Artemis Capital Q3 2011 Fighting Greek Fire With Fire 2

7/31/2019 Artemis Capital Q3 2011 Fighting Greek Fire With Fire 2

1/11

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.


2/11

Letter to Investors Third Quarter 2011 Page

www.artemiscm.com (310) 496-4526

520 Broadway, Suite 35

Santa Monica, CA 9040

(310) 496-4526 pho

(310) 496-4527 f

www.artemiscm.co

[email protected]

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

The world economy is fighting a fearsome wildfire as the European sovereign debt crisisburns its way closer toward the tinderbox of a second global recession. 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 third quarter of 2011 was characterized by explosivemovements in equity markets as the S&P 500 index declined -14% in the worst

performance since the crash of 2008. Global indices officially entered bear market territory

with the MSCI All-Country World Index down more than -20% since peaking in May. The

10-year US Treasury yield reached the lowest level on record in September as credit

markets braced for an economic slowdown. Over the quarter implied volatility increased

+96% as the VIX index climbed to 42.96. If you heeded the omens of variance markets

earlier this year you were richly rewarded by this increase in volatility.A wildfire is blind and cruel in violently transforming the essence of any material to ash. In this sense the end-effect of fire

always correlation and volatility. The common method to extinguish a wildfire is by dousing it with water but what if this

not enough? Is it possible for fire to resist or spread through the addition of liquidity? Ironically in recorded history thereone such type of flame... Greek Fire. Greek Fire was the most feared weapon of the Byzantine Empire because water alo

was powerless against its flames. The composition of the weapon is an ancient secret but modern scientists believe it w

made with calcium phosphide (heating lime, bones, charcoal) which, upon contact with water, ignites spontaneously. GreFire was so difficult to extinguish that it was known to continue to burn even underneath bodies of water. The fire could f

to any surface, including the sea, explode and spread uncontrollably. For this reason the ancient napalm was very effective

naval warfare and saved Constantinople from two Arab sieges. The guardians of the formula were so afraid it would fall ienemy hands that its secrets were eventually lost to time(1). For those who fought against Greek Fire a liquidity trap becam

liquidity grave.

In the new era of global interconnectedness liquidity alone is not enough to extinguish Europe's Greek Fire. The smolderiflames of default are spreading impervious to fiat money creation. The unintended consequences of unpreceden

intervention in markets are culminating in higher cross-asset correlations and violent price gyrations. All we left have to shfor our three year liquidity orgy is the most correlated period in modern finance. The propensity for erratic movements

DJIA daily lagged returns is at the most extreme levels in over nine decades of recorded data. We are trapped in a bina

market governed by the flip of a macroeconomic coin with deflation on one side and government bail-outs on the other. In t

hyper-correlated market many alpha generating strategies resemble directional volatility trades.

The more global asset classes move in lockstep the more haphazardly the international response to the crisis has become

currency war is raging as central banks alternate dousing sovereign insolvency flames with uncoordinated curren

devaluation. Whether this is Brazil unexpectedly cutting rates by 50 basis points despite the highest inflation in six years

Switzerland pegging the Franc to the Euro to protect exports it is every man, woman, and central bank for itself. Every day

see new kinks in the armor of prior economic and political alliances that lay vulnerable to surrender in a vicious sereinforcing cycle of devaluation. While public opposition grows to bail-out economics the Federal Reserve has very fcredible stimulus options remaining to battle the inferno.

Greek Fire in Europe threatens to ignite a global recession and if you haven't already noticed, your alpha is burning. There

no safe havens and to survive the flames of the next decade we must embrace and harness their nature.

Fight fire with fire ...volatility with volatility

In markets and in life, to find truth


3/11



Thoughts on Volatility - 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).

Earlier this year it was clear the volatility markets were

bracing for a correction following the end of QE2. Withthis thesis in mind Artemis recommended shorting the

long-end of the VIX futures curve where volatility ofvolatility ("VOV") was expensive and replacing that

exposure with more sensitive volatility positions on the

front of the curve where VOV was cheap. The strategywas extremely effective when equity markets collapsed

and the VIX futures curve inverted while options skew

flattened.

What happens from here is much more difficult to

understand. 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 isvery expensive. Nonetheless my intuition tells me that

given the current Euro-crisis, hyper-correlations, lack of

remaining stimulus options, 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 thepotential for greater realized volatility. 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. 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). 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 89.53 reached on October 24,

2008 at the height to the last crash. 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). This is improbable

but within the realm of possibility so look for signs of

contagion that would spark realized and implied volatilityto break the rules of power laws all over again.

With this uncertainty in mind the best course of action is to play both tails of the probability distribution. Global marke

are now hyper-correlated and therefore asset selection is less important. Look for tail risk hedges in assets that exhibit lo

implied volatility relative to realized and cheap skew to the upside and downside. You can use this market schizophrenia

your advantage by entering long volatility tail positions on both sides of the return distribution during the peaks and t

valleys of the market rollercoaster.

VIX

VXF1

VXF2

VXF3

VXF4

VXF5

VXF6

VXF7

16-Sep-08

14-Nov-08

20-Jan-09

23-Mar-09

22-May-

24-Jul-09

24-Sep-09

24-Nov-09

28-Jan-10

31-Mar-10

02-Jun-10

03-Aug-10

04-Oct-10

03-Dec-10

04-Feb-11

07-Apr-11

09-Jun-11

10-Aug-11

VIX Futures

Volatility of VIX Futures Curve (Vol of Vol)

(2008 to Present)

VIX

VXF1

VXF2

VXF3

VXF4

VXF5

VXF6

0.50x

0.70x

0.90x

1.10x

1.30x

1.50x

1.70x

Jan-11

Feb-11

Mar-11

Apr-11

May-11

Jul-11

Aug-11

Sep-11

VIX Futures

VixFuture/VIX

spot

VIX Futures Curve

(normalized by spot VIX / Jan 2011 to Sept 201


4/11



Fire & Water / Volatility and Money

From water comes life and from cash liquidity

comes asset prices. 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, defined here as annualized

monthly changes in M1 through M3, reflect

important turning points in the US economy. Tothis effect we havenever

When the money supply is volatile the risk of a

recession grows incrementally higher. The

volatility of M1, defined as physical currency in

circulation and checking deposits, typically

spikes before the onset of a recession because

market participants transfer risk assets back into

physical cash (see graphic). In this sense, money

is one of the only assets whereby volatility spikes

occur in conjunction with high demand (USTreasury securities also come to mind).

experienced a spike in

M1 volatility as large as what was recorded inAugust 2011 without an ensuing recession.

The evolution of cash volatility provides clues to

the mystery of elevated global correlations. 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). 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). 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. Europe is a

perfect example of this paradox. How can the EUprovide 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 theprocess? 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, not the solution to, market

disequilibrium.

0

5

10

15

20

25

30

35

1

971

1

972

1

974

1

976

1

978

1

980

1

982

1

984

1

986

1

988

1

990

1

992

1

994

1

995

1

997

1

999

2

001

2

003

2

005

2

007

2

009

VolatilityofMoneySupply

Volatility of Money Supply

(annualized / 1971 to 2011)

Recession (Peak to Trough)

Volatility of M1

Volatility of M2

Volatility of M3 Source: M1,M2 & M3 values from Shadow Government Statis

-25

-20

-15

-10

-5

0

5

10

15

1972

1974

1976

1978

1979

1981

1983

1985

1986

1988

1990

1992

1993

1995

1997

1999

2000

2002

2004

2006

2007

DifferenceMoneySupplyVolatility

Difference Annual M3 Volatility- M1 Volatility

(annualized / 1971 to 2011)

Recession (Peak to Trough)

Volatility of M3 - Volatility of M1

Source: M1,M2 & M3 values from Shadow Government Statistics


5/11



Assets to Ash - 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 tradition

portfolio diversification futile. For example in this quarter we recorded the highest realized correlation readings ever for th

50 largest S&P 500 index stocks, S&P 500 sectors, Country ETFs, and in the CBOE S&P 500 Implied Correlation Index. W

have yet to fully comprehend the extent to which bail-out economics, competitive currency devaluation, and unprecedente

global monetary stimulus are contributing to what is now a decade long trend of higher correlation drift.

Volatility of the FireIf volatility is the heat of the fire correlations are the windsstirring the flames. The implied volatility of an index, such as

the S&P 500, is more sensitive

5

15

25

35

45

55

65

75

85

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

Feb-07

Jun-07

Oct-07

Feb-08

Jun-08

Oct-08

Feb-09

Jun-09

Oct-09

Feb-10

Jun-10

Oct-10

Feb-11

Jun-11

S&P500-21dayRollingCorrelationInd

ex

Realized Correlation of 50 Largest Cap S&P 500 stocks

(1 month rolling- 2005 to Present)

33

38

43

48

53

58

63

68

73

78

Feb-07

May-07

Aug-07

Nov-07

Feb-08

May-08

Aug-08

Nov-08

Feb-09

May-09

Aug-09

Nov-09

Feb-10

May-10

Aug-10

Nov-10

Feb-11

May-11

S&P500IndexImpliedCorrelation

Implied Correlation of S&P 500 Index

(12 month constant adjustement)

-80

-60

-40

-20

0

20

40

60

80

100

120

1 101 201 301 401 501 601 701 801 901 1001 1101 1201

21dayRealizedCorrelation

Ranking (Lowest to Highest)

Ranked 21 day Realized Correlations of 50 LargeCap Stocks in SPX

(2005 to Present)

9/7/2011 (Highest Correlation at 0.82)

2008 Crash High (11/13/2008 -Correlation at 0.76)Bull Market Low (11/3/2006 - Correlation at 0.10)

0.05

0.15

0.25

0.35

0.45

0.55

0.65

0.75

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

S&P 500 Sector Correlation

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Country ETF Correlation

when the average correlations

between the components of the index are greater. For

example, if average correlation of index components risesfrom 0.35 to 0.70 the volatility of that index should be 45%

more sensitive. Therefore as correlations have drifted higher

over the past decade so has the volatility of volatility. Today

correlation is at all-time highs so it is natural to expect

similar extremes for changes in volatility. This partly

explains why the volatility of the VIX index reached the

highest level in its history at the end of August (see graph)surpassing readings achieved during the 2008 financial crash

and 2010 flash crash. The trend is troublesome for traditional

portfolio management but presents opportunities for

volatility as an asset class. Look to capitalize on highervolatility of volatility potential through timely execution of

long vega/convexity positions in the tails of the return

distribution.

20

70

120

170

220

270

Jan-00

Jun-00

Nov-00

Apr-01

Sep-01

Feb-02

Jul-02

Dec-02

May-03

Oct-03

Mar-04

Aug-04

Jan-05

Jun-05

Nov-05

Apr-06

Sep-06

Feb-07

Jul-07

Dec-07

May-08

Oct-08

Mar-09

Aug-09

Jan-10

Jun-10

Nov-10

Apr11

VolatilityoftheVIXindex(%annualized)

21d Volatility of the VIX Index

(2000 to Present)


6/11



Everyone is a Volatility Trader

It is becoming harder and harder to make money

from money. The alpha derived from active

management can be decomposed into two

components 1) asset selection and; 2) volatility bias.

In highly correlated markets the asset selection

component is negated and alpha becomes

increasingly driven by rising and falling vol. Whenthis happens many classic hedge fund strategies

converge to simple synthetic volatility trades. This

could be one reason why many high profilemanagers including Druckenmiller and Soros are

quitting the business while they are still ahead of thecurve. For example strategies that rely upon mean

reversion such as traditional value investing, pairs

trading, and statistical arbitrage become akin to

shorting volatility. 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). Remove the asset selection component entirely and you aeffectively shorting volatility. Likewise investment strategies that rely on trend following such as managed futures an

global-macro are akin to going long volatility. This is one reason why, like everything else, hedge fund returns are becomin

more correlated with one another (see graphic / HFRX indices).

Volatility and the Carry Trade

When Greek Fire fuses to the sea the water itself becomes an extension of the flames. To this effect the daily performance

equity volatility and currencies is increasingly indistinguishable. I understand that some volatility traders hate currencies othe basis that you never know when central banks will change the rules of the game. In today's markets currency trading an

volatility trading are being played on the same court with the same unpredictable referees. We can best understand excessiv

correlation drift between equity vol and risk currencies as being driven by lower interest rates in developed economies th

provide fuel to the carry trade fire. Since 2008 the VIX index and the JPY/AUD cross has moved in near perfect lockste

(see below) recording a 0.85 correlation. The trend is also noticeable in the correlation drift between the VIX index and

cross-section of "risk" currencies. Furthermore the correlation drift between the VSTOXX (European equity volatility) an

the Euro/USD is also at historical extremes. The marriage of volatility and currency is a worrisome devlopment because

implies the equity risk premium is not about economic fundamentals but instead is a function of global central banks fuelin

leveraged carry trades.

-0.9

-0.7

-0.5

-0.3

-0.1

0.1

0.3

0.5

Aug-03

Feb-04

Aug-04

Feb-05

Aug-05

Feb-06

Aug-06

Feb-07

Aug-07

Feb-08

Aug-08

Feb-09

Aug-09

Feb-10

Aug-10

3-month Correlation VIX to

Risk Currencies(AUD.USD; CAD.USD ; NZD.USD; AUD.JPY; EUR.CH

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

Mar-00

Sep-00

Mar-01

Sep-01

Mar-02

Sep-02

Mar-03

Sep-03

Mar-04

Sep-04

Mar-05

Sep-05

Mar-06

Sep-06

Mar-07

Sep-07

Mar-08

Sep-08

Mar-09

Sep-09

Mar-10

Sep-10

Mar-11

Sep-11

3-month Correlation VSTOXX to

Euro/USD0

20

40

60

80

100

1200

10

20

30

40

50

60

70

80

90

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Jul-11

JPY/AUD

VIXin

dex%

VIX (lhs) vs. Japanese Yen/Aussie Dollar(rhs)

Correlation = 0.85 since September 2008

-0.3

-0.1

0.1

0.3

0.5

0.7

0.9

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Jul-11

Hedge Fund Strategies 1-month Correlations(HFRX Equity Hedge, Relative Value, Event Driven / 2-day lag)


7/11



40 years of Mean Reversion

The degree of up and down days in the DJIA is at the most extreme level in recorded history representing a pinnacle in aera of daily mean reversion. It only takes a casual observer of markets to see that the propensity for large-up days followe

by large-down days seems particularly vicious in today's cycle. The excessive intra-day and day-to-day volatility

nauseating to professional and retail investors alike and multi-100 point swings in the DJIA are all too common.

On a macro-level changes in the size and volatility of the money supply may be connected to a phenomenon called seri

correlation drift. Modern derivative pricing theory is based on a conceptual idea that knowledge of past prices has n

bearing on future returns (martingales). Despite this fact there is evidence that asset returns show signs of "serial correlatio

whereby past returns are correlated (to some level) with future results. There are two forms of serial correlation 1) Negati

serial correlation measures the propensity for today's return to be the opposite of yesterday's and rewards reversion to th

mean strategies. For example an asset that alternates between being +1% and -1% every day demonstrates perfect negativserial correlation. 2) Positive serial correlation is associated with consecutive days of asset price movement in the sam

direction and rewards trend following models. Both forms of serial correlation can occur in up or down trending markets.

We are going nowhere at the fastest pace in market history. The rolling one year serial correlation of daily laggelogarithmic returns in the DJIA reached a generational peak on May 25th, 1971. Less than three months later on August 15t

1971 President Nixon surprised the international monetary system by cancelling the direct convertibility of the United Stat

dollar to gold. After the "Nixon Shock" positive serial correlation in DJIA daily returns began a four decade decline. OAugust 11th, 2011 we reached the lowest levels of serial correlation in the 82 year history of the DJIA almost exactly 4

years to the day that Nixon abandoned the gold standard.

Is this a statistical coincidence? A random coin flip, whereby heads represent a +1%

day on the market and tails a -1%, will also occasionally exhibit serial correlation

extremes on a rolling one year basis. Despite this fact, this coin flip test, run over100 years through 10,000 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).

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?

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

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0.5

1929

1932

1935

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1941

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1947

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1953

1956

1959

1962

1965

1968

1971

1974

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1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

Rolling 1yr Serial Correlation of daily lagged returns

Dow Jones Industrial Average (1928 to 2011)0 Positive Daily Correlation

PositiveSer

ialCorrelation

NegativeSerialCorrelation

10/9/1931

6mo Return = -51%11/24/1964

6mo Return = +3%Lowest Negative Serial Correlation

8/11 /2011 6mo Return = ??

9/30/2008 6mo Return = -37%

3/18/2004 6mo Return = -0.1%

8/15/1971

US leaves gold standard

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

Year1

Year9

Year17

Year25

Year33

Year41

Year49

Year57

Year65

Year73

Rolling Correlation Random Coin (Heads = +1% , Tails = -1%)

0 Positive Daily Corre la

PositiveSerial

NegativeSerial


8/11



Smoke in the Panic Room

As investors sought refuge from crashing markets many "safe haven" assets actually began to appear risky. At alternatin

times during the quarter confidence was shaken in established havens including the US dollar, US Treasury securities, Swi

Franc, and Gold. This was a stark reminder that "risk-free" is a myth.

MBA programs teach their students to use the yield on US government debt as the "risk-free rate" of return in the capit

asset pricing model. The only problem is now "risk-free" is rated AA+. In a bold decision on August 5th, Standard & Poo

announced that it lowered the United States' credit rating citing political risks and a rising debt burden. Prior to th

downgrade US Treasury Bonds and the dollar were already losing value as partisan bickering over the debt ceiling raised thspecter of an unthinkable US default. Counter intuitively this represented a buying opportunity. In August and Septemb

US Treasury securities rallied on recession fears and the yield on the 10 year fell 84 basis points to an all time low of 1.72

by September 22nd. Nonetheless our political risk is rapidly becoming credit risk.

Over the past few years the Swiss Franc was a popular safe haven appreciating +28% against the Euro and +50% against th

dollar since 2003 much to a chagrin of the people who export quality watches and chocolate. On September 6th in a surprisdecision the Swiss National Bank devalued the Franc pegging it at 1.20x to the Euro resulting in an immediate +8.9% ga

against the dollar.

The new risks in supposedly "safe

haven" currencies may encourage us

all to become gold bugs, but before

you buy a shotgun and a strongboxkeep in mind that gold also took a

beating this quarter. In September the

GLD ETF was down -11.06%

compared to -7.18% decline in the

S&P 500 index. The thesis for gold

ownership is logical considering

global competitive currency

devaluation but it is always dangerousto be in the most crowded trade when

the margin comes due. In these

markets gold has behaved like a safe

haven in the good times, and acommodity during the bad. This is

disappointing if the objective is true

safe haven status.

If recent history is any guide investors

seeking shelter from crisis are finding

smoke in every panic room. The

global financial system seems poised

for monumental changes over the next

decade and there is no telling if today's

safe haven may be tomorrow's risk

asset.

To this effect the importance ofvolatility and convexity in a portfolio

shouldn't be underestimated because

they offer protection against risks wedon't yet know or fully understand.

-50%

-40.0%

-3

0.0%

-20

.0%

-10.0%

ATM

10.0%

20.0%

30.0%

40.0%

0.95x

1.15x

1.35x

1.55x

1.75x

1.95x

24-Jun-11

08-Jul-11

22-Jul-11

05-Aug-11

19-Aug-11

02-Sep-11

16-Se

p-11

30-Sep-1

1

% OTM

ImpliedVolatility/ATMV

olRatio

GLD ETF - 120 Day Volatility Skew

June 24 to September 30, 2011

-0.20x

-0.15x

-0.10x

-0.05x

0.00x

0.05x

0.10x

0.15x

0.20x

Jun-11 Jul-11 Aug-11 Sep-11

GLD 20% OTM Vol Skew

-50%

-40.0

%

-30.0

%

-20.0

%

-10.0

%ATM

10.0

%

20.0

%

30.0

%

40.0

%

0.75x

0.95x

1.15x

1.35x

1.55x

1.75x

1.95x

2.15x2.35x

24-Jun-11

08-Jul-11

22-Jul-11

05-Aug-11

19-Aug-11

02-Sep-11

16-Sep-11

30-Sep-11

% OTM


olRatio

UUP ETF ($USD Index Bullish) - 120 Day Volatility Skew


-0.60x

-0.50x

-0.40x

-0.30x

-0.20x

-0.10x

0.00x

Jun-11 Jul-11 Aug-11 Sep-11

UUP 10% OTM Vol Skew

-50%

-40.0%

-30.0%

-20.0%

-15.0%

-10.0%

-5.0%

ATM

5.0%

10.0%

15.0%

20.0%

30.0%

40.0%

0.80x

0.90x

1.00x

1.10x

1.20x

1.30x

1.40x

1.50x

1.60x

1.70x

24-Jun-11

15-Jul-11

5-Aug-11

26-Aug-11

16-Sep-11

% OTM

ImpliedVol/ATMV

olRatio

TLT 20+ US Treasury ETF- 120 Day Volatility Skew

June 24 to Sept 30 2011

0.17x

0.19x

0.21x

0.23x

0.25x

0.27x

Jun-11 Jul-11 Aug-11 Se

TLT 20+ US Treasury ETF - 5% OTM Vol Skew

-50%

-40.0

%

-30.0

%

-20.0

%

-10.0

%ATM

10.0

%

20.0

%

30.0

%

40.0

%

50.0

%

0.95x

1.00x

1.05x

1.10x

1.15x

1.20x

1.25x

24-Jun-11

08-Jul-11

22-Jul-11

05-Aug-11

19-Aug-11

02-

Sep-11

16-Sep

-11

30-Sep-11

% OTM


olRatio

FXF ETF (Swiss Franc Bullish) - 120 Day Volatility Skew


-0.15x

-0.10x

-0.05x

0.00x

0.05x

0.10x

0.15x

0.20x

Jun-11 Jul-11 Aug-11 Sep

FXF Swiss Franc 10% OTM Vol Skew

Evolution of Implied Volatility Surface for Investor Safe Havens

Third Quarter 2011


9/11



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. The strategy is effectively a

global macro-straddle that is long volatility and

convexity. As world draws closer to a secondrecession the unpredictable rising and falling tides ofliquidity will either lift or sink all ships. 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. The table to right presents a

multi-asset comparison of volatility risk premiums

that will serve as a starting point. For example during

the next vicious short covering rally you may consider

buying competitively priced far-OTM put options in

emerging economies or Asian equities. In the event

developed economies like the US and Europe fall backinto recession there is little reason to believe equity

volatility in China, Japan, South Africa, or Chile will

be immune given trends in correlation. When equity

markets are oversold protect against surprise monetary

intervention using unloved far-OTM call options on

financials, high yield debt, and OTM puts on the Yen

and US dollar index. With a small amount of riskcapital you can win on both sides of the

macroeconomic coin toss.

Monetize Volatility of Volatility

VIX options provide attractive opportunities forsophisticated investors to hedge against global

contagion risk. Although the VIX index is currently

elevated the skew, or spread between the local

volatilities for VIX options (adjusted by historical

standard deviation moves) is extremely flat. When theVIX index increases the option skew typically

pancakes as volatility of volatility shifts from OTM

calls to OTM puts reflecting higher probability ofmean reversion (see chart). 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. To execute this trade sell OTM VIX callsat +1 or +2 standard deviations above the respective

November or December VIX futures price and

purchase 2x the number of further OTM calls. This

"Euro-apocalypse" hedge will provide an exponential

payoff in the event the VIX increases above 50+ but

will otherwise result in a small loss of capital.

0.60x

0.70x

0.80x

0.90x

1.00x

1.10x

1.20x

1.30x

1.40x

Volatilit

yofVIXFuturesasaratiotoATMV

ol

VIX Strike Price Expressed as Standard Deviation of VIX future

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 0.20x 0.40x 0.60x 0.80x 1.00x 1.20x 1.40x

SPYQQQIWM^VIX

XLYXLPXLE

XLFXLIXLKXLBXLUEFA

EEMFXI

EWHEWYEWAEWJEWZECH

EWWEZA

EWGEWI

EWPEWU

TLTIEI

IEFLQDHYGJNKPFFTIP

BNDAGGUUP

FXCFXAFXFFXEFXSFXYGLDSLV

USOGDXUNGDBA

MOODBB

JJC

Volatility Insurance Ratio

ExchangeTradedProduct

Cross-Asset ETF Volatility Insurance Ratio

Ratio = Avg. 12 Month Volatility Skew & Implied Vol / Historic Vol

Higher Ratio = Higher Cost for Protection against Loss

Domestic Equity

Volatility

Domestic Equity - SectorsIntl. Equity - Index

Intl. Equity - Asia

Intl. Equity - Americas & S. A

Intl. Equity - Europe

Domestic Fixed Income

Currency

Commodities

Source: Ivolatility.com Ratio= Average of [(10% OTM Put Vol - 10% OTM Call Vol) / ATM Vol] and [1m Implied Vol/1m Historic Realized Vol]


10/11



Volatility and Truth

It is becoming harder for markets to deny the existential state of the global economy. The large banks that were too-big-t

fail are now even bigger than before the crisis. Unemployment is an epidemic and will result in a lost generation for million

of Americans and Europeans. The middle class is under significant pressure with 14 million Americans officially out of wo

and another 16 million underemployed which in combination would form a state with the population of Texas. In Spa

nearly half of the people under the age of 25 are unemployed and in Greece, Italy, and Ireland nearly a third. The number o

unemployed youth in OECD countries is higher than at any time since the organization started collecting data in 1976

These are the lost children of the global economy.

Things are likely to get worse before they get better. As we move closer to a second global recession it is highly questionabwhether or not the European and domestic banking systems can withstand another systemic shock. The difference this time

that Main Street is ready to revolt against any new round of bail-out economics. A movement called Occupy Wall-Street th

opposes corporate greed, financial bail-outs, and the political influence of banks is attracting hundreds of grass-roo

followers and conducting protests in lower Manhattan and across the country. As I write this letter 700 people were ju

arrested for blocking traffic on the Brooklyn Bridge. This movement is spreading and has held demonstrations in Boston, S

Louis, Chicago, Philadelphia, and Los Angeles. The group is similar to protests across Europe including the indignados ("th

outraged") movement in Spain and escalating strikes and sit-ins in Greece. A recent poll shows that two thirds of German

believe their parliament should block any more demands for euro bail-outs (4). The question we should ask ourselves is n

whether policy makers can or cannot orchestrate another massive bail-out of the global banking system, but whether or n

the citizens of developed countries are going to allow it. How this will end is impossible to predict, but in the next deca

we are about to learn a lot more about volatility.

Volatility as a concept is widely misunderstood. Volatility is not fear. Volatility is not the

VIX index. Volatility is not a statistic or a standard deviation, Black-Scholes input,

GARCH model, or any other number derived by abstract formula. Volatility is nodifferent in markets than it is to life.

Volatility is an instrument of truth. Regardless of how it is measured it reflects thedifference between the world as we imagine it to be and the world that actually exists. It

is the fire in Plato's cave that illuminates the shadows of reality for those chained to the

darkness. It is as global as a violent revolution resulting in social change; or as personal as

an exhilarating relationship with a complex woman who is very there and then

inexplicably gone. Volatility hurts but is necessary for growth. In nature volatility is so

fundamental that the trees of the great sequoia forest will not release their seeds withoutfirst sensing heat from wildfires. It is from the flames of change that we derive the

potential for healthy resurrection and birth. In markets and in life if we don't recognize the

truth in each moment, deny revolution, suppress volatility no matter how painful, we will

not allow ourselves to prosper.

Volatility is change and the world is changing. The truth is that Greece will default. The truth is that if our leaders continue

deny our problems history tells us the US will eventually default. These shocking events will hurt many people, markets w

collapse, life savings will be lost, there will be violence, upheaval, and massive political change but you know what? Th

world will not end. When it is all said and done people will work, they will spend time with their children, they will cr

laugh, and love... life will go on. We will find a way to prosper if we relentlessly search for nothing but the truth, otherwi

the truth will find us through volatility.

Vive la vrit Vive le volatilit

Artemis Capital Investors, L.P.

Christopher R. Cole, CFA

Managing Partner and Portfolio Manager

Artemis Capital Management, L.L.C.


11/11


www artemiscm com (310) 496 4526

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 NOTHAVE 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:

Notes: 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)

Greek Fire / from Madrid Skylitzes / public domain Flaming globe & Sequoia Tree photographs reproduced with rights from Istockphoto.comLiberty Leading the People by Eugne Delacroix / public domain. Security price data from Bloomberg and Yahoo FinanceImplied volatility data from IVolatility.comFootnotes:

(1) "Greek Fire" from Toxepedia.com http://toxipedia.org/display/toxipedia/Greek+Fire

(2) The Federal Reserve ceased reporting M3 in March 2006. 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. See

www.shadowstatistics.com for more information.(3) "It's grim down south" & "the jobless young Left Behind", The Economist September 10th, 2011

(4) "Angela Merkel denies euro bailout backlash was cause of election defeat" The Telegraph September 5th, 2011

Documents

Artemis Capital Q3 2011 Fighting Greek Fire With Fire 2