Fighting Greek Fire with Fire: Volatility, Correlation, and Truth

Note: The following article is an excerpt from the Third Quarter 2011 Letter to Investors from Artemis Capital Management LLC published on September 30, 2011.

In the new era of global interconnectedness liquidity alone is not enough to extinguish Europe's Greek Fire. and Truth The world economy is fighting a fearsome wildfire as the European sovereign debt crisis burns its way closer toward the tinderbox of a second global recession. charcoal) which. While public opposition grows to bail-out economics the Federal Reserve has very few credible stimulus options remaining to battle the inferno. Greek Fire in Europe threatens to ignite a global recession and if you haven't already noticed. The smoldering flames of default are spreading impervious to fiat money creation. bones. woman. All we left have to show for our three year liquidity orgy is the most correlated period in modern finance. We are trapped in a binary market governed by the flip of a macroeconomic coin with deflation on one side and government bail-outs on the other. The guardians of the formula were so afraid it would fall into enemy hands that its secrets were eventually lost to time(1). upon contact with water. For those who fought against Greek Fire a liquidity trap became a liquidity grave. In this sense the end-effect of fire is always correlation and volatility. Greek Fire. Global indices officially entered bear market territory with the MSCI All-Country World Index down more than -20% since peaking in May. CA 90401 (310) 496-4526 phone (310) 496-4527 fax www. If you heeded the omens of variance markets earlier this year you were richly rewarded by this increase in volatility.96. Whether this is Brazil unexpectedly cutting rates by 50 basis points despite the highest inflation in six years or Switzerland pegging the Franc to the Euro to protect exports it is every man. Greek Fire was so difficult to extinguish that it was known to continue to burn even underneath bodies of water. For this reason the ancient napalm was very effective in naval warfare and saved Constantinople from two Arab sieges. Suite 350 Santa Fighting Greek Fire with Fire: Volatility. The more global asset classes move in lockstep the more haphazardly the international response to the crisis has become. your alpha is burning. The common method to extinguish a wildfire is by dousing it with water but what if this is not enough? Is it possible for fire to resist or spread through the addition of liquidity? Ironically in recorded history there is one such type of c.cole@artemiscm.artemiscm. ignites spontaneously. In this hyper-correlated market many alpha generating strategies resemble directional volatility trades.artemiscm. Every day we see new kinks in the armor of prior economic and political alliances that lay vulnerable to surrender in a vicious selfreinforcing cycle of devaluation.volatility with volatility In markets and in life. The third quarter of 2011 was characterized by explosive movements in equity markets as the S&P 500 index declined -14% in the worst performance since the crash of (310) 496-4526 . A wildfire is blind and cruel in violently transforming the essence of any material to ash.. Fight fire with fire . to find truth www. including the sea. The composition of the weapon is an ancient secret but modern scientists believe it was made with calcium phosphide (heating lime. The insolvency inferno has no prejudice and will fuse to the flesh of any asset class fueling a blistering spiral of correlation and volatility. The unintended consequences of unprecedented intervention in markets are culminating in higher cross-asset correlations and violent price gyrations. and central bank for itself. The propensity for erratic movements in DJIA daily lagged returns is at the most extreme levels in over nine decades of recorded data.. There are no safe havens and to survive the flames of the next decade we must embrace and harness their nature. Over the quarter implied volatility increased +96% as the VIX index climbed to 42.Artemis Capital Management. LLC | Letter to Investors– Third Quarter 2011 Page 2 520 Broadway. The 10-year US Treasury yield reached the lowest level on record in September as credit markets braced for an economic slowdown. explode and spread uncontrollably. A currency war is raging as central banks alternate dousing sovereign insolvency flames with uncoordinated currency devaluation. Greek Fire was the most feared weapon of the Byzantine Empire because water alone was powerless against its flames.. Correlation. The fire could fuse to any surface.

Artemis Capital Management. This is improbable but within the realm of possibility so look for signs of contagion that would spark realized and implied volatility to break the rules of power laws all over again. If options existed during the Great Depression we would have seen multiple observations of 50+ implied volatility levels from 1928 to 1933 (based on realized volatility calculated from DJIA returns). lack of remaining stimulus options. hyper-correlations.Omens and Intuition In my last letter I spoke at length about the abnormally steep volatility term-structure arguing it represented structural imbalances in risk driven by the unintended consequences of monetary policy ("Is Volatility Broken: Normalcy Bias and Abnormal Variance" Q1 2011).53 reached on October 24. A retest of volatility extremes last seen in 2008 and 1987 would require an uncontrolled default on Greek debt (similar to Lehman 2008) in combination with some kind of structural shock (similar to the flash crash in 2010). Earlier this year it was clear the volatility markets were bracing for a correction following the end of QE2. You can use this market schizophrenia to your advantage by entering long volatility tail positions on both sides of the return distribution during the peaks and the valleys of the market 10-Aug-11 09-Jun-11 07-Apr-11 (310) 496-4526 04-Feb-11 03-Dec-10 04-Oct-10 03-Aug-10 02-Jun-10 31-Mar-10 28-Jan-10 24-Nov-09 24-Sep-09 24-Jul-09 22-May-… 23-Mar-09 20-Jan-09 14-Nov-08 16-Sep-08 16-Jul-08 VIX VIX Futures 251 201 151 101 51 1 VIX VXF1 VXF2 VXF3 VXF4 VXF5 VXF6 VXF7 . Look for tail risk hedges in assets that exhibit low implied volatility relative to realized and cheap skew to the upside and downside.70x 0. With this thesis in mind Artemis recommended shorting the long-end of the VIX futures curve where volatility of volatility ("VOV") was expensive and replacing that exposure with more sensitive volatility positions on the front of the curve where VOV was cheap. www. The consensus view is that volatility is mean reverting and when the VIX is above 40 and realized volatility is only at 30 the implied volatility premium is very expensive.10x 0. What happens from here is much more difficult to understand. Page 3 VIX Futures Curve (normalized by spot VIX / Jan 2011 to Sept 2011 1. Global markets are now hyper-correlated and therefore asset selection is less important.50x Jan-11 Feb-11 Mar-11 Apr-11 May-11 VXF7 VXF6 VXF5 VXF4 VXF3 VXF2 Jul-11 Aug-11 Sep-11 VXF1 Volatility of VIX Futures Curve (Vol of Vol) (2008 to Present) VIX Futures With this uncertainty in mind the best course of action is to play both tails of the probability distribution. 2011 at the height to the last crash. and structural fragility of markets there are enough catalysts for the VIX to break even higher in the next few months. Investors have a limited imagination regarding the potential for greater realized volatility. The strategy was extremely effective when equity markets collapsed and the VIX futures curve inverted while options skew flattened.artemiscm. Historical realized volatility data of the DJIA going back to 1929 shows volatility climbed to 2008 highs a total of six times in the past eighty years. During the Black Monday crash of 1987 the VIX index would most likely have recorded levels above 100! That blows away the intra-day high of 89.30x 1.50x 1. LLC | Letter to Investors– Third Quarter 2011 Thoughts on Volatility .90x 0.70x Vix Future / VIX spot 1. Nonetheless my intuition tells me that given the current Euro-crisis.

The volatility of M1.artemiscm. The volatility of the money supply has been climbing higher since the 1970s and the relationship between the volatility of M3 and M1 resembles an expanding sine wave or feedback loop (see chart). typically spikes before the onset of a recession because market participants transfer risk assets back into physical cash (see graphic). How can the EU provide unlimited liquidity to a stability fund backstopping most of southern Europe without threatening the sovereign credit of stronger member nations like France or Germany in the process? What happens if a member nation that serves as a pillar of that facility in calm markets is then forced to use it in times of market stress? In this self-feeding predicament excess liquidity during a contagion fuels further insolvency and is arguably the cause of. Europe is a perfect example of this paradox. reflect important turning points in the US economy.Volatility of M1 Source: M1. The evolution of cash volatility provides clues to the mystery of elevated global (310) 496-4526 2011 .M2 & M3 values from Shadow Government Statistics Volatility of M3 15 10 Difference Money Supply Volatility Difference Annual M3 Volatility. Therefore it takes vastly more liquidity today to rouse the shadow banking system but at the cost of higher potential for market dislocation. The ancient weapon of Greek Fire was deadly because its flames fused to the very liquidity used to fight it resulting in a larger blaze. In this sense. money is one of the only assets whereby volatility spikes occur in conjunction with high demand (US Treasury securities also come to mind). defined as physical currency in circulation and checking deposits. To this effect we have never experienced a spike in M1 volatility as large as what was recorded in August 2011 without an ensuing recession.M1 Volatility (annualized / 1971 to 2011) 5 0 -5 -10 -15 -20 -25 1972 1974 1976 1978 1979 1981 1983 1985 1986 1988 1990 1992 1993 1995 1997 1999 2000 2002 2004 2006 2007 2009 2011 Recession (Peak to Trough) Volatility of M3 . Page 4 35 30 Volatility of Money Supply (annualized / 1971 to 2011) Volatility of Money Supply 25 20 15 10 5 0 1971 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1995 1997 1999 2001 2003 2005 2007 2009 Recession (Peak to Trough) Volatility of M1 Volatility of M2 Source: M1. defined here as annualized monthly changes in M1 through M3. Money itself is not immune to the laws of supply and demand and we can measure its volatility. Extremes in the volatility of the money supply. market disequilibrium.Artemis Capital Management.M2 & M3 values from Shadow Government Statistics www. not the solution to. When the money supply is volatile the risk of a recession grows incrementally higher. This is indicative of the fact increasingly violent shifts in the M1 physical cash supply are not matched by higher volatility in the broader M3 measurement that estimates credit creation and animal spirits(2). LLC | Letter to Investors– Third Quarter 2011 Fire & Water / Volatility and Money From water comes life and from cash liquidity comes asset prices.

is more sensitive when the average correlations between the components of the index are greater.05 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Volatility of the Fire If volatility is the heat of the fire correlations are the winds stirring the flames.artemiscm. competitive currency devaluation.2005 to Present) 78 73 68 63 58 53 48 43 38 33 May-07 Implied Correlation of S&P 500 Index (12 month constant adjustement) May-08 May-09 May-10 May-11 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Feb-07 Feb-08 Feb-09 Feb-10 Feb-11 Nov-07 Nov-08 Nov-09 Nov-10 Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 120 100 80 Feb-05 Ranked 21 day Realized Correlations of 50 LargeCap Stocks in SPX (2005 to Present) Feb-06 Feb-09 Feb-10 Feb-11 Feb-07 Feb-08 0.35 to 0. and in the CBOE S&P 500 Implied Correlation Index.Correlation at 0.Correlation at 0.6 0. We have yet to fully comprehend the extent to which bail-out economics.4 0.9 0.3 0.35 0. Country ETFs.55 0. and unprecedented global monetary stimulus are contributing to what is now a decade long trend of higher correlation drift.15 0. The trend is troublesome for traditional portfolio management but presents opportunities for volatility as an asset class. such as the S&P 500. The implied volatility of an index.5 0.70 the volatility of that index should be 45% more sensitive. 85 S&P 500 .75 0.25 S&P 500 Sector Correlation 0.76) Bull Market Low (11/3/2006 . Therefore as correlations have drifted higher over the past decade so has the volatility of (310) 496-4526 2011 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sep-11 Apr-11 Nov-10 Jun-10 Jan-10 Aug-09 Mar-09 Oct-08 May-08 Dec-07 Jul-07 Feb-07 Sep-06 Apr-06 Nov-05 Jun-05 Jan-05 Aug-04 Mar-04 Oct-03 May-03 Dec-02 Jul-02 Feb-02 Sep-01 Apr-01 Nov-00 Jun-00 Jan-00 .21 day Rolling Correlation Index S&P 500 Index Implied Correlation 75 65 55 45 35 25 15 5 Oct-05 Realized Correlation of 50 Largest Cap S&P 500 stocks (1 month rolling.45 0.2 Country ETF Correlation 21 day Realized Correlation 60 40 20 0 -20 -40 -60 -80 1 101 201 301 401 9/7/2011 (Highest Correlation at 0.7 0. The volatility of the VIX index reached the highest level in history at the end of August (see graph) surpassing readings achieved during the 2008 financial crash and 2010 flash crash.Correlation in the Greek Fire It is not a secret that we are experiencing some of the highest cross-asset correlations in market history rending traditional portfolio diversification futile. For example.10) Ranking (Lowest to Highest) 501 601 701 801 901 1001 1101 1201 0. if average correlation of index components rises from 0.82) 2008 Crash High (11/13/2008 .65 0. To this effect volatility itself should be moving faster than ever before and it is. Look to capitalize on higher volatility of volatility potential through timely execution of long vega/convexity positions on the tails of the return distribution.8 0. S&P 500 sectors. LLC | Letter to Investors– Third Quarter 2011 Page 5 Assets to Ash .Artemis Capital Management. 270 21d Volatility of the VIX Index (2000 to Present) Volatility of the VIX index (% annualized) 220 170 120 70 20 www. For example in this quarter we recorded the highest realized correlation readings ever for the 50 largest S&P 500 index stocks.

hedge fund returns are becoming more correlated with one another (see graphic / HFRX indices).Artemis Capital Management.85 since September 2008 0. When this happens many classic hedge fund strategies 0.1 -0.7 In highly correlated markets the asset selection component is negated and alpha becomes 0. Jul-09 Jul-08 Jul-10 Jul-11 Apr-09 Apr-08 Apr-10 Apr-11 Jan-08 Jan-09 Jan-10 Jan-11 Oct-08 Oct-09 Oct-10 Volatility and the Carry Trade When Greek Fire fuses to the sea the water itself becomes an extension of the flames.9 100 10 0 120 Sep-11 Mar-11 Sep-10 Mar-10 Sep-09 Mar-09 Sep-08 Mar-08 Sep-07 Mar-07 Sep-06 Mar-06 Sep-05 Mar-05 Sep-04 Mar-04 Sep-03 Mar-03 Sep-02 Mar-02 Sep-01 Mar-01 Sep-00 Mar-00 Jul-11 Apr-11 Jan-11 Oct-10 Jul-10 Apr-10 Jan-10 Oct-09 Jul-09 Apr-09 Jan-09 Oct-08 Jul-08 Apr-08 Jan-08 Oct-07 Jul-07 Apr-07 Aug-11 Feb-11 Aug-10 Feb-10 Aug-09 Feb-09 Aug-08 Feb-08 Aug-07 Feb-07 Aug-06 Feb-06 Aug-05 Feb-05 Aug-04 Feb-04 Aug-03 www. 90 80 20 70 60 40 VIX (lhs) vs.3 -0. AUD.6 -0. CAD. Since 2008 the VIX index and the JPY/AUD cross has moved in near perfect lockstep (see below) recording a 0.5 0.4 0. In today's markets currency trading and volatility trading are being played on the same court with the same unpredictable referees.USD . like everything else. This could be one reason why many high profile 0.5 increasingly driven by rising and falling vol.9 (HFRX Equity Hedge. The common retail strategy of buying a stock on dips and selling on strength is literally part of the process for synthetic replication of a variance swap (rebalanced to one share every day). For example strategies that rely upon mean -0. and statistical arbitrage become akin to -0. The marriage of volatility and currency is a worrisome devlopment because it implies the equity risk premium is not about economic fundamentals but instead is a function of global central banks fueling leveraged carry trades. Relative Value.3 0. Remove the asset selection component entirely and you are effectively shorting volatility.2 -0.1 reversion such as traditional value investing.USD.CHF) 0. The trend is also noteceable in the correlation drift between the VIX index and a cross-section of "risk" currencies. The alpha derived from active 0. LLC | Letter to Investors– Third Quarter 2011 Everyone is a Volatility Trader Page 6 It is becoming harder and harder to make money Hedge Fund Strategies 1-month Correlations from money.5 -0. Furthermore the correlation drift between the VSTOXX (European equity volatility) and the Euro/USD is also at historical extremes.3 converge to simple synthetic volatility trades. To this effect the daily performance of equity volatility and currencies is increasingly indistuinguisable. NZD. We can best understand excessive correlation drift between equity vol and risk currencies as being driven by lower interest rates in developed economies that provide fuel to the carry trade fire.85 correlation. 2) volatility bias.2 JPY/AUD VIX index % 50 40 30 20 60 80 0 -0.3 shorting volatility.1 managers including Druckenmiller and Soros are quitting the business while they are still ahead of the curve.JPY.1 3-month Correlation VIX to Risk Currencies (AUD. Japanese Yen/Aussie Dollar(rhs) Correlation = 0. Event Driven / 2-day lag) management can be decomposed into two components 1) asset selection and.6 0 3-month Correlation VSTOXX to Euro/USD 0. 0. Likewise investment strategies that rely on trend following such as managed futures and global-macro are akin to going long volatility. pairs trading.artemiscm.4 -0. This is one reason (310) 496-4526 . EUR. I understand that some volatility traders hate currencies on the basis that you never know when central banks will change the rules of the game.7 -0.

05 -0. this coin flip test. If DJIA serial correlation drift is real is it possible that monetary expansion has artificially rewarded stock market mean reversion strategies (such as value investing and buying on dips) for the past 40 years? If this is true does today represent the beginning of the new era of trend following and volatility? Positive Serial 0.3 0. Modern derivative pricing theory is based on a conceptual idea that knowledge of past prices has no bearing on future returns (martingales).2 0. run over 100 years through 10.1 -0. On August 11th.4 0. Tails = -1%) <0 Negative Daily Correlation >0 Positive Daily Correlation Rolling Correlation Random Coin Flips Negative Serial -0.2 -0. 2011 we reached the lowest levels of serial correlation in the 82 year history of the DJIA almost exactly 40 years to the day that Nixon abandoned the gold standard. The excessive intra-day and day-to-day volatility is nauseating to professional and retail investors alike and multi-100 point swings in the DJIA are all too common.3 -0.artemiscm.2 Year 17 Year 25 Year 33 Year 41 Year 49 Year 57 Year 65 Year 73 www. 2) Positive serial correlation is associated with consecutive days of asset price movement in the same direction and rewards trend following models. After the "Nixon Shock" positive serial correlation in DJIA daily returns began a four decade decline. On a macro-level changes in the size and volatility of the money supply may be connected to a phenomenon called serial correlation drift.15 0. It only takes a casual observer of markets to see that the propensity for large-up days followed by large-down days seems particularly vicious in today's cycle.Artemis Capital Management.1 0 (310) 496-4526 Year 81 Year 1 Year 9 2007 2010 . There are two forms of serial correlation 1) Negative serial correlation measures the propensity for today's return to be the opposite of yesterday's and rewards reversion to the mean strategies. 0. We are going nowhere at the fastest pace in market history.05 0 (Heads = +1% . Despite this fact there is evidence that asset returns show signs of "serial correlation" whereby past returns are correlated (to some level) with future results.5 Page 7 Negative Serial Correlation Positive Serial Correlation Rolling 1yr Serial Correlation of daily lagged returns Dow Jones Industrial Average (1928 to 2011) <0 Negative Daily Correlation >0 Positive Daily Correlation 0.1% 9/30/2008 6mo Return = -37% 11/24/1964 6mo Return = +3% Lowest Negative Serial Correlation 8/11/2011 6mo Return = ?? 1935 1938 1971 1974 1977 1929 1932 1941 1944 1947 1950 1953 1956 1959 1962 1965 1968 1980 1983 1986 1989 1992 1995 1998 2001 2004 The degree of up and down days in the DJIA is at the most extreme level in recorded history representing a pinnacle in an era of daily mean reversion.4 10/9/1931 6mo Return = -51% 8/15/1971 US leaves gold standard 3/18/2004 6mo Return = -0.25 Is this a statistical coincidence? A random coin flip. 1971. will also occasionally exhibit serial correlation extremes on a rolling one year basis.15 -0.000 simulations shows nowhere near the serial correlation drift seen in the DJIA results and has much lower positive and negative extremes (see one sample simulation to the right). Both forms of serial correlation can occur in up or down trending markets. The rolling one year serial correlation of daily lagged logarithmic returns in the DJIA reached a generational peak on May 25th.1 0. Despite this fact.1 -0. For example an asset that alternates between being +1% and -1% every day demonstrates perfect negative serial correlation. LLC | Letter to Investors– Third Quarter 2011 40 years of Mean Reversion 0.2 0. Less than three months later on August 15th. 1971 President Nixon surprised the international monetary system by cancelling the direct convertibility of the United States dollar to gold. whereby heads represent a +1% day on the market and tails a -1%.

The global financial 1.20x -0.0% 40.90x decline in the S&P 500 index. MBA programs teach their students to use the yield on US government debt as the "risk-free rate" of return in the capital asset pricing model.0% 15.0% Aug-11 -30.25x 1. Standard & Poor's announced that it lowered the United States' credit rating citing political risks and a rising debt burden.15x system seems poised for 1. In 1. but June 24 to September 30.05x -0.50x during the bad.27x TLT 20+ US Treasury ETF .0% -10.0% 40. The 0. Counter intuitively this represented a buying opportunity.95x 1.05x 0.15x 0.30x 1.0% ATM 02-Sep-11 26-Aug-11 -5.0% 30.120 Day Volatility Skew true safe haven status.9% gain against the dollar.0% 20.0% 20.00x 0.0% 20.75x 0.95x investors seeking shelter from 1.0% -20.0% -10.0% 10.0% 16-Sep-11 -20.55x 1.10x 0. In August and September US Treasury securities rallied on recession fears and the yield on the 10 year fell 84 basis points to an all time low of 1.0% 24-Jun-11 Implied Volatility / ATM Vol Ratio 08-Jul-11 24-Jun-11 22-Jul-11 08-Jul-11 22-Jul-11 02-Sep-11 16-Sep-11 02-Sep-11 16-Sep-11 30-Sep-11 Jun-11 Jul-11 Aug-11 Sep-11 Jun-11 Jul-11 30-Sep-11 -50% -40.0% 30.Artemis Capital Management.0% www.120 Day Volatility Skew FXF ETF (Swiss Franc Bullish) . Nonetheless our political risk is rapidly becoming credit risk.0% -30.00x 0.0% -40.35x 1.20x to the Euro resulting in an immediate +8.75x 1.0% 5.60x 2.95x 1. June 24 to September 30. and Gold.20x 1.0% ATM 10.15x crisis are finding smoke in every 1. Evolution of Implied Volatility Surface for Investor “Save Havens” The new risks in supposedly "safe Third Quarter 2011 haven" currencies may encourage UUP ETF ($USD Index Bullish) . This was a stark reminder that "risk-free" is a myth.20x September the GLD ETF was 1.10x -0.00x against risks we don't yet know or -0.15x Implied Volatility / ATM Vol Ratio 24-Jun-11 08-Jul-11 22-Jul-11 Implied Vol / ATM Vol Ratio 05-Aug-11 24-Jun-11 -20. To this effect the importance of volatility % OTM % OTM and convexity in a portfolio 0.5% OTM Vol Skew UUP 10% OTM Vol Skew comes due.20x 0.95x monumental changes over the next decade and there is no telling if today's safe haven may be tomorrow's risk asset.0% 19-Aug-11 15-Jul-11 5-Aug-11 50.10x 0.0% 19-Aug-11 -50% Sep-11 . Prior to the downgrade US Treasury Bonds and the dollar were already losing value as partisan bickering over the debt ceiling raised the specter of an unthinkable US default. This is -0. -0. and a commodity -0.35x 1.19x -0.0% 16-Sep-11 -15. Swiss Franc.00x 0. 2011 June 24 to September 30.0% ATM 10.0% 05-Aug-11 19-Aug-11 05-Aug-11 40.05x 1. 2011 If recent history is any guide 1.15x strongbox keep in mind that gold 1.72% by September 22nd.10x fully understand.0% -40.20x has behaved like a safe haven in 0.10x because they offer protection 0. The only problem is now "risk-free" is rated AA+.18% 0.0% 50. At alternating times during the quarter confidence was shaken in established havens including the US dollar. LLC | Letter to Investors– Third Quarter 2011 Page 8 Smoke in the Panic Room As investors sought refuge from crashing markets many "safe haven" assets actually began to appear risky. US Treasury securities.15x -0. In a bold decision on August 5th.0% ATM -10. Over the past few years the Swiss Franc was a popular safe haven appreciating +28% against the Euro and +50% against the dollar since 2003 much to a chagrin of the people who export quality watches and chocolate.artemiscm.30x 0.35x panic room.05x -0.40x 1.0% 30.10x down -11.0% -10.05x 0.00x 0.0% 20.25x -0. 2011 June 24 to Sept 30 2011 1.55x 1.80x thesis for gold ownership is logical considering global competitive currency devaluation but it is always dangerous to be in the most % OTM % OTM crowded trade when the margin 0.21x the good times.95x 0.0% 10.20x GLD 20% OTM Vol Skew FXF Swiss Franc 10% OTM Vol Skew shouldn't be underestimated 0.120 Day Volatility Skew TLT 20+ US Treasury ETF.17x Jun-11 Jul-11 Aug-11 Sep-11 Jun-11 Jul-11 Aug-11 Sep-11 disappointing if the objective is GLD ETF .50x 1.15x 1.23x -0.0% 40.120 Day Volatility Skew us all to become gold bugs.70x before you buy a shotgun and a 2.60x 0.0% -50% 30-Sep-11 -50% Implied Volatility / ATM Vol Ratio -40.0% -30.40x 0.15x 0.75x also took a beating this quarter.10x 1.06% compared to -7.0% 30. In these markets gold -0. On September 6th in a surprise decision the Swiss National Bank devalued the Franc pegging it at 1.0% (310) 496-4526 -20.

60x VIX Strike Price Expressed as Standard Deviation of VIX future www. South (310) 496-4526 .80x 0. or Chile will be immune given trends in correlation.20x 1. Owning a small amount of volatility in both tails of the distribution gives the potential for exponential profits during the next deflationary crisis or shock-and-awe government intervention. In the event developed economies like the US and Europe fall back into recession there is little reason to believe equity volatility in China.20x 0.Index Intl.00x Volatility Insurance Ratio 1. When equity markets are oversold protect against surprise monetary intervention using unloved farOTM call options on financials.10% OTM Call Vol) / ATM Vol] and [1m Implied Vol/1m Historic Realized Vol] 1.80x 1.60x Exchange Traded Product Domestic Equity Volatility Domestic Equity . LLC | Letter to Investors– Third Quarter 2011 Fighting Greek Fire with Fire Fight volatility with volatility and take advantage of the erratic movements in markets to strategically establish long tail risk positions on both sides of the return distribution in asset classes with competitively priced skew and vol. Africa Intl. For example during the next viscious short covering rally you may consider buying competitively priced far-OTM put options in emerging economies or Asian equities.Asia Intl. Hedgers can monetize this flat skew by executing a reverse ratio spread that will protect a portfolio in the event of cataclysmic decline in markets. Equity . To execute this trade sell OTM VIX calls at +1 or +2σ standard deviations above the respective November or December VIX futures price and purchase 2x the number of further OTM calls. This "Euro-pocalypse" hedge will provide an exponential payoff in the event the VIX increases above 50+ but will otherwise result in a small loss of capital.70x Volatility Skew of the VIX Index (VIX options at 30 days to expiry) Current Skew VIX@ 42 Average Skew Since 2004 Average Skew for 1yr Average Skew for 6mos Post-Lehman Sept16 2008 OTM VIX Puts OTM VIX Calls 0.00x 0.90x 0. Monetize Volatility of Volatility VIX options provide attractive opportunities for sophisticated investors to hedge against global contagion risk.60x Source: Ratio= Average of [(10% OTM Put Vol .Sectors Intl. 12 Month Volatility Skew & Implied Vol / Historic Vol Higher Ratio = Higher Cost for Protection against Loss SPY QQQ IWM ^VIX XLY XLP XLE XLF XLI XLK XLB XLU EFA EEM FXI EWH EWY EWA EWJ EWZ ECH EWW EZA EWG EWI EWP EWU TLT IEI IEF LQD HYG JNK PFF TIP BND AGG UUP FXC FXA FXF FXE FXS FXY GLD SLV USO GDX UNG DBA MOO DBB JJC 0. Equity .30x 1. and OTM puts on the Yen and US dollar index.10x 1.Americas & S. Equity .20x 1.Europe Domestic Fixed Income Currency Commodities 0. Volatility of VIX Futures as a ratio to ATM Vol Page 9 Cross-Asset ETF Volatility Insurance Ratio Ratio = Avg.artemiscm. The table to right presents a multi-asset comparison of volatility risk premiums that will serve as a starting point.Artemis Capital Management. or spread between the local volatilities for VIX options (adjusted by historical standard deviation moves) is extremely flat.40x 1. The strategy is effectively a global macro-straddle that is long volatility and convexity. When the VIX index increases the option skew typically pancakes as volatility of volatility shifts from OTM calls to OTM puts reflecting higher probability of mean reversion (see chart). Japan.40x 0.00x 0. Although the VIX index is currently elevated the skew. With a small amount of risk capital you can win on both sides of the macroeconomic coin toss.40x 1. As world draws closer to a second recession the unpredictable rising and falling tides of liquidity will either lift or sink all ships. high yield debt. Equity .

We will find a way to prosper if we relentlessly search for nothing but the truth. there will be violence. The truth is that if our leaders continue to deny our problems history tells us the US will eventually default. CFA Managing Partner and Portfolio Manager Artemis Capital Management.L. The group is similar to protests across Europe including the indignados ("the outraged") movement in Spain and escalating strikes and sit-ins in Greece. The difference this time is that Main Street is ready to revolt against any new round of bail-out economics. In nature volatility is so fundamental that the trees of the great sequoia forest will not release their seeds without first sensing heat from wildfires. A movement called Occupy Wall-Street that opposes corporate greed. Italy. they will cry. The middle class is under significant pressure with 14 million Americans officially out of work and another 16 million underemployed which in combination would form a state with the population of Texas. A recent poll shows that two thirds of German's believe their parliament should block any more demands for euro bail-outs(4). Volatility is not a statistic or a standard deviation. L. St. but whether or not the citizens of developed countries are going to allow it. Volatility is change and the world is changing. suppress volatility no matter how painful. we will not allow ourselves to prosper. Philadelphia. otherwise the truth will find us through volatility. How this will end is impossible to predict. Louis. It is the fire in Plato's cave that illuminates the shadows of reality for those chained to the darkness. deny revolution. As I write this letter 700 people were just arrested for blocking traffic on the Brooklyn Bridge. they will spend time with their children.. The question we should ask ourselves is not whether policy makers can or cannot orchestrate another massive bail-out of the global banking system. and love. The truth is that Greece will default. These are the lost children of the global economy.. and massive political change but you know what? The world will not end. www. Black-Scholes input. life will go on. Volatility as a concept is widely misunderstood. Volatility is not the VIX index. financial bail-outs. Volatility is not (310) 496-4526 . This movement is spreading and has held demonstrations in Boston. Christopher R. and the political influence of banks is attracting hundreds of grass-roots followers and conducting protests in lower Manhattan and across the country. upheaval. or as personal as an exhilarating relationship with a complex woman who is very there and then inexplicably gone. GARCH model. Things are likely to get worse before they get better. It is from the flames of change that we derive the potential for healthy resurrection and birth.artemiscm. Cole. Volatility hurts but is necessary for growth. markets will collapse.C. Chicago. As we move closer to a second global recession it is highly questionable whether or not the European and domestic banking systems can withstand another systemic shock. It is as global as a violent revolution resulting in social change. The large banks that were too-big-tofail are now even bigger than before the crisis.Artemis Capital Management.P. These shocking events will hurt many people. life savings will be lost. and Los Angeles. When it is all said and done people will work. Regardless of how it is measured it reflects the difference between the world as we imagine it to be and the world that actually exists. Volatility is an instrument of truth. Unemployment is an epidemic and will result in a lost generation for millions of Americans and Europeans. but in the next decade we are about to learn a lot more about volatility. or any other number derived by abstract formula. L. The number of unemployed youth in OECD countries is higher than at any time since the organization started collecting data in 1976(3). and Ireland nearly a third. laugh. LLC | Letter to Investors– Third Quarter 2011 Volatility and Truth Page 10 It is becoming harder for markets to deny the existential state of the global economy. In markets and in life if we don't recognize the truth in each moment. Vive la vérité Vive le volatilité Artemis Capital Investors. In Spain nearly half of the people under the age of 25 are unemployed and in Greece. Volatility is no different in markets than it is to life.

See www. (3) "It's grim down south" & "the jobless young Left Behind". (THE “FUND”).  Security price data from Bloomberg and Yahoo Finance  Implied volatility data from IVolatility. THERE IS NO SECONDARY MARKET FOR THE INTERESTS AND NONE IS EXPECTED TO (310) 496-4526 .com for more information. Price changes an volatility measurements are calculated according to the following formula % Change = LN (Current Price / Previous Price)  Greek Fire / from Madrid Skylitzes / public domain  Flaming globe & Sequoia Tree photographs reproduced with rights from Istockphoto. Actual investor performance may differ depending on the timing of cash flows and fee structure. REDEMPTION AND TRANSFERABILITY OF INTERESTS ARE RESTRICTED.P. L. The General Partner has hired Unkar Systems. AN INVESTMENT IN THE FUND IS SPECULATIVE AND INVOLVES A HIGH DEGREE OF RISK. LLC | Letter to Investors– Third Quarter 2011 Page 11 THIS IS NOT AN OFFERING OR THE SOLICITATION OF AN OFFER TO PURCHASE AN INTEREST IN ARTEMIS CAPITAL INVESTORS. This report uses estimates of M3 provided by Shadow Government Statistics which uses Fed reporting of major M3 components and SGS modeling of missing components. as NAV Calculation Agent and the reported rates of return are produced by Unkar for Artemis Capital Fund. 2011 www. CERTAIN DATA CONTAINED HEREIN IS BASED ON INFORMATION OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE.shadowstatistics. SO INVESTORS MAY NOT HAVE ACCESS TO CAPITAL WHEN IT IS NEEDED.artemiscm. Footnotes and Citations: Notes:  Unless otherwise noted all % differences are taken on a logarithmic basis. Inc. The Economist September 10th. ANY SUCH OFFER OR SOLICITATION WILL ONLY BE MADE TO QUALIFIED INVESTORS BY MEANS OF A CONFIDENTIAL PRIVATE PLACEMENT MEMORANDUM (THE “MEMORANDUM”) AND ONLY IN THOSE JURISDICTIONS WHERE PERMITTED BY LAW. BUT WE CANNOT GUARANTEE THE ACCURACY OF SUCH INFORMATION. INVESTMENT RESULTS MAY VARY SUBSTANTIALLY OVER ANY GIVEN TIME PERIOD. OPPORTUNITIES FOR WITHDRAWAL. AN INVESTMENT SHOULD ONLY BE MADE AFTER CAREFUL REVIEW OF THE FUND’S http://toxipedia. 2011 (4) "Angela Merkel denies euro bailout backlash was cause of election defeat" The Telegraph September 5th. THE INFORMATION HEREIN IS QUALIFIED IN ITS ENTIRETY BY THE INFORMATION IN THE (2) The Federal Reserve ceased reporting M3 in March 2006.Artemis Capital Management. NO ASSURANCE CAN BE GIVEN THAT THE INVESTMENT OBJECTIVE WILL BE ACHIEVED OR THAT AN INVESTOR WILL RECEIVE A RETURN OF ALL OR ANY PORTION OF HIS OR HER INVESTMENT IN THE FUND. Past performance not indicative of future  Liberty Leading the People by Eugène Delacroix / public Footnotes: (1) "Greek Fire" from Toxepedia.

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