually does is dependent on their inventory, and they have alternate ways of hedging, but I don’t think any of the alternative approaches would change the ultimate effect on S&P 500 prices.

My analysis indicates that as the VIX futures market grows it will  have a neutral influence on the overall volatility of the market.

A final observation.   People commenting on the growth of the VIX futures market often note that the current surge in demand has occured during a relatively quiet market.  If volatility goes up additional demands due to required rebalancing for inverse and leveraged funds could spur additional contract purchases.  These demands are proportional to the assets under management, which should roughly track the open interest on volatility contracts.

The chart below shows the open interest on the short term VIX futures compared to the VIX index and SPX (it uses the non-logarithmic scale on the right).  The dashed vertical lines mark the major volatility peaks of the last 4 years.

Short Term VIX Futures Open Interest vs. SPX

Besides the spooky correlation between the log futures open interest and SPX, the other thing to note is that the future’s open interest stayed flat or dropped during these market crashes/corrections.  The inverse and leveraged volatility funds were not a factor before 2011, but during the 2011 correction XIV and TVIX were running combined daily volumes in the tens of millions so the last correction included some contributions from them.

This data shows that historically the demand for VIX futures does not spike with the VIX, but rather the spike marks the beginning of decline in the short term demand for futures.

As the VIX futures market grows I expect we will see disruption of some historical price relationships, but I think the answer to the big question—will they crash the market, is no.

VQT Backtest to 2004

VQT makes the S&P 500 index look pretty anemic.

I was surprised at the number of “stop loss” events, where VQT is moved into cash if the index (SPVQDER:IND) falls two percent or more.   There were a hundred days where this would have happened in the March 2004 to March 2012 timeframe.

VQT Backtest showing days in cash

VQT prospectus

As you can see below it didn’t take a lot of new shares to pull TVIX back close to its indicative value.

TVIX Fund Flows

About $40 million in cash added 6 million TVIX shares to the market—bringing the total outstanding to 46.7 million. The chart was created by IndexUnverse’s Fund Flows Tool.

March 26th’s open interest on first and second month VIX futures contracts was 195K. With VIX at 15, these contacts total around $2.9 billion in value—it took 1.4% of that to resync TVIX.

Thursday that problem departed—in a very ungraceful fashion.  Apparently the word got out early, because by Thursday evening when Credit Suisse announced reopening of share creation on a limited basis, TVIX had plunged 29% to $10.2

It’s tough to keep a quarter billion dollar secret.

TVIX was trading at $9.00 in the Thursday after-market—still 15% away from its closing indicative value of $7.83.  Most if not all of that difference will go away Friday.

There was a lot of finger pointing going on Thursday, but what surprised me the most was the level of ignorance displayed by some of the general media (e.g., CNBC, Forbes).  I don’t expect them to be experts on this corner of esoterica, but I do expect them to know that they didn’t understand this field and take the time to consult an expert.   It’s not like Bill Luby is an unknown personality in the volatility arena.

Regarding Credit Suisse’s reopening, the first step, starting as soon as Friday, March 23rd will be to make TVIX shares available for lending—this will enable short sellers to drive down any remaining premium of  TVIX over its IV.

As early as the 28th, share creation may resume, but Credit Suisse can require market makers to sell them specified hedging instruments as part of the transaction.    This takes them close to the Exchange Traded Fund (ETF) model, where this is the standard process (e.g., UVXY).    TVIX is an Exchange Traded Note (ETN), which normally does share creation on a cash basis, but adding this requirement allows Credit Suisse to at least partially protect themselves if the underlying hedges (e.g.. VIX futures, variance swaps) get pricey.

To exactly hedge these VIX future based volatility funds all ETN and ETF providers (complete list) would need to roll their mix of futures on a daily basis.    In addition most leveraged and inverse funds, with the exception of Barclays‘ products,  may need to rebalance their hedges as often as daily to setup for their daily percentage performance goal.   In volatile times, for a ETN of TVIX’s size,  this rebalancing can involve buying or selling hundreds of millions dollars worth of hedging instruments (example).   They can’t put the market makers on the hook for that, but if the market makers can get the hedging instruments at reasonable prices, Credit Suisse should be able to also.

In the interests of accuracy I should point out that neither the volatility ETNs or ETFs are obligated to do their daily rolls or rebalancing in a certain way, or at all, based on what they say in their SEC documents.  It is up to them how they manage this, and they aren’t obligated to reveal their hedging or risk management processes.

The Credit Suisse press release is silent regarding the “internal limits” that caused this mess in the first place.  I’m assuming they won’t pull the plug again just based on fund size.  Their additional restrictions give them an objective way to halt share creations if hedging costs go out of line, and an ever present possibility of creation resuming should help keep the share price close to the indicative value.

Volatility as an asset class is showing some growing pains.   People have flipped out because the futures rolling/hedging needs of the volatility ETN / ETFs now dominate the VIX futures market, and a lot of people have learned the hard way that a gap between the market value of an ETF / ETN and the indicative value can vaporize in an instant.  But it doesn’t look like growth has changed the underlying structure of the market—the volatility marketplace does not show any objective signs of distortion.  Sure the VIX futures term structure is in major contango, but most people feel the market is overdue for a correction, so that is not surprising.

Feel free to place your bets if you think those are distorted prices.

However for the buy and hold investor there isn’t a lot to celebrate.  We are still 16% below the S&P 500′s 2007 peak.  Not including dividends a January 1, 2007 investment in SPY, an ETF that tracks the S&P 500 would still be down 0.7%.  Adding dividends improves the return to +10%, but that’s only a 1.6% annual growth rate—certainly not enough to keep up with inflation.

S&P 500 1998 - 2012

After the 56% decline from the S&P 500’s peak in 2007 the market had to climb 131% from the bottom to break even—depressing.  Some advisors counsel patience saying that the value of the companies in the S&P 500 didn’t really go down by that much, so it’s not so daunting to get that much growth.

But others argue that the market has fundamentally changed with this go no-where cyclical pattern that started in 2000. The ferocity of the 2008/2009 crash unnerved everyone.   The 50% drop during the 2000 tech crash took two years to grind out, but this time around it only took 9 months to plunge the same percentage.   This was excruciating for many people.  Quite a few people I know bailed out of the market in the months before the March 2009 bottom.    A Merrill Lynch broker I spoke with said 5% of his clients capitulated during that period, and I suspect that was a good track record.

Why has the market become more volatile?   Some analysts rate the 2008/2009 financial crisis as a once in a lifetime event.  Others believe that higher volatility will be the new normal.  The more volatile crowd asserts:

• The world has become much more interconnected.  International markets now track within milliseconds.
• ETFs have transformed traditionally illiquid or hard to access asset classes (e.g., commodities, bonds) into stock-like instruments that are much easier to buy and sell.
• Sovereign debt, including US Treasuries have become return-less risk.  At current prices/yields they aren’t attractive for diversifying a portfolio.
• Heavy volumes in futures trading (e.g., S&P E-minis) and ETFs (e.g, SPY,IWM, QQQ) are increasingly driving the prices of the stocks that comprise them, not the other way around.

The likely effect of these changes is to increase the correlation of the markets—everything moving in unison.  And when correlation increases, volatility increases too.  Asset classes that used to move independently, or in opposition to each, now reinforce. Unfortunately we can’t prove who’s right about volatility—the world won’t hold still while we run experiments. However there’s one trend that strongly supports the increased correlation theory—a statistic called implied correlation.

The CBOE has an index that tracks the implied correlation of the S&P 500.  It evaluates the market’s volatility expectation for 50 individual stocks compared to the expected volatility of the overall index. The implied correlation will be high if the expected volatilities of the subset are similar to the expectation for the index.

Differing expectations between the subset and the index result in a low implied correlation.  For example, if most of the individual stocks (e.g., Exxon) are expected to be quiet and the overall index is expected to be volatile then the overall implied correlation is low.  The index uses the implied volatility (IV) of options on the various securities compared to IVs on the index itself to make this calculation.  The chart below shows the CBOE’s implied correlation over the last 5 years.

Clearly the options market is expecting correlation to increase.

If  the market continues to be volatile we’ll have the following issues:

• Many people won’t invest.  The market (and the media) will scare them away
• Buy and hold investing will give poor results. Volatility is not conducive to compound growth.
• New ways of investing that profit from volatility, or at least mitigate its impact will need to be developed

At the recent IndexUniverse’s Inside ETFs Conference I had the opportunity to talk with Jim Lonergan, CEO of The Connors Group.  One of The Connors Group’s products is specifically targeted at the issues above—it’s called The Machine®.   Using 11 years of historical data, and backtested trading strategies, this software takes the emotion out of trading by objectively generating buy and sell signals for your portfolio.  The package supports a multitude of different trading strategies, many of which are designed to move the investor into cash during a market down-swing.  I’ve been using The Machine for two months, and I’ve been impressed.   The setup is straightforward, and it leads you step-by-step through the initial decisions you need to make:

• Define your asset allocations (e.g., percent in bonds, cash, gold, equities)
• Select your trading strategies (e.g., risk parameters, drawdown percentage, frequency of  trades)

Once you’ve made your choices the software automatically backtests your selections to simulate how your portfolio would have performed in the past.

Of course this is no guarantee of how things will go in the future, particularly since things like inter-security correlation is changing, but it’s a reasonable view of what to expect.  The screenshot below (click to magnify) shows my portfolio allocations and strategy selections.

Asset Allocation

Next are the simulated results.

Simulation Results

The backtested 10.50% compounded growth compared to the S&P500′s 3.55% is pretty impressive.

If you like your setups you can make the specified investments, and then follow the recommended buy and sell signals. The Machine has network linkages available to broker dealers including Lightspeed Trading LLC, OptionsXpress Institution, and TradeStation Securities if you want to automate this part of the process.

Looking at the backtest results, you can see that the real advantage in my portfolio was the downside protection. During the majority of the critical September 2008 through March 2009 period The Machine would have kept over 60% percent of my portfolio in cash.

Performance during 2008/2009 Crash

The remaining investments would have returned +38% (!) during the crash.

I don’t think automated trading will be the only viable approach to taming volatile markets in the future.  But I’m convinced we need new approaches to investing that take human subjectivity out of trading, and attack volatility head on, instead of trying to ignore it.

The market has changed.