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.

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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

Normalized Volatility Plane

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

considered a metric of fear and panic in financial markets, therefore the 1.20x

lack of sustained volatility following a market shock event could be 1.15x

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
mathematical definition, can never be negative, so the term refers more to Current Volatility Surface

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.
Historically Steep Volatility Surface
The Negative Volatility Regime: The behavior of equity volatility has 12 Week MA of Normalized ATM S&P 500 Implied Volatility Term Structure
2000 to 2011
undergone radical changes over the past three quarters the persistence
Normalized ATM IV (Implied Vol / 21 day realized volatility)
2.50x
of which is tantamount to a regime change as opposed to a temporary 2.30x
phenomenon. The current volatility market refuses to sustain fear in the 2.10x

wake of several shock events despite flashing continued warning signs 1.90x

1.70x
of longer-term risks. The regime resembles a more extreme version of
1.50x
the volatility curves experienced between 2006 and early 2007 prior to 1.30x

the onset of the credit crisis. The new paradigm of volatility officially 1.10x

began after the May 2010 Flash Crash but the most extreme changes 0.90x

0.70x
have coincided with announcement of the Fed's second quantitative
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

easing program in late-August. The new volatility regime is

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
characterized by:
15-May-2009
30-Oct-2009

720 days
360 days
16-Apr-2010

180 days
150 days
1-Oct-2010

120 days
90 days
18-Mar-2011
60 days
30 days
1. Large declines in spot volatility
The past nine months have shown an unusually high number of large
Volatility Term Structure
declines in spot volatility (realized and implied) that are of a much
higher magnitude and length than what has been observed historically. Large Declines in Spot Volatility
As a result of these large declines the VIX index and short-term
21 day Realized Volatility of S&P 500 Index
realized volatility are below historic averages; May 2010 to March 2011
35.00%
2. Abnormally steep volatility curve
The manifestation of an abnormally steep volatility curve (as a % of 30.00%
Realizedd Volatility (%)

spot volatility) with a linear shape that more closely resembles a glacial 25.00%

cliff as opposed to the more traditional desert plateau (see chart); 20.00%

3. Underperformance of Variance Hedges 15.00%

Low volatility-of-volatility on the back of the variance term-structure 10.00%

results in the underperformance of out-of-the-money options and
5.00%
variance as a hedge against market declines;
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

4. High Volatility Skew:

22-Oct-10
05-Nov-10
19-Nov-10
03-Dec-10
17-Dec-10
31-Dec-10

14-Jan-11

28-Jan-11

High levels of volatility skew for far out-of-the-money options showing

11-Feb-11

25-Feb-11

11-Mar-11

25-Mar-11

increased likelihood of large declines in equity prices.

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 Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance Page 4
Large Declines in Spot Volatility
Abnormal VIX Index Drawdowns of the New Regime (May 2010 - April 2011)
10,000
Ranked by % Vol Drop from 1990 to 2011 Ranking of VIX Index Drawdowns
Ranking (1990- During
End Date # Days % Vol Drop
(% drop in volatility over consecutive days)
2011) QE2?
(January 1990 to April 2011)
#1 May 12, 2010 3 days -42.88%
#2 Yes March 25, 2011 7 days -40.86%
Drawdowns
1,000
#17 July 12, 2010 7 days -30.14% explainable by
#34 May 25, 2010 3 days -25.64% power law

Ranking (Logarithmic Scale)

Not explained by power law function
#43 Yes December 3, 2010 3 days -24.47%
function
#45 June 15, 2010 4 days -24.25%
#56 Yes September 3, 2010 4 days -22.40% 100
#70 Yes November 19, 2010 3 days -21.20%
#71 Yes February 4, 2011 5 days -21.14%
#83 April 29, 2010 2 days -20.21% July 12, 2010
#107 June 3, 2010 2 days -18.37%
10
#128 Yes February 28, 2011 3 days -17.71%
% Drawdown in VIX Index - 1990 to May 2010
#144 Yes November 5, 2010 4 days -16.92%
March 25, 2011 % Drawdown in VIX Index - May 2010 to April 2011
#153 May 27, 2010 1 days -16.54%
#189 April 20, 2010 2 days -14.90%
May 12, 2010
#278 Yes January 27, 2011 4 days -12.83% 1
#291 October 12, 2010 3 days -12.63% -46.00% -41.00% -36.00% -31.00% -26.00% -21.00% -16.00% -11.00% -6.00% -1.00%
#313 Yes March 3, 2011 2 days -12.02% 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 30 Effect of QE2 on Daily % Changes in VIX & S&P 500 Index
November 10, 2010 to March 30, 2011 November 10, 2010 to March 30, 2011
25 25 VIX Index S&P 500 Index
Days w/o QE2 (% Change) +2.14% -0.01%
FR Treasury Purchase (QE2) in $Billions

QE2 Days (% Change) -0.45% +0.11%

20 20 QE2 Days >=$3bn (% Change) -0.18% +0.11%
QE2 Days >=$5bn (% Change) -0.25% +0.14%
VIX Index (%)

15 15
QE2 Days >=$7bn (% Change) -0.57% +0.21%
FR Treasury Purchase (TIPS) ($bn) +2.50%
FR Treasury Purchase (Treasury Bonds) ($bn) +2.14%
VIX Index +2.00%
10 10
Average VIX since 1990
% Change (Logarythmic)

+1.50% VIX Index

S&P 500 Index
+1.00%
5 5
+0.50% +0.21%
+0.11% +0.11% +0.14%
+0.00%
0 0 -0.01%
-0.50% -0.18% -0.25%
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

-0.45%
-0.57%
-1.00%
Days w/o QE2 QE2 Days QE2 Days >=$3bn QE2 Days >=$5bn QE2 Days >=$7bn

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 Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance Page 5
Abnormally Steep Volatility Curve
1.42x
VIX Term Structure (Normalized)
1.37x

1.32x

1.27x
VIX Future / VIX Index

1.22x

1.17x

1.12x

1.07x Current VIX Term Structure (March 2011)

Historical Average Term Structure (2004-Present)
1.02x 3-month Average VIX Term Structure
Term Structure Since QE2
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 (z-
axis) 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) Normalized ATM S&P 500 Implied Volatility Term Structure
April 2007 to April 2011
1.40x
1.60x
Normalized ATM IV (Implied Vol / 30 day Implied Vol)

1.35x 1.50x

1.40x
ATM S&P 500 Implied Volatility / 30 day ImpliedVolatility

1.30x 1.30x

1.20x

1.25x 1.10x

1.00x
1.20x 0.90x

0.80x
1.15x 0.70x
5-Apr-2007
29-Jun-2007
21-Sep-2007
14-Dec-2007
29-Feb-2008

1.10x
23-May-2008
15-Aug-2008
7-Nov-2008
23-Jan-2009
17-Apr-2009
10-Jul-2009
2-Oct-2009

1.05x
24-Dec-2009

Current Vol Structure (March 2011)

19-Mar-2010
11-Jun-2010

720 days

Average since October 2010

3-Sep-2010

360 days
180 days
150 days
26-Nov-2010

120 days
90 days

1.00x
18-Feb-2011

60 days

Historical Average (2000 to Present)

30 days

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

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

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Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance Page 6
Underperformance of Variance Hedges
Ratio Sensitivity of VIX Futures to the VIX Index Given a 10%+ Jump in Vol
The steeper volatility term-structure has eroded the 0.57x 100%

Sensitivity Ratio = % Change VIX Future / % Change in VIX Index

effectiveness of long-term variance as a hedge against abrupt 0.52x
90%

market declines. This problem is worth serious consideration for 80%

Loss of Hedge Effectiveness Since QE2

0.47x
any institution using variance or out-of-the-money options as Loss of Hedge Effectiveness (-%) Since QE2 70%
0.42x VIX Sensitivity Ratio - January 2007 to September 2010
portfolio insurance. In essence, investors are getting less return VIX Sensitivity Ratio - Average Since QE2 Sep 2010 to March 2011
60%

for their money on their volatility insurance policies. For example, 0.37x 50%

in the QE2 environment long-dated VIX futures are 0.32x

40%

approximately 18% less effective in capturing changes in 0.27x

30%

volatility as compared to prior periods. Since there is an arbitrage 20%

0.22x
relationship between VIX futures and one-month forward variance 10%

swaps we should expect similar erosion of performance in the 0.17x

Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7
0%

over-the-counter swaps market and for far out-of-the-money

options. The chart to the right shows the percentage change in Volatility of VIX Futures Curve - Post QE2
VIX futures as a ratio to the percentage change in the VIX index 200
on days when volatility jumped 10% or more. From September
150
2010 to March 2011 the volatility of volatility on the back of

Volatility of Volatility %
100
curve has lost significant sensitivity to negative shock events. As
50
can be seen from the graphic to the lower right, the VOV for
0
months 4-7 of the volatility surface did not shift significantly

10-Sep-10
30-Sep-10
following the natural disaster in Japan. This is because volatility

20-Oct-10
09-Nov-10
30-Nov-10
shocks were already priced into the steep volatility curve.

20-Dec-10
10-Jan-11
Investors using variance as portfolio insurance are hurt in two

31-Jan-11
18-Feb-11
ways: (1) less effective performance during volatility shock events

11-Mar-11
and (2) significant time decay erosion during low-volatility

31-Mar-11
periods. While long-term volatility hedges still offer valid
protection in the event of a crash they are clearly underperforming VIX Futures Term

in this market.
High Volatility Skew S&P 500 Index - Historical Skew Levels
(OTM Put IV - OTM Call IV) / ATM IV
(2001 to Present) - 150 days to maturity
The new volatility regime is characterized by an increased 2.00x
1.80x
expectation for extreme price movements, as exemplified by 1.60x
1.40x
elevated levels of implied volatility skew for far out-of-the- 1.20x
1.00x
money options. Skew is an important indication of where 0.80x
0.60x
investors are placing leveraged bets. In essence, skew measures 0.40x
0.20x

perceived tail risk.

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

The normalized skew for SPX options has been increasing

4-Nov-05
3-Mar-06
30-Jun-06
27-Oct-06
23-Feb-07
22-Jun-07
19-Oct-07

since early 2009, but the unusually robust skew for far out-of-the-
8-Feb-08
6-Jun-08
3-Oct-08
23-Jan-09
22-May-09

18-Sep-09

1.80x-2.00x 1.60x-1.80x

50% OTM Skew

money index options signifies a greater than average probability 15-Jan-10

40% OTM Skew

14-May-10

30% OTM Skew

10-Sep-10
1.40x-1.60x 1.20x-1.40x

20% OTM Skew

7-Jan-11
10% OTM Skew
of a large price dislocation over the next five months. For 1.00x-1.20x
0.60x-0.80x
0.80x-1.00x
0.40x-0.60x
example the volatility skews for options that are 40-50% out-of- 0.20x-0.40x

the-money are now close to their highest levels in a decade (see

chart to the lower right). This means the investors are placing 2.50x
S&P 500 Index - Historical Skew Levels
(OTM Put IV - OTM Call IV) / ATM IV
bigger bets on large declines in prices than they are increases. 2.00x
(2001 to Present) - 150 days to maturity
[% OTM Put IV - % OTM Call IV]/ ATM IV

Oddly the skew for options that are only 10% out-of-the- 1.50x

money are not showing strong cause for alarm. Why is there such
the large difference and what does it mean? One interpretation is 1.00x

that although the risk of a market decline is low, if a pull-back

0.50x
does occur it is much more likely to be a dramatic crash rather
than a routine correction. 0.00x
10% OTM Skew
20% OTM Skew
30% OTM Skew
40% OTM Skew
50% OTM Skew
-0.50x
Oct-01

Oct-02

Oct-03

Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10
Jan-01
Apr-01
Jul-01

Jan-02
Apr-02
Jul-02

Jan-03
Apr-03
Jul-03

Jan-04
Apr-04
Jul-04

Jan-05
Apr-05
Jul-05

Jan-06
Apr-06
Jul-06

Jan-07
Apr-07
Jul-07

Jan-08
Apr-08
Jul-08

Jan-09
Apr-09
Jul-09

Jan-10
Apr-10
Jul-10

Jan-11

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

1.40x 2.40x

1.35x
Implied Volatility / ATM Vol Ratio

2.20x

Implied Volatility / ATM Vol Ratio

1.30x
2.00x
1.25x
1.20x 1.80x
1.15x
1.60x
1.10x
1.05x 1.40x
1.00x 1.20x
0.95x
0.90x
12-Dec-08 1.00x
20-Feb-09
0.80x
08-May-09

03-Jun-08
24-Jul-09

28-Jul-08
22-Sep-08
17-Nov-08
09-Oct-09

05-Jan-09
02-Mar-09
27-Apr-09
24-Dec-09

22-Jun-09
17-Aug-09
12-Mar-10

12-Oct-09
07-Dec-09
28-May-10

01-Feb-10
29-Mar-10
13-Aug-10

24-May-10
19-Jul-10
29-Oct-10

13-Sep-10
08-Nov-10
50.0%
40.0%
30.0%

14-Jan-11

03-Jan-11
20.0%
10.0%

28-Feb-11
ATM
-10.0%

30-Mar-11
-20.0%
-30.0%
-40.0%
-50%

% OTM
% OTM

0.25x SLV 30% OTM Vol Skew 0.40x GLD 30% OTM Vol Skew
0.20x 0.30x
0.15x 0.20x
0.10x 0.10x
0.05x 0.00x
0.00x -0.10x
-0.05x -0.20x
Correction
-0.10x -0.30x Correction
Coming?
-0.15x -0.40x Coming?
-0.20x -0.50x
Feb-09

Sep-09

Feb-10

Sep-10

Feb-11
Nov-09

Nov-10
Jun-09

Jun-10
May-09

May-10
Dec-08

Dec-09

Dec-10
Mar-09

Mar-10

Mar-11
Oct-09

Oct-10
Aug-09

Aug-10
Apr-09

Apr-10
Jan-09

Jan-10

Jan-11
Jul-09

Jul-10

Sep-08

Feb-09

Sep-09

Feb-10

Sep-10
Nov-08

Nov-09
Jun-08

Jun-09

Jun-10
May-09

May-10
Dec-08

Dec-09
Mar-09

Mar-10
Oct-08

Oct-09
Aug-08

Aug-09

Aug-10
Apr-09

Apr-10
Jan-09

Jan-10
Jul-08

Jul-09

Jul-10
USO Oil ETF - 120 Day Volatility Skew TLT 20+ US Tresury ETF- 120 Day Volatility Skew
May 2007 to March 2011 January 2004 to March 2011

1.60x
1.90x
1.50x
Implied Vol / ATM Vol Ratio
Implied Vol / ATM Vol Ratio

1.40x 1.70x

1.30x
1.50x
1.20x

1.10x 1.30x

1.00x
1.10x
0.90x

0.80x 0.90x
11-May-07

2-Jan-04
3-Aug-07

21-May-04
26-Oct-07

8-Oct-04
11-Jan-08

25-Feb-05
4-Apr-08

15-Jul-05
27-Jun-08

2-Dec-05
19-Sep-08

21-Apr-06
12-Dec-08

8-Sep-06
27-Feb-09

26-Jan-07
22-May-09

15-Jun-07
14-Aug-09

2-Nov-07
14-Mar-08
6-Nov-09
29-Jan-10

1-Aug-08
19-Dec-08
23-Apr-10

1-May-09
16-Jul-10
8-Oct-10

18-Sep-09
5-Feb-10
31-Dec-10

25-Jun-10
25-Mar-11

12-Nov-10

29-Mar-11

% OTM
% OTM

0.50x USO Oil ETF - 30% OTM Vol Skew 0.60x TLT 20+ US Treasury ETF - 10% OTM Vol Skew
0.40x 0.50x
0.30x 0.40x Higher Call IV? Means ↓
LT UST Yields?
0.20x 0.30x
0.10x Higher Oil 0.20x
0.00x 0.10x
-0.10x 0.00x
-0.20x -0.10x
Sep-07

Sep-08

Sep-09

Sep-10
Nov-07

Nov-08

Nov-09

Nov-10

Feb-04

Feb-05

Feb-06

Feb-07

Feb-08

Feb-09

Feb-10

Feb-11
Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

Nov-10
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

Aug-03

Aug-04

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10
Jan-08

Jan-09

Jan-10

Jan-11
Jul-07

Jul-08

Jul-09

Jul-10

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Artemis Capital Management, LLC | Is Volatility Broken? Normalcy Bias and Abnormal Variance Page 8
Reasons for the New Volatility Regime
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 (short-
term 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? Normalcy Bias?
NYSE Margin Debt vs. VIX Index (monthly avg.) PIGS 10yr CDS spread vs. European Volatility
600
45
$310
47
550
$290
40
500 42
Avg. 10yr PIGS CDS Spread (bps)

$270
NYSE Margin Debt ($mil)

European Volatility (%)

35 450
37
$250
Volatility (%)

400
$230 30
32

350
$210
25 27
300
$190

20 22
250
$170 Average PIGS 10 Year CDS (Por-Ire-Gre-Spa)
NYSE Margin Debt ($mil)
European Volatility - VSTOXX Index %
US Volatility (Avg. Monthly VIX Index)
200 17
$150 15
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-…

13-Nov-10
27-Nov-10

22-Jan-11

5-Mar-11
18-Sep-10

19-Feb-11
2-Oct-10
12-Jun-10
26-Jun-10

7-Aug-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

Nov-09

Jan-10

Nov-10

Jan-11
Feb-09

Sep-09

Feb-10

Sep-10

Feb-11
May-09

May-10
Jun-09

Jun-10
Jul-09

Jul-10
Mar-09

Mar-10

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

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 vérité Vive la volatilité

Sincerely,

Artemis Capital Investors, L.P.

Christopher R. Cole, CFA

Managing Partner and Portfolio Manager

Artemis Capital Management, L.L.C.

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 FUND’S 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