Is Volatility Broken?

Normalcy Bias and Abnormal Variance

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

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance

Page 2 520 Broadway, Suite 350 Santa Monica, CA 90401 (310) 496-4526 phone (310) 496-4527 fax www.artemiscm.com c.cole@artemiscm.com

Is Volatility Broken? Normalcy Bias and Abnormal Variance

The financial markets have endured a flock of geopolitical "black swans" including the devastating earthquake and nuclear crisis in Japan, widespread revolution and violence in the Middle East and North Africa, and escalation of the European sovereign debt crisis. Incredibly domestic markets shrugged aside fear from each transformational event as stocks registered their best first quarter in over a decade led by a recovery in corporate earnings and job growth. The absence of sustained price volatility despite several global shock events is interpreted as a bullish omen by many investors. In regard to geopolitical risk it feels like volatility should be perched above 30%, but surprisingly, after increasing in mid-March, the VIX index registered its second largest drop in history (and the third longest) falling -40.86% over seven days and ending the month below historic averages. The passive mood of spot volatility is masking a dramatic revolution in the structure and behavior of the volatility curve that has wide-ranging ramifications for anyone who trades variance or uses portfolio insurance. The timing of recent volatility distortions has coincided with the implementation of the Federal Reserve's second quantitative easing program and is likely an unintended consequence of loose monetary policy. In an increasingly volatile world many investors are talking about how to protect their portfolios against the black swan event. What may be more relevant is to explore the psychology of a market that fears the black swan but refuses to acknowledge its presence upon arrival. In behavioral psychology this is called a "normalcy bias" and the concept provides a framework to understand the current volatility market. Normalcy Bias and Crisis: A quirk of the human condition is for the mind to desire normalcy so intensely as to consciously or subconsciously disregard knowledge that is disruptive to a pre-conditioned reality. This phenomenon is an important part of crisis management and market psychology. The consequence of a normalcy bias is that warning signs of a potential crisis go unnoticed or are interpreted optimistically. When a crisis occurs people are so overwhelmed by events inconsistent with a desired reality they lose their ability to make decisions. Researchers believe when the mind encounters an entirely new experience or event it attempts to match that reality to relevant experiences from the past. If there are no matching experiences the mind enters into a kind of feedback loop resulting in passivity. This lack of action as a response to risk is called negative panic1 and it culminates in a dangerous inability to act assertively in crisis. In essence, the psyche struggles to come to terms with what is really happening. Paralysis follows. On November 18, 1987 a fire broke out during morning rush hour in the crowded King's Cross Underground station in London. The Underground staff was unprepared for the disaster and failed to initiate an appropriate emergency response. As the fire spread ferociously the trains kept arriving at the station dropping unwitting passengers into the thick of the disaster. Incredibly many commuters simply carried on with their daily routines despite the presence of thick black smoke coming from the station. In some cases commuters boarded escalators that carried them directly into the fire. One irritated woman even asked a manager if her morning train was canceled apparently unaware that people were dying just below her. In total 31 people perished in the accident, many of them from passivity2. On March 27, 1977 644 people lost their lives in one of the worst disasters in aviation history when a KLM plane collided with a Pan Am aircraft on a runway in the Canary Islands. Based on interviews with some of the 64 survivors, the passengers aboard the Pan Am craft had enough time to evacuate but many remained paralyzed in their seats even as flames were observable in the cabin. Many would have survived if they had just evacuated3.

www.artemiscm.com

(310) 496-4526

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance

Page 3

Negative Panic = Negative Volatility: In financial markets normalcy bias Negative Volatility in the VIX Curve provides a psychosomatic explanation as to why lower than appropriate (the absence of expected volatility due to normalcy bias) volatility can be sustained for long periods of time despite increasing signs 1.40x of systemic risk. This phenomenon was observable in 2007 as volatility 1.35x remained at extremely low levels even after problems in the subprime 1.30x housing market began to take root. The volatility of asset prices is widely 1.25x 1.20x considered a metric of fear and panic in financial markets, therefore the 1.15x lack of sustained volatility following a market shock event could be 1.10x viewed as a form of negative panic. If we accept that investors may 1.05x subject to a consensus normalcy bias then it is logical to accept that 1.00x negative volatility can also exist as a quantifiable response to exogenous VIX Index Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 shock events. Admittedly this may sound odd since volatility, by Expected Volatility Surface Current Volatility Surface mathematical definition, can never be negative, so the term refers more to a cancellation of short-term volatility risk premium that should otherwise exist. The theory of negative volatility is a temporary state of low volatility caused by the market's failure to acknowledge the enduring risks of a black swan event. The concept may go a long way toward explaining why high geopolitical risk can co-exist with extremely low volatility in the current market. The physical passivity of a person who psychologically denies risk is analogous to a kind of low volatility. The paradox of the new volatility regime, similar to the concept of negative panic, is that it personifies two dimensions of fear that exist concurrently at the same time. One dimension is passivity and the second dimension is great peril. The theory of negative volatility bridges the psychological disconnect between these two vastly different worlds of risk. For example, the optimism of an economic recovery is reflected in lower spot volatility but exists simultaneously with a steep volatility curve that warns of great systemic risk. Volatility is now a market of risk duality. This is a negative volatility regime.
Normalized Volatility Plane

Historically Steep Volatility Surface

25-Feb-11

11-Mar-11

www.artemiscm.com

(310) 496-4526

25-Mar-11

The Negative Volatility Regime: The behavior of equity volatility has undergone radical changes over the past three quarters the persistence of which is tantamount to a regime change as opposed to a temporary phenomenon. The current volatility market refuses to sustain fear in the wake of several shock events despite flashing continued warning signs of longer-term risks. The regime resembles a more extreme version of the volatility curves experienced between 2006 and early 2007 prior to the onset of the credit crisis. The new paradigm of volatility officially began after the May 2010 Flash Crash but the most extreme changes have coincided with announcement of the Fed's second quantitative easing program in late-August. The new volatility regime is characterized by: 1. Large declines in spot volatility The past nine months have shown an unusually high number of large declines in spot volatility (realized and implied) that are of a much higher magnitude and length than what has been observed historically. As a result of these large declines the VIX index and short-term realized volatility are below historic averages; 2. Abnormally steep volatility curve The manifestation of an abnormally steep volatility curve (as a % of spot volatility) with a linear shape that more closely resembles a glacial cliff as opposed to the more traditional desert plateau (see chart); 3. Underperformance of Variance Hedges Low volatility-of-volatility on the back of the variance term-structure results in the underperformance of out-of-the-money options and variance as a hedge against market declines; 4. High Volatility Skew: High levels of volatility skew for far out-of-the-money options showing increased likelihood of large declines in equity prices.

Normalized ATM IV (Implied Vol / 21 day realized volatility)

12 Week MA of Normalized ATM S&P 500 Implied Volatility Term Structure 2000 to 2011
2.50x 2.30x 2.10x 1.90x 1.70x 1.50x 1.30x 1.10x 0.90x 0.70x
22-Sep-2000 9-Mar-2001 24-Aug-2001 1-Feb-2002 19-Jul-2002 31-Dec-2002 13-Jun-2003 28-Nov-2003 7-May-2004 22-Oct-2004 8-Apr-2005 23-Sep-2005 10-Mar-2006 25-Aug-2006

9-Feb-2007

27-Jul-2007

4-Jan-2008

20-Jun-2008

5-Dec-2008

15-May-2009

30-Oct-2009

720 days 360 days 180 days 150 days 120 days 90 days 60 days 30 days

16-Apr-2010

1-Oct-2010

Large Declines in Spot Volatility

21 day Realized Volatility of S&P 500 Index May 2010 to March 2011
35.00% 30.00%
Realizedd Volatility (%)

25.00% 20.00% 15.00% 10.00% 5.00%

04-Jun-10 18-Jun-10 02-Jul-10 16-Jul-10 30-Jul-10 13-Aug-10 27-Aug-10 10-Sep-10 24-Sep-10

08-Oct-10

22-Oct-10

05-Nov-10

19-Nov-10

03-Dec-10

17-Dec-10

31-Dec-10

14-Jan-11

28-Jan-11

11-Feb-11

18-Mar-2011

Volatility Term Structure

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance Large Declines in Spot Volatility
Abnormal VIX Index Drawdowns of the New Regime (May 2010 - April 2011) Ranked by % Vol Drop from 1990 to 2011
Ranking (19902011) #1 #2 #17 #34 #43 #45 #56 #70 #71 #83 #107 #128 #144 #153 #189 #278 #291 #313 Yes Yes Yes Yes Yes Yes Yes Yes Yes During QE2? End Date May 12, 2010 March 25, 2011 July 12, 2010 May 25, 2010 December 3, 2010 June 15, 2010 September 3, 2010 November 19, 2010 February 4, 2011 April 29, 2010 June 3, 2010 February 28, 2011 November 5, 2010 May 27, 2010 April 20, 2010 January 27, 2011 October 12, 2010 March 3, 2011 # Days 3 days 7 days 7 days 3 days 3 days 4 days 4 days 3 days 5 days 2 days 2 days 3 days 4 days 1 days 2 days 4 days 3 days 2 days % Vol Drop -42.88% -40.86% -30.14%

Page 4

Ranking of VIX Index Drawdowns (% drop in volatility over consecutive days) (January 1990 to April 2011)
Drawdowns explainable by power law function

10,000

1,000

Ranking (Logarithmic Scale)

-25.64% -24.47% -24.25% -22.40% -21.20% -21.14% -20.21% -18.37% -17.71% -16.92% -16.54% -14.90% -12.83% -12.63% -12.02%

Not explained by power law function

100

July 12, 2010

10 % Drawdown in VIX Index - 1990 to May 2010

March 25, 2011 May 12, 2010

% Drawdown in VIX Index - May 2010 to April 2011

1 -46.00% -41.00% -36.00% -31.00% -26.00% -21.00% -16.00% -11.00% -6.00% -1.00% Drawdown in Volatility (over consecutive days) %

Total Ranked Observations 1990 to 2011 = 1365

The new volatility regime is typified by a higher frequency of large magnitude drops in volatility that has prevented the VIX index from sustaining above average levels despite several negative shock events. For example, the period between May 2010 and March 2011 included 6 of the top 50 highest drawdowns in the 20 year history of the VIX (12% overall). This includes the top 2 ranked observations. The same period recorded 4 of the top 13 longest drops in the VIX as defined by declines on consecutive days. The two largest drops in the VIX index both occurred during the new regime including the -40.86% drop over 7 consecutive days ending March 25, 2011.The recent high number of unnatural volatility declines can be interpreted as feedback loops fueled by unprecedented monetary stimulus and government support of risk assets. There is compelling evidence the Federal Reserve is artificially suppressing spot volatility through the quantitative easing program. Consider the chart below that shows how the VIX and the S&P 500 index performed on days when the Federal Reserve purchased US Treasury bonds as part of QE2 compared to days without Fed intervention (November 10, 2010 to March 30, 2011) 4. On days without debt purchases the VIX index was up +2.14% and the S&P 500 registered a slight decline. On days with debt monetization the VIX dropped -0.45% and the S&P 500 index increased. What is even more convincing, the greater the amount of the debt monetization the larger the corresponding drop in volatility and increase in stock prices. During the 44 days on which the Federal Reserve purchased $7 billion+ in debt or more the VIX index dropped -0.57% and the S&P 500 gained 0.21%! The connection between lower volatility and QE2 is undeniable. It is not hard to imagine that spot volatility would be much higher absent government intervention in markets. The artificially low volatility in markets may contribute to a dangerous build up in systemic risk. Many investment banks and hedge funds use volatility as an input to determine leverage capacity. When the Fed artificially depresses spot volatility it produces a feedback loop whereby large banks can increase their appetite for risk, increasing assets prices, and further lowering volatility. It should be no surprise that NYSE margin debt is at its highest level since July of 2008 (see page 8).
30

VIX Index & QE2 US Treasury Purchase Schedule November 10, 2010 to March 30, 2011

30

Effect of QE2 on Daily % Changes in VIX & S&P 500 Index November 10, 2010 to March 30, 2011 Days w/o QE2 (% Change) QE2 Days (% Change) QE2 Days >=$3bn (% Change) QE2 Days >=$5bn (% Change) QE2 Days >=$7bn (% Change)
+2.50% +2.00%
% Change (Logarythmic)

25

25
FR Treasury Purchase (QE2) in $Billions

20
VIX Index (%)

20

15 FR Treasury Purchase (TIPS) ($bn) FR Treasury Purchase (Treasury Bonds) ($bn) VIX Index Average VIX since 1990

15

VIX Index +2.14% -0.45% -0.18% -0.25% -0.57%

S&P 500 Index -0.01% +0.11% +0.11% +0.14% +0.21%

+2.14% VIX Index S&P 500 Index +0.14% +0.21%

10

10

+1.50% +1.00% +0.50% +0.00% -0.50% -1.00% Days w/o QE2 QE2 Days -0.01% -0.45% +0.11% -0.18% +0.11% -0.25%

0
2-Feb-11 9-Feb-11 1-Dec-10 8-Dec-10 2-Mar-11 9-Mar-11 12-Jan-11 19-Jan-11 26-Jan-11 16-Feb-11 23-Feb-11 10-Nov-10 17-Nov-10 24-Nov-10 5-Jan-11 15-Dec-10 22-Dec-10 29-Dec-10 16-Mar-11 23-Mar-11 30-Mar-11

-0.57% QE2 Days >=$3bn QE2 Days >=$5bn QE2 Days >=$7bn

www.artemiscm.com

(310) 496-4526

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance Abnormally Steep Volatility Curve
1.42x

Page 5

VIX Term Structure (Normalized)

1.37x

1.32x

VIX Future / VIX Index

1.27x

1.22x

1.17x

1.12x

1.07x

Current VIX Term Structure (March 2011) Historical Average Term Structure (2004-Present) 3-month Average VIX Term Structure Term Structure Since QE2

1.02x

0.97x 14 days 33 days 52 days 76 days 96 days 120 days 140 days

The abnormally steep volatility-surface, shown in VIX futures (above) and S&P 500 index implied volatility (below), is perhaps the most striking feature of new volatility regime. The steep slope implies the market is anticipating higher volatility in the future and is willing to pay a significant premium for it today. The volatility curve first began to steepen in July of 2010 but the effect was magnified following the announcement of QE2 in late-August. The volatility slope peaked in late-October and has maintained its unusually steep incline throughout first quarter of 2011 despite several global shock events. The six-month period ending in February 2011 represented the steepest cumulative average slope for months 4-7 of the curve for over a decade worth of data. As seen from the charts the term structure has assumed a more linear form implying significantly higher long-term volatility expectations. In each graphic the structure has been normalized by spot vol providing a visual representation of the risk premium demanded by the market (y-axis) at different expirations dates (zaxis) and points in time (x-axis). A steep slope will usually occur in a low volatility environment as the relationship between the front of the volatility curve and the back widens. Although in the past there have been other periods when the volatility plane was very steep, most notably in 2006 and early 2007, an important distinction is that in those periods spot volatility hovered in the low teens to single digits. In the new regime we are seeing a steeper curve with the VIX at 18% to 25% than what was previously observed with the VIX at 12% or below. The current environment is unique because it is odd for the volatility slope to consistently maintain this extreme incline even when variance returns to levels at or above historical averages.
S&P 500 Index ATM Implied Volatility Term Structure (normalized vs. 30 day vol)
1.40x
Normalized ATM IV (Implied Vol / 30 day Implied Vol)

Normalized ATM S&P 500 Implied Volatility Term Structure April 2007 to April 2011
1.60x 1.50x 1.40x 1.30x 1.20x 1.10x 1.00x 0.90x 0.80x 0.70x
5-Apr-2007 29-Jun-2007 21-Sep-2007 14-Dec-2007 29-Feb-2008 23-May-2008 15-Aug-2008 7-Nov-2008 23-Jan-2009 17-Apr-2009 10-Jul-2009 2-Oct-2009

1.35x
ATM S&P 500 Implied Volatility / 30 day ImpliedVolatility

1.30x

1.25x

1.20x

1.15x

1.10x

19-Mar-2010

Current Vol Structure (March 2011) Average since October 2010

24-Dec-2009

1.05x

11-Jun-2010

720 days

3-Sep-2010

360 days

180 days

150 days

26-Nov-2010

120 days

90 days

18-Feb-2011

1.00x

60 days

Historical Average (2000 to Present) Average with ATM Vol = 15% to 25% (2000 to Present)

30 days

0.95x 30 days 60 days 90 days 120 days 150 days 180 days 360 days 720 days

www.artemiscm.com

(310) 496-4526

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance Underperformance of Variance Hedges The steeper volatility term-structure has eroded the effectiveness of long-term variance as a hedge against abrupt market declines. This problem is worth serious consideration for any institution using variance or out-of-the-money options as portfolio insurance. In essence, investors are getting less return for their money on their volatility insurance policies. For example, in the QE2 environment long-dated VIX futures are approximately 18% less effective in capturing changes in volatility as compared to prior periods. Since there is an arbitrage relationship between VIX futures and one-month forward variance swaps we should expect similar erosion of performance in the over-the-counter swaps market and for far out-of-the-money options. The chart to the right shows the percentage change in VIX futures as a ratio to the percentage change in the VIX index on days when volatility jumped 10% or more. From September 2010 to March 2011 the volatility of volatility on the back of curve has lost significant sensitivity to negative shock events. As can be seen from the graphic to the lower right, the VOV for months 4-7 of the volatility surface did not shift significantly following the natural disaster in Japan. This is because volatility shocks were already priced into the steep volatility curve. Investors using variance as portfolio insurance are hurt in two ways: (1) less effective performance during volatility shock events and (2) significant time decay erosion during low-volatility periods. While long-term volatility hedges still offer valid protection in the event of a crash they are clearly underperforming in this market. High Volatility Skew The new volatility regime is characterized by an increased expectation for extreme price movements, as exemplified by elevated levels of implied volatility skew for far out-of-themoney options. Skew is an important indication of where investors are placing leveraged bets. In essence, skew measures perceived tail risk. The normalized skew for SPX options has been increasing since early 2009, but the unusually robust skew for far out-of-themoney index options signifies a greater than average probability of a large price dislocation over the next five months. For example the volatility skews for options that are 40-50% out-ofthe-money are now close to their highest levels in a decade (see chart to the lower right). This means the investors are placing bigger bets on large declines in prices than they are increases. Oddly the skew for options that are only 10% out-of-themoney are not showing strong cause for alarm. Why is there such the large difference and what does it mean? One interpretation is that although the risk of a market decline is low, if a pull-back does occur it is much more likely to be a dramatic crash rather than a routine correction.
[% OTM Put IV - % OTM Call IV]/ ATM IV
2.00x 1.80x 1.60x 1.40x 1.20x 1.00x 0.80x 0.60x 0.40x 0.20x
5-Jan-01 4-May-01 31-Aug-01 28-Dec-01 19-Apr-02 16-Aug-02 13-Dec-02 4-Apr-03 1-Aug-03 28-Nov-03 19-Mar-04 16-Jul-04 12-Nov-04 11-Mar-05 8-Jul-05 4-Nov-05

Page 6
100% 90%

Ratio Sensitivity of VIX Futures to the VIX Index Given a 10%+ Jump in Vol
0.57x
Sensitivity Ratio = % Change VIX Future / % Change in VIX Index

0.52x 0.47x 0.42x 0.37x 0.32x 0.27x Loss of Hedge Effectiveness (-%) Since QE2 VIX Sensitivity Ratio - January 2007 to September 2010 VIX Sensitivity Ratio - Average Since QE2 Sep 2010 to March 2011

70% 60% 50% 40% 30% 20%

0.22x 0.17x Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7

10% 0%

Volatility of VIX Futures Curve - Post QE2

200 150 100 50 0

VIX Futures Term

S&P 500 Index - Historical Skew Levels (OTM Put IV - OTM Call IV) / ATM IV (2001 to Present) - 150 days to maturity

3-Mar-06

30-Jun-06

27-Oct-06

23-Feb-07

22-Jun-07

19-Oct-07

31-Mar-11

8-Feb-08

6-Jun-08

11-Mar-11

3-Oct-08

23-Jan-09

18-Feb-11

22-May-09

31-Jan-11

15-Jan-10

14-May-10

1.80x-2.00x 1.40x-1.60x 1.00x-1.20x 0.60x-0.80x 0.20x-0.40x

1.60x-1.80x 1.20x-1.40x 0.80x-1.00x 0.40x-0.60x

18-Sep-09

10-Sep-10

2.50x

2.00x

S&P 500 Index - Historical Skew Levels (OTM Put IV - OTM Call IV) / ATM IV (2001 to Present) - 150 days to maturity

1.50x

1.00x

0.50x

0.00x

-0.50x
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 Jan-07 Oct-06 Jul-06 Apr-06 Jan-06 Oct-05 Jul-05 Apr-05 Jan-05 Oct-04 Jul-04 Apr-04 Jan-04 Oct-03 Jul-03 Apr-03 Jan-03 Oct-02 Jul-02 Apr-02 Jan-02 Oct-01 Jul-01 Apr-01 Jan-01

www.artemiscm.com

(310) 496-4526

7-Jan-11

10-Jan-11 20-Dec-10 30-Nov-10 09-Nov-10 20-Oct-10 30-Sep-10 10-Sep-10

10% OTM Skew 20% OTM Skew 30% OTM Skew 40% OTM Skew 50% OTM Skew

Volatility of Volatility %

Loss of Hedge Effectiveness Since QE2

80%

50% OTM Skew 40% OTM Skew 30% OTM Skew 20% OTM Skew 10% OTM Skew

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance

Page 7

A multi-asset mosaic of volatility skews appears to be bracing for a "risk-off" environment following the end of QE2 in June. The four month implied volatility for far out-of-the-money options for ETFs tracking gold (GLD), silver (SLV), oil (USO), and long-term treasury bonds (TLT) are now all showing normalized skews near historic highs or lows. Volatility skews are giving bearish signals for stocks and metals (high positive skew) and bullish readings for oil and long-term bonds (negative skew). The market for leveraged tail risk seems to contradict the consensus optimism with the notable exception being a very bullish outlook for oil prices.
SLV ETF - 120 Day Volatility Skew December 2008 to March 2011
1.40x
2.40x

GLD ETF - 120 Day Volatility Skew June 2008 to March 2011

Implied Volatility / ATM Vol Ratio

1.30x 1.25x 1.20x 1.15x 1.10x 1.05x 1.00x 0.95x 0.90x 12-Dec-08 20-Feb-09 08-May-09 24-Jul-09 09-Oct-09 24-Dec-09 12-Mar-10 28-May-10 13-Aug-10 29-Oct-10

Implied Volatility / ATM Vol Ratio

1.35x

2.20x 2.00x 1.80x 1.60x 1.40x 1.20x 1.00x 0.80x

03-Jun-08 28-Jul-08 22-Sep-08 17-Nov-08 05-Jan-09 02-Mar-09 27-Apr-09 22-Jun-09 17-Aug-09 12-Oct-09 07-Dec-09 01-Feb-10

29-Mar-10

24-May-10

19-Jul-10

13-Sep-10

03-Jan-11

10.0%

20.0%

-40.0%

-50%

-30.0%

-20.0%

30-Mar-11

28-Feb-11

14-Jan-11

-10.0%

08-Nov-10

ATM

30.0%

40.0%

50.0%

% OTM
0.40x 0.30x 0.20x 0.10x 0.00x -0.10x -0.20x -0.30x -0.40x -0.50x

% OTM

0.25x 0.20x 0.15x 0.10x 0.05x 0.00x -0.05x -0.10x -0.15x -0.20x

SLV 30% OTM Vol Skew

GLD 30% OTM Vol Skew

Correction Coming?
Feb-10 Feb-09 Sep-09 Sep-10 May-10 May-09 Nov-10 Nov-09 Dec-08 Mar-09 Mar-10 Dec-10 Dec-09 Feb-11 Jun-10 Jun-09 Mar-11 Oct-09 Aug-09 Aug-10 Apr-09 Apr-10 Oct-10 Jan-09 Jan-10 Jan-11 Jul-09 Jul-10

Correction Coming?
Sep-08 Feb-09 Sep-09 Nov-08 Nov-09 May-10 May-09 Dec-08 Dec-09 Mar-10 Mar-09 Aug-09 Aug-08 Aug-10 Sep-10 Feb-10 Jun-08 Jun-09 Oct-08 Apr-09 Oct-09 Apr-10 Jun-10 Jan-09 Jan-10 Jul-08 Jul-09 Jul-10

USO Oil ETF - 120 Day Volatility Skew May 2007 to March 2011
1.60x 1.50x

TLT 20+ US Tresury ETF- 120 Day Volatility Skew January 2004 to March 2011
1.90x

Implied Vol / ATM Vol Ratio

Implied Vol / ATM Vol Ratio 11-May-07 3-Aug-07 26-Oct-07 11-Jan-08 4-Apr-08 27-Jun-08 19-Sep-08 12-Dec-08 27-Feb-09 22-May-09 14-Aug-09

1.40x 1.30x 1.20x 1.10x 1.00x 0.90x 0.80x

1.70x

1.50x 1.30x 1.10x 0.90x

29-Jan-10

2-Jan-04 21-May-04 8-Oct-04 25-Feb-05 15-Jul-05 2-Dec-05 21-Apr-06 8-Sep-06 26-Jan-07 15-Jun-07 2-Nov-07 14-Mar-08

6-Nov-09

1-Aug-08

19-Dec-08

23-Apr-10

8-Oct-10

1-May-09

16-Jul-10

18-Sep-09

31-Dec-10

5-Feb-10

25-Mar-11

25-Jun-10

12-Nov-10

% OTM

29-Mar-11

% OTM

0.50x 0.40x 0.30x 0.20x 0.10x 0.00x -0.10x -0.20x

USO Oil ETF - 30% OTM Vol Skew

0.60x 0.50x 0.40x 0.30x

TLT 20+ US Treasury ETF - 10% OTM Vol Skew

Higher Call IV? Means LT UST Yields?

Higher Oil

0.20x 0.10x 0.00x -0.10x

Sep-07

Sep-08

Sep-09

Sep-10

Feb-04

Feb-05

Feb-06

Feb-07

Feb-08

Feb-09

Feb-10

Nov-07

Nov-08

Nov-09

Nov-10

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

May-07

May-08

May-09

May-10

May-03

May-04

May-05

May-06

May-07

May-08

May-09

May-10

Mar-08

Mar-09

Mar-10

Mar-11

www.artemiscm.com

(310) 496-4526

Nov-10

Aug-03

Aug-04

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Feb-11

Jan-08

Jan-09

Jan-10

Jan-11

Jul-07

Jul-08

Jul-09

Jul-10

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance Reasons for the New Volatility Regime

Page 8

The new volatility regime can best be understood as resulting from the combination of structural imbalances in risk, the unintended consequences of loose monetary policy, and a vast normalcy bias. The persistence of the steep volatility surface has been a surprise to this market observer. I expect the volatility plane will flatten and spot volatility will increase as the Fed winds down the current monetary stimulus. Nonetheless there is a chance that we may be witnessing the beginning of a lasting trend in steep long-term volatility risk premiums. Structural Imbalance in Volatility Supply-Demand Dynamics Recent structural changes in the supply demand dynamics of volatility may be contributing to the distortions reflected in today's vol surface. First, a liquidity shortage on the long-end of the OTC volatility surface emerged as sophisticated players covered short positions following substantial losses on volatility derivatives in May (less supply). Secondly, there has been a recent proliferation of new "tail risk" or "black swan" hedging strategies that have increased the demand for long-dated volatility and far out-of-the-money options (more demand). Thirdly, as margin debt has expanded many funds are now shorting spot volatility and buying long-vol to collect pennies from underneath the proverbial steamroller (shortterm supply, long-term demand). Unintended Effects of Quantitative Easing The most significant changes in the volatility surface corresponded with the timing of the Fed's second quantitative easing program providing strong evidence that volatility dislocations are a consequence of loose monetary policy. Looking back, when the QE1 program began volatility was already at historical highs so it had the effect of normalizing conditions. When QE2 was announced in late August volatility was closer to historic averages so the latest round of easing only served to warp its behavior. As noted previously, QE2 had a measurable impact on daily percentage changes in the VIX between November 2010 and March 2011. For example there was a +2.7% average differential in the daily percentage change of the VIX index on days without bond purchases versus days when the Fed purchased over $7 billion in bonds (see data on page 4). While spot volatility is forced to follow the Fed's lead the back of the volatility curve clearly refuses to dance to that same beat. The result is an exceptionally steep volatility plane that reflects higher overall systematic risk. Normalcy Bias and an Abnormal World
Normalcy Bias? NYSE Margin Debt vs. VIX Index (monthly avg.)
$310 $290 $270 45

600

Normalcy Bias? PIGS 10yr CDS spread vs. European Volatility

47

550 40 500

42

Avg. 10yr PIGS CDS Spread (bps)

NYSE Margin Debt ($mil)

35

450

Volatility (%)

$250 $230 $210 $190

37

30

400 32 350 27 300 22

Average PIGS 10 Year CDS (Por-Ire-Gre-Spa) European Volatility - VSTOXX Index %

25

20 $170 $150 NYSE Margin Debt ($mil) US Volatility (Avg. Monthly VIX Index) 15

250

200

17

As the economic recovery has taken hold many people are cheering a return to normalcy, hence driving spot volatility lower even as many systematic risks remain unaddressed. The optimistic case for markets going forward is supported by improvements in the labor market, much higher asset prices, and the best corporate profits in a century... but something just doesn't feel right. The steep volatility curve and high skews are a reflection of this unease. In the end it is hard to come to terms with this sense of normalcy while looking at some very abnormal facts. For example, is it normal for the US to pass China as the largest holder of its own debt? Is it normal for the Federal Reserve to purchase an estimated 70% of the new supply of that debt5? How can inflation be normal when a broad cross-section of food and commodities appreciate 23% in only six months?6 Or when global inflation contributes to violent protests, revolutions, and war that spread across the Middle East and Northern Africa causing oil price shocks? Can we say it is normal when the European Union bails out its

www.artemiscm.com

(310) 496-4526

European Volatility (%)

11-Dec-10

25-Dec-10

2-Apr-11

16-Oct-10

30-Oct-10

21-Aug-10

4-Sep-10

5-Feb-11

15-May-

29-May-

22-Jan-11

13-Nov-10

27-Nov-10

5-Mar-11

18-Sep-10

19-Feb-11

2-Oct-10

7-Aug-10

12-Jun-10

26-Jun-10

10-Jul-10

24-Jul-10

19-Mar-11

8-Jan-11

1-May-10

Dec-09

Dec-10

Oct-09

Oct-10

Aug-09

Aug-10

Apr-09

Apr-10

Jan-09

Jan-10

Jan-11

Nov-09

Nov-10

Feb-09

Sep-09

Feb-10

Sep-10

Feb-11

May-10

May-09

Jun-09

Jun-10

Jul-09

Jul-10

Mar-09

Mar-10

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance

Page 9

third member nation in under a year? Or when the Swiss Franc appreciates nearly +30% against the USD in only nine months, cancelling out a +27% gain in the Dow Jones Industrial Index from currency devaluation alone? Why is it so easy for markets to return to normal after a massive disaster in Japan threatens the financial viability of the world's third largest economy and purchaser of US debt? Each and every one of these facts is a fire burning on the wings of the economy. The markets may be passive but not without hidden fear. The denial of truth is the denial of volatility. Vive la vrit Sincerely, Artemis Capital Investors, L.P. Christopher R. Cole, CFA Managing Partner and Portfolio Manager Artemis Capital Management, L.L.C. Vive la volatilit

www.artemiscm.com

(310) 496-4526

Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance

Page 10

THIS IS NOT AN OFFERING OR THE SOLICITATION OF AN OFFER TO PURCHASE AN INTEREST IN ARTEMIS CAPITAL INVESTORS, L.P. (THE FUND). 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. AN INVESTMENT SHOULD ONLY BE MADE AFTER CAREFUL REVIEW OF THE FUNDS MEMORANDUM. THE INFORMATION HEREIN IS QUALIFIED IN ITS ENTIRETY BY THE INFORMATION IN THE MEMORANDUM. AN INVESTMENT IN THE FUND IS SPECULATIVE AND INVOLVES A HIGH DEGREE OF RISK. OPPORTUNITIES FOR WITHDRAWAL, REDEMPTION AND TRANSFERABILITY OF INTERESTS ARE RESTRICTED, SO INVESTORS MAY NOT HAVE ACCESS TO CAPITAL WHEN IT IS NEEDED. THERE IS NO SECONDARY MARKET FOR THE INTERESTS AND NONE IS EXPECTED TO DEVELOP. 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. INVESTMENT RESULTS MAY VARY SUBSTANTIALLY OVER ANY GIVEN TIME PERIOD. CERTAIN DATA CONTAINED HEREIN IS BASED ON INFORMATION OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE, BUT WE CANNOT GUARANTEE THE ACCURACY OF SUCH INFORMATION. The General Partner has hired Unkar Systems, Inc. as NAV Calculation Agent and the reported rates of return are produced by Unkar for Artemis Capital Fund. Actual investor performance may differ depending on the timing of cash flows and fee structure. Past performance not indicative of future returns. Footnotes and Citations: Note: Unless otherwise noted all % differences are taken on a logarithmic basis. Price changes an volatility measurements are calculated according to the following formula % Change = LN (Current Price / Previous Price) Implied volatility data from IVolatility.com Black Swan photo purchased from IStockPhoto.com (1) The Survivor's Club: The Secrets and Science that Could Save Your Life, First Edition, by Ben Sherwood p.62 (2) The Survivor's Club: The Secrets and Science that Could Save Your Life, First Edition, by Ben Sherwood p.36 (3) Barthelmess, Sharon "Coming to Grips With Panic" Flight Safety Foundation Cabin Crew Safety Vol.23 No2 March/April 1988 (4) Federal Reserve Bank of New York website / Temporary Open Market Operations / www.newyorkfed.org (5) Gross, Bill "Two-Bit, Four-Bits, Six Bits, a Dollar" Pimco Investment Outlook March 2011 (6) Based on the Dow/Jones Broad Commodity Index

www.artemiscm.com

(310) 496-4526