In this episode I speak with Dean Curnutt, founder of Macro Risk Advisors and host of the Alpha Exchange podcast.
This episode is all about the nature of risk. More specifically, the endogenous risk that can manifest in markets. We discuss the crash of 1987, Long-Term Capital Management, the Financial Crisis of 2008, the XIV implosion of February 2018, and the 2020 COVID crisis.
With these crises in mind, we touches upon topics such as reflexivity, crowding, risk recycling, and the evolving role of the Fed. Dean also shares his thoughts about the nature of risk, how it is woven into the fabric of markets, and why it seems like there’s a crisis every 11 years.
For those who love to think about risk and the nature of markets, this episode is for you.
So sit back, relax, and enjoy this episode of Flirting with Models with Dean Curnutt.
Corey Hoffstein 00:00
Are you ready?
Dean Curnutt 00:01
I sure am.
Corey Hoffstein 00:02
All right 321 Let’s jam. Hello and welcome everyone. I’m Corey Hoffstein. And this is flirting with models, the podcast that pulls back the curtain to discover the human factor behind the quantitative strategy.
Corey Hoffstein Is the co founder and chief investment officer of new found research due to industry regulations. He will not discuss any of newfound researches funds on this podcast all opinions expressed by podcast participants are solely their own opinion and do not reflect the opinion of newfound research. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of newfound research may maintain positions and securities discussed in this podcast for more information is it think newfound.com.
Corey Hoffstein 00:53
In this episode, I speak with Dean Curnutt, founder of macro risk advisors and host of the Alpha exchange podcast. This episode is all about the nature of risk, more specifically the endogenous risks that can manifest in markets. We discussed the crash of 1987 long term capital management, the financial crisis of 2008, the XIV implosion of February 2018, and the 2020 COVID crisis. With these crises in mind we touch upon topics such as reflexivity, crowding, risk recycling and the evolving role of the Fed. Dean also shares his thoughts about the nature of risk, how it’s woven into the fabric of markets, and why it seems like there’s a crisis every 11 years. For those who love to think about risk and the nature of markets. This episode is for you. So sit back, relax, and enjoy this episode of flirting with models with Dean Curnutt.
Corey Hoffstein 01:48
Dean, welcome to the show. Very excited to have you here. Before we even get going, I just want to start with a very big thank you because you host one of my favorite podcasts. So if anyone is listening to flirting with models right now and has not listened to the alpha exchange, I cannot recommend highly enough that after you listen to this episode, you quickly go find the Alpha exchange. I can’t say enough good things about the content you put out and the guests you have on and the quality of the discussion and the conversations. And I know as a podcast host how difficult that is. So I commend you, I thank you. I know it’s often a bit of a thankless thing. So I really appreciate all the effort you put in. And thank you for joining me today.
Dean Curnutt 02:31
Absolutely. I’m pleased to be here to flirt with the flirter with models, so to speak. And thanks for the positive feedback on the off exchange, you were a guest it’s been a great five year journey and really enjoying it. And it’s honestly a function of the guests, I just get to ask the questions. So thanks for the positive feedback, I’ll keep it up
Corey Hoffstein 02:50
a while I always say the same thing. I just asked the questions, and the guests make me look good. And I’m sure this episode will be no different. So let’s begin with a little bit of background, we’re going to spend a lot of time going through your history. So maybe we can keep this a little bit abbreviated. But can you give me an idea where you got started in the industry and take me forward through today?
Dean Curnutt 03:10
Cool. Sure. So I have a son that just finished his first year of college, and I have a second son who’s in 11th grade going to be a senior. And we’re in the college process. And these days, they really want you to choose a major in 11th grade, it seems it’s a little bit early, I wound up a little bit by happenstance going to St. John’s University, in Queens, in the liberal arts program with really no ideas to what I wanted to do. I somehow came across an economics class, which I just really thought this kind of fits how I think about the world little mathy a little scientific, but descriptive of the sort of engine that I think, you know, empowers humanity, which is self interest, and making sense of markets. One economics class became a second and then I sort of found finance and I started taking these finance classes and doing pricing of bonds and so forth. And I said why this really makes sense to me. I was stuck in this liberal arts program at St. John’s. And so I wound up getting this rare Bachelor of Arts in Economics, but it was really stuffed to the gills with finance classes so much though, that my professors were complaining. I wasn’t taking enough liberal arts classes, but that’s really where my interest started was in college, I came across an options pricing class. And that really sent me down the path of exploration on markets. I wound up writing a paper I think it was my third year of college. So this was 1989. And it was on the 1987 stock market crash. And boy that really got me interested. I’d started college in September of 87 But I didn’t really make heads or tails of this epic event on October 19, of 87. But when I started doing this research project on that momentous day, and started really trying to understand the why of it, that really got me fascinated, I got my hands on this thing called the Brady report. And I really started to dive in to economics and finance. And that launched me into the goal of finding my way onto Wall Street, which I did, starting at Nomura Securities in 1991. With I don’t know, I want to say an eight and a half percent long bond amidst 4% inflation. So let’s not think that interest rates can even go up from here. But that sort of started me on the path mostly on the sell side, I can kind of walk through some more on my career history. But that’s really what got me started was college and this exploration into the 87. stock market crash.
Corey Hoffstein 05:54
Well, let’s start there. Because in our pre call, you said that reading that Brady commission report about 87 was truly a formative event, as you’ve mentioned, but really specifically use this language. And to quote you, you said all the things that conspire to occur, and quote, with regards to the crash, I thought that was a really interesting, specific choice of words. And I was hoping maybe you could explain what you meant by that. And how that report really influenced your early thinking about markets.
Dean Curnutt 06:23
Yeah, well, I’ve been lucky enough to reconnect with my alma mater, St. John’s and become an adjunct professor there. And my idea was really to try to teach a class that’s a little bit theoretical, a very practical try to give the students some understanding of market history. And one of my catchphrases is you learn the most about markets by studying the periods when things go horribly wrong. That’s really where you start to really appreciate the inherent fragilities, and learn context. And it’s just hard to argue that, you know, at least for one day that epic downdraft is without precedent, it’s just there’s nothing, you know, through the GFC through COVID, even going back to 1929, it just wasn’t nearly of that one day magnitude of 20 odd percent in the s&p. And so you sort of start to look at this thing, and you’ll learn a number of things pretty quickly. The first is that this thing didn’t come out of nowhere. You had a increasingly unstable backdrop in the days and weeks prior, they’ve recreated the VIX for that period. And the VIX on the 87, crash got to 150. But in the week before, it was 40 Plus, so things were super unstable at that point in time, and there’s a number of things. So, of course, we’ll talk about portfolio insurance in this sort of keyhole effect of too many people trying to do the same thing at once. But there were a number of other things. And some people talk about tax law changes that made the m&a backdrop which was a big kind of tailwind for the markets less favorable. So there were some contemplated tax law changes the dollar, the dollar was getting weaker, because inflation was rising. And this was a different time period, people were worried about balance of payments. For the US, I suppose it’s still a thing, but not necessarily in the crosshairs of market risk. Inflation was rising, as I said, but I think really importantly, long in yields are rising dramatically. When I step back, and I think about the causes of the stock market crash, I can’t get away from a tenure note that got to 10 and a half percent nominal yields in the week before the crisis. And I always say, Listen, if I suddenly gave you a 10%, risk free now, we can say it’s not risk free in the sense that it’s not inflation protected. But we always talk about US Treasury securities as risk free, if suddenly you could get 10% for doing nothing, bearing no risk at all. Against the backdrop of a 40 Odd VIX, boy, that becomes awfully tempting, especially when equity valuations were pretty stretched. So you had a whole bunch of things happening at once. And then of course, you have this very fascinating overlay of portfolio insurance, which we can dive into. It’s really the first in my opinion, the market did it risk off event, right? It’s the set of strategies and exposures, the dynamic ways in which they create effectively a short gamma profile for the market without even any optionality. They behave like optionality, as you know, a lot about momentum and trend strategies. Boy, this was just way too big for the market. And, you know, ultimately, when I think about market risk events, something’s got to happen. So the mark Gotta get some new news that it adjusts to, there’s got to be some shattering of a consensus view. But then the set of strategies that lives and breathes within the markets, oftentimes, they’re related to volatility and convexity, those can really serve to amplify. And in the case of portfolio insurance, this thing relative to the size of the market had just gotten absolutely enormous. You can go back and, of course, Google didn’t exist at the time. But there are ways to look at newspaper articles and so forth, you know, you can do a count of sort of like you would do in Google Trends. And it just goes off the charts people searching for and talking about in portfolio insurance in 1986 1987. So the strategy got really big at the wrong time. It’s mechanistic, and it overwhelmed the market in a big way.
Corey Hoffstein 10:54
And I think that’s going to be a pattern of this whole discussion is the observation and study of these endogenous market events. And and I’m excited to talk through your career and how you’ve seen markets change because of that. You spent a lot of your career in the equity derivatives market. But that’s not really how you began, right? You started at New, More early 1990s, actually, in the economic research department. And I wanted to highlight this because this was a period of time where the communication policy for the Fed was this idea of, quote, purposeful obfuscation, which really stands in very stark contrast to the clarity policies today, where the Fed is not trying to catch anyone off guard in terms of what they do. I’m curious how you think this shift in policy has affected the behavior of market participants and maybe more specifically, equity volatility markets?
Dean Curnutt 11:42
Yeah. So I go back to Greenspan, I love that term, purposeful obfuscation. And I won’t get this quote entirely right. But the thrust of it I will get right, which is, he said something like, if you think I’ve been clear, you must have misunderstood me, something like that. Right? It’s to say that look, I’m not trying to tell you what’s next. That’s part of the value in Fed policy. And I think a lot about this in the post financial crisis period of forward guidance. And I think at every turn, the Fed got more and more active in markets we can talk about, even the response to the 87 crash was a prosaic statement about market functioning, we’re here to provide liquidity, of course, they lowered interest rates a fair amount, there was no buying of government bonds, there was no promise to keep rates, low ad infinitum. They just reacted. And that was enough. And I think we can argue that the financial system was much less derivatized, the counterparty cross exposures were considerably smaller, they were less global, the system was just more innocent. You didn’t have credit default swaps, and variant swaps, and exotics, and so forth. So perhaps that was a luxury that fed policy had at that time, you know, 98 occurs, we’ll talk about LTCM, they broker a deal. But then in this post crisis period, of course, they had to throw the kitchen sink at it, they really embraced this communication. And I just look at market risk taking as a function of a lot of things. But certainly one part of it is trying to evaluate uncertainty and price uncertainty. And by removing one core element of uncertainty, ie the potential that interest rates would change, squishing interest rate volatility, to something that’s so low, not just by the virtue of rates going lower, you know, when rates go low, it’s different than equities going lower, because at least in the US, there’s a lower bound, right, we’ve never really embraced negative rates, thankfully, in my opinion. So when you get lower, you reduce one side of the distribution to zero. So yes, that’s going to bring in interest rate volatility. But there was a second effect. In that long slog post the crisis, when growth was anemic, but positive, inflation was low, they thought it was too low. And they just promised something in terms of not changing the backdrop for rates. And I think they just got very overdone, carry traders lean into that right, a carry trade is really successful. And it effectively states that I think the world will unfold tomorrow as it looks today. Right? That’s really it and the shape of the yield curve. I’ll never forget, I just remember reading a quote from Bill Gross, obviously a famous and vastly successful investor, founder of PIMCO in 2014. Saying you know, loving being long the two year note now I’m an outsider know a little bit about interest rates, but I look at the two year note and say, this thing’s yielding one and a half percent. How could you love that? That seems so Dangerous to be short. And really what he the second part of his sentence was the roll down, right? This two year note is going to become a one year piece of paper in a year. And the one year is yielding 1%. Right. And so that natural pull to something that’s a lower yield is a source of incremental, positive carry, even if the coupon on the piece of paper is low. And with the promise from the Fed, it becomes really interesting. And that’s to me what that really low move index was saying. And then I think Jay Powell took it to another level, which is we’re gonna do a press conference, each time we believe in transparency. I just don’t know that it’s successful in the sense that you and I may have even shared some of these quotes on maybe Chris Cole has also said it, you know, you can’t destroy volatility, you can only maybe move it around a little bit, maybe transform it into something else. And so I think sometimes what we do, where we excessively give the roadmap to investors through monetary policy is we create near term certainty, but we also create the conditions that make trades that benefit from that so successful, that they just get too big. And then that leads to at least potentially some real exacerbation once these trades, or if these trades, get unwound or get tested from a mark to market standpoint at some point.
Corey Hoffstein 16:23
Well, speaking of trades that get too big, that’s a nice segue into where I want to go next, as we sort of work chronologically through your career, which is to the LTCM event. And as you’ve noted many times on your podcast this year, we’re actually celebrating two major anniversaries. It’s the 25th anniversary of LTCM but also the 50th anniversary of Black Scholes and I was listening to an old podcast you did it was one from this year as a bit of a monologue and you in the quote you said was Black Scholes was imprinted in the DNA of LTCM. So wondering first, what you meant by that and what were the major lessons you learned covering LTCM especially with respect to your understanding of Black Scholes?
Dean Curnutt 17:06
So very quickly, I was at Nomura from 91 to 94. I got a hold of this Cox and Rubinstein book, this red book on binomial trees and options market, I was enthralled. And one of my closest friends Ross Stevens was a PhD student at the University of Chicago at the time, has made a gigantic gift to the Ph. D. program. It’s now named the Stephens doctoral program at the University of Chicago. And he sold me on becoming or trying to get into the MBA program, which thankfully I did at the UFC. I joined there in 94. I studied econometrics and modeling and so forth for options. And I joined the Lehman Brothers equity derivatives desk in 1996. It’s a pretty low period for vol in 96. So we’re talking 11 and 12 VIX. We started doing trades like vol swaps. I remember doing some of those at 12, which was extraordinarily low, but I learned a little bit about fallen through 96 or 97. Asian contagion hit in 97. The VIX momentarily got to 40 as the IMF had to intervene. I think it was October of 97. Pretty extraordinary things quieted down, but I was covering LTCM I was enthralled by this group of all stars, you know, coming out of Salomon bond arbitrage. What a team Merriweather Larry Hildebrand. You know, you had Victor Ghani in Europe. You had backup from the Fed David Mullins was the ex vice chair of the Fed. And then of course, you had Scholes and Merton, right. It’s really black, Scholes, Merton. Some people even think that Merton deserves more credit, in some ways for kind of finalizing some of these proofs. But these are two extraordinary, extraordinary academics that are at LTCM LTCM own interpretation of itself. They call themselves a financial technology company. They, you know, we’re very, very focused on the math behind these trades, whether it was convergence trades, but they were an extremely, extremely bright and mathy group. Most of them were, in some ways professors from MIT. And again, it was incredible to have an opportunity to cover them. We did some very interesting options trades, not just incredibly sizeable, but there was some interesting correlation trades we did on spread assets. And so, you know, they really thought a lot about optionality that was really to me in the DNA of the firm was to think about risk from a, you know, these guys weren’t stock pickers. They never put themselves out there weren’t studying the newspaper and looking for the next big product. They were literally focused on trying to find inefficiencies in the market where they could step in and be a liquidity provider. lighter, and get compensated for Baron gap risk, and did it incredibly successfully in 9495 9697, the compound return for those four years is gotta be 35 to 40%. And that’s after fees. And to me, one of the lessons I just sort of looked at myself as this is, the success and the resumes, of these folks, to me made the strategies just self evident in terms of how good these guys were. I saw it in how the process of getting credit approval was for them. Internally, I could bullied my credit officer and say, It’s LTCM. And there was some part of Look, do you want to do the business or not because Merrill or Goldman or Morgan Stanley will do it at basically 0% collateral. And then there was a second part, which is, these guys are successful. So you don’t have to worry about the credit risk, you know, these guys aren’t gonna lose money. So there was a combination of luck, we want to be involved. But also, you know how good these guys are. So that, to me, there’s a lot of lessons there.
Corey Hoffstein 21:08
Stay on the theme of sort of endogenous market impacts, fast forwarding again, a little bit, this time to the mid 2000s 2004 to 2007 Was this period where major European banks were recycling correlation risk from their structure products back into the market. First, just a comment I’ll make, I always, I always find it very interesting that the trades in which the retail investors are actually buying, they don’t realize the actual expression of that trade in the market, they’re often buying a payoff. But they’re totally unaware of sort of the levered impact of that potential flow into the market. I’m not sure if you put in writing the actual trades that are being executed. Those are the trades that they would say they wanted to take. But regardless, I was hoping maybe you could talk to me a bit about how you saw this trade getting absorbed by the market, how it may have influenced prices, both sort of on average, and in the tails.
Dean Curnutt 22:04
Yeah, so I think there’s one quick corollary, I just wanted to make as you were describing that, if you ask this man on the street, this consumer of this complex structure product that might have three to five years of maturity, it’s got all kinds of bells and whistles, it might have three underlyings. It’s got multiple coupon payments, contingent on different events occurring, different levels of the underlying being reached knock ins knockouts. If you asked if you got a lot of these folks in a room and said, you know, you guys are some of the biggest buyers of correlation in the world, they’d have no idea what you were talking about. Similarly, if in Jan of 2021, you got 100,000 of these meme stalkers in a room and said, You guys are the biggest consumers of gamma on the planet right now, they’d still probably have not much idea, maybe a little bit more of an idea as to what you’re talking about. But the point is that in aggregate, these exposures, while not important, among any one individual, these are contracts that could be in notional sizes of 100,000 to $500,000 of notional, but there’s so much appetite. These are through the Swiss banking, high net worth networks. There’s an appetite for these products that is starting to catch up in the US but was never that big, as it was especially in through this private bank networks in Europe and Asia. And so a lot of these are issued by French banks, the expertise of the equity derivative desks at sock Jen and BNP. And they are able to create exposures that even for the trained eye of a derivatives expert, you’d look at and go, Hmm, that’s a pretty good deal. Right? So they’re optically cheaper than they really are. Even for the folks that know something about this. And so there’s edge, right? There’s this mathematical sort of edge that comes about by risk managing the trades of very complex Greeks, cross Greeks through correlation, DivX, risk, Vega, all kinds of stuff. And they’re sold in mass to these retail networks, the French banks and also the JP Morgan’s and Morgan Stanley’s they love the business, it’s good business that occasionally blows up, things do go wrong, but in general, there’s a good markup and a healthy pipeline for these businesses, but they get so big, there’s so much appetite for them, that even at prices that they love, they want to I think do two things. One is they do want to reduce some of the exposure and two, they want to ratify the prices. You know, these things are all Model Driven. As you know, there are so many exotic options out there that you can make some variations to Black Scholes and the differential equations and so forth within it. At, and you can press a bunch of buttons and put a bunch of numbers in and come out with a level. Right? That doesn’t mean that it’s really helpful. They’re in the context of the market. So you could come up with a price for some of these exotics. But the real price is where you could lay it off. That’s what they’re looking to do through these risk recycling efforts. One is to reduce the risk, but to let’s see if we can get a backstop for where we think this would trade through a fundamentally rigorous evaluation from a hedge fund, let’s say. And so these exotic structures wind up getting recycled into things like correlation swaps, variant swaps, and that business got bigger and bigger in Oh, 4050607.
Corey Hoffstein 25:44
So one of the common discussion points that you hear, post 2020 Is the idea of the derivative tail wagging the dog. And I look back to that 2004 to 2007 period with all this risk recycling of correlation risk. And in many ways, I often think that a lot of these products get hedged with simpler and simpler structures. exotics get hedged with vanilla as vanilla as get hedged with underlying and it sort of always makes its way in some way back to the s&p and s&p Vol market. I’m curious, did you see this risk recycling? Do you think it had an actual impact either directionally, or on the overall volatility of the market? This was a period of of extremely low vol. Yeah, so
Dean Curnutt 26:23
one of the things we’ll talk about is just the idea of market efficiency across assets, right? We like to believe that clearing prices don’t exist just within asset classes, but there’s some fair price across asset classes, right? There are instruments that are related to one another. If I told you that IG credit spreads were at 50 basis points on the CDs. But suddenly, the VIX was at 60. Something happened there, right? That doesn’t make any sense. These things are not exactly the same, but they move together any good equity of all events, gonna have some credit component to it, one can lead the other. You know, the XIV event in 2018 was much more about the VIX than anything else. But when you’re within your own assets, so for me, as you mentioned, equity derivatives is my stomping ground. I was at Bank of America at the time, we were doing a tremendous amount of business with hedge funds, the sizes of these trades just got bigger and bigger and bigger. Our book got just gigantic, we had a lot of progress gone a lot of customer risk on. And then I started to learn that honestly, we were small potatoes, not inequity derivatives. But relative to what was happening in credit derivatives. There was a headline that came about, I don’t know, maybe it was like 2005 or so that the New York Fed was very concerned that there were all these unsigned credit default swap is the contracts, that there was this giant backlog of an executing conference. And so I started talking more to our credit derivative, folks. And I started to realize just how sizable the exposures were in credit, we were doing a lot. But in credit, that really was a true one way train of more credit risk being assumed. And in the process of assuming it against the very benign backdrop. Remember, the Fed had absolutely convinced itself that it had brought to us through central banking, the heroism of central banking, the Great Moderation of inflation, they tamed the business cycle. They’d also convinced themselves and us that financial innovation, specifically in credit derivatives had dispersed credit risk in a way that made the entire system much safer. Hey, just look, the I G CDs contract is at 20 basis points, what more do you need to know about how stable the system is? So of course, it turns out to be this epic misread. It was really the selling of CDs, that was pushing it down, creating more and more and mark to market gains. And what happens you just restack that money back into the same system that’s treated you well. So that to me was another probably the biggest lesson in how endogenous risk can be for both better and worse, that period leading into the GFC. You know, the books got huge, and they sort of mark themselves to market because it was all one way it was selling vol selling credit protection and very successful allowing the system to get more and more leveraged in the process.
Corey Hoffstein 29:31
Well, let’s stay in that same time period, because I think you mentioned on our pre call to me that while you were at B of A helped create an option on variance which you actually sold internally to the credit desk as a hedge. And I was listening to another one of your podcasts where you mentioned that this experience made you realize how far equity markets were behind in their understanding of the GFC. Right talking about that potential dispersion between markets actually exists. staying curious again, why do you think equity markets were so far behind? And what opportunities did this afford in equity volatility markets.
Dean Curnutt 30:09
So I ran the derivative and convertible sales and strategy effort, I was part of this leadership team that reported to the head of Global market sales. And so once a week, we would all get into a conference room, it would be myself, the head of mortgage sales, the head of credit, derivative sales and their trading counterparts as well. And I used to hear a lot about the magnetar trade. And essentially, this was some trade very controversial in some people’s eyes. But effectively, it was a transaction involving the tranches in CDOs. That, in some ways allowed the kind of daisy chain of risk taking in the mortgage arena to continue. It was a brilliant, brilliant transaction. But I kept hearing about it. And I started to try to learn more about what was going on and credit derivatives. As I got to know these guys better. They were starting to say, you know, things are really feeling like, if one thing goes wrong, the sizes are so gigantic, that this whole system could crack then that could be in corporate CDs, it could be in this giant system of mortgages and the trades and the credit expansion that had come about through the housing bubble. I started working on their behalf, they were looking to try to hedge credit risk looking for some alternatives. And yeah, I was working with our head of structuring on the equity derivatives side, we came up with this idea of buying an option on a variant swap. So a variant swap, synthetic instrument allows you to get long or short realized volatility, very, very big product, especially in the pre GFC period. While these guys weren’t in a position to just do the swap, they needed to know exactly how much they could lose. Look, what’s interesting about equity voller about risk premium in general, is that when something gets really low, it looks mouthwateringly cheap, but you just gotta respect the fact that it got that low. It was brought to that level by a certain set of conditions that made the previous trades so unprofitable, so loss making that you just have to think it could get worse still, sometimes these things feed on themselves in the other direction. So they needed a trade that allowed them to pay out a certain amount of premium. And if they’re long volatility bet designed to hedge credit risk went horribly wrong, they’d lose a specific fixed amount. And so we were left effectively to price not just the variant swap that was actually easy. But the option on the variants which was effectively some version of Vala vol. It was a precursor to options on the VIX. This was 2005. And again, it helped me see that things in the credit markets were moving at a speed that the equity vol market was behind. Things definitely started to get funky this summer of oh seven, but even after Bear Stearns Asset Management in June oh seven, the quant quick in August oh seven. By October 7, the equity the equity market was an all time high. Now it wasn’t a below 10 VIX. So vol had gone higher. There was some repricing, but credit was way ahead, way ahead. And if you really talk to enough people about the set of things that was in motion, from a systemic risk standpoint, and I’m certainly not claiming I got it all right, by any stretch. But to me, it’s humbling, you know, sometimes on a backward looking basis to see some of what was available that you could have learned if you truly dug in enough. One of my favorite things. Just really quickly. I think I might have mentioned this to you. There’s, I’ve read my fair share of books on the financial crisis, there’s one I think is very under followed under read. That’s called fatal risk. It’s on AIG specifically. And AIG was really the last provider of subprime CDs, they insured the entire street. There’s this very controversial decision made by the Treasury Secretary Geithner, to make the counterparties to AIG FP hole, they made sock general, they made Goldman hole, and there’s testimony where he’s, I think, on the hill with Warren, Senator Warren, grilling him over. Why is Goldman Sachs made whole? Listen, I’m not here to argue that it’s just that AIG had such a giant book on this stuff. And as you read through this book, fatal risks you realize that one of the things that really set in motion During the financial crisis, was them losing their triple A status, triple A counterparties, don’t post any collateral ever, no mark to market collateral, no upfront collateral. It’s a poison chalice. It’s something that will allow your book to get so much bigger than it otherwise would be. And so once they lost the AAA, they started to have to post. And those postings just got more and more sizable. There’s a lot of discussion in Michael Lewis’s book, The Big Short about the back and forth with Deutsche Bank, and Goldman and AIG. So, you know, you just look back on these things. And, to me, it’s just humbling, because sometimes it’s there, if you can really put the pieces of the puzzle together. But you know, it can be very tough to do.
Corey Hoffstein 35:44
One of the major changes post GFC was the regulatory regime for banks. I remember, I was actually in graduate school studying for computational finance, with the intention of going and work on a sales and trading bank and complex derivatives or structured products. And by the time I got out of graduate school, a lot of those jobs no longer existed. And we’re never coming back to the banks. Curious on your perspective of how the influence of banks in the volatility space specifically changed when you compare the pre and post GFC environments, either in the influence of trading desks and the warehousing risks or structured products that they were able to offer? Well, let’s start
Dean Curnutt 36:26
diving into that by first observing the relative level of implied volatility on the XL F. So that’s the financials ETF became a huge part of the financial crisis, the relative implied vol of that to the s&p in let’s say, late oh, six. And what I’ll say is x LF implied was probably 11 and a half or 12. And the s&p was about 10. So one and a half to two vol, spread, B of A was a nine implied vol. I mean, these things were super, super skinny, Morgan Stanley, one of my favorite, I think, at CDs level got to 18 basis points for five years. Think about how cheap that protection was. And it’s not like buying a one day option when the volume is low, you got five years to be right. And what I just again, will say and I’ll use the word humbling, the price of the risk was the lowest, when the risk was really the highest, right? The leverage in these banks, the leverage profile, you can just do a Google Images and look at debt to equity of US banks. And you’ll see a time series and you’ll see most of them get to 35 to one in Oh 506. Right. That’s a two and a half to 3% wiped out. And everybody thought that was okay at the time. So of course, Dodd Frank and a lot of the other regulatory initiatives, post GFC are about reducing that leverage ratio, a lot of it, I think, was done voluntarily as well. And so the banks become something much different, right? They’re just have much smaller books, much smaller appetite for risk. They’re in the moving business, not the storage business. As Paul Brittain, the founder, Capstone likes to say, always like that one. You know, they’re trying to discover prices, by being an intermediary and sitting between ultimate buyer and seller, a little bit more of a broker. Of course, they still have a balance sheet, and they’re taking plenty of risk, but relative to where it was that just become smaller. In the equity derivatives context. I think what I’ve observed is this consistent reading reduction of the weighted average expiration of traits. So going back to long term, these guys were sellers of five year evolve. No one really does that as a systematic strategy these days, I think, in some ways, the prices don’t really lend themselves to it, but the mark to market risk of that is so toxic as to make it almost un investable strategy, even for banks. So you don’t see a lot of trades even outside of nine months in big s&p options. Some of those I’m not sure Cory might just be our attention spans are so much shorter. You know, we’ll talk about zero days to expiration options but in their their voracious appetite for profits. The CBOE went from quarterly to monthlies to weeklies and now there are dailies there is an option that expires every day in the s&p. So I think what you’ll see is the intermediation process is become much more electronic fide. So there’s not a person on the other side of that that’s a very, very well built and well thought out mathematical engine that prices this stuff, and you know much more about quant trading than I do but the provision of liquidity and the decision to turn on or off is not some trader going It’s doesn’t feel good it anymore, right? I don’t love being short skew here. It is a predestined level at which the system is going to take more or less risk, right and it learns over time, but it’s not a person anymore. So the liquidity provision process has changed dramatically. And it’s moved away, in some ways from some of the larger banks, you know, Citadel and others are vastly making markets and providing liquidity electronically. Now.
Corey Hoffstein 40:27
I want to take a step back and maybe look at the different crises that have unfolded over your career, you’ve got 1987, long term capital management, GFC 2020. And one of the common themes here seems to be this idea of endogenous reflexivity. And I’m curious if you think that this is ultimately a feature or a bug in markets,
Dean Curnutt 40:51
it’s become a feature. And if you just step back, and you sort of think about the very basic premise of our financial system, and any capitalist financial system is fractional reserve banking. And we know, without a doubt that it everybody today showed up at JPMorgan, let’s just use that, as you know, an incredibly well respected and well funded bank, it can’t meet the margin call. You know, they’ve lent it out. There’s of course, the It’s A Wonderful Life, right? And so, there’s always a question around sizing, the sizing is inherently the question around loan to deposit ratios. It’s inherently the question around when we put risk on our sheets, how much risk can we withstand? And so I guess the question, you know, really becomes around things like the extension of margin, do trades of a certain type get too well consumed? Is that in some ways, a function of the regulatory landscape? How far do we want to go? The VIX product blow up in 2018? Listen, I’m not suggesting that this stuff was easy. But in some ways, you could have seen it a mile away. We had macro risk advisors and others, were basically just showing that listen, if the front month future goes up five or six, from 12 to 18. You know, you got about 130,000, vix futures, or more to buy in one day, and that’s much more than the daily volume. Right? So you kind of see these things, sometimes in far corners of the market. I don’t know if that’s a regulatory issue. If someone’s supposed to say, look, you’re not allowed to create that product. I really believe in the flexibility to create new products, even as I think a lot of them are pretty awful, and not really serving a purpose. I’m not sure you’re supposed to regulate them away. You know, how do we take counterparty risk? So what did we learn from LTCM? Boy, Lehman’s exposure to LTCM is gigantic, but so too is Merrill’s and Morgan Stanley’s, and Goldman Sachs’s, and now you add them all up, right. And we learned the exact same thing and the ARCHOS equity swap meltdown 25 years later, the same exact thing happens in an OTC product, not a complex OTC product, a very basic just leveraged through swap, but people not necessarily paying attention. I’m a big believer in Exchange Traded products. I kind of talked my own book here, but man do I love what the US equity options market provides you, which is just this instantaneous access to liquidity and a view on the depth of the market. I think it’s just critical not just to be able to get into a trade with ease, but to know that you can get out with ease. And listen, I grew up in structured products and OTC derivatives. I do not like this idea of the counterparty having to sort of beg the bank to make a price to get out. I don’t think that’s right. So, you know, to this feature or bug question, some of the regulatory construct matters how big we can get matters. Just one last thing I’ll say is lit listed markets are not a cure all go back to the Amaranth blow up in natural gas in 2006. Those were in very liquid exposed nat gas futures, but they were huge. The positions right. So maybe in hindsight, we just learned that this trade was too big, right? There was just too much risk in a trade even in a listed product that we can see and monitor. So it’s a hard one. It really is it really comes down to in some ways the speed limit right speed limits 55 Not many people drive 55 You wouldn’t want to set the speed limit to 30. That’s probably really bad for economic growth getting to and fro. There’s only so much regulation we can deal with. By Have you got to ask yourself, you know, in some ways, what the proper role of regulation is, in terms of some of these blow ups? I think it’s an open question. I don’t profess in any way to have the answer, either. It’s a tough one.
Corey Hoffstein 45:12
Well, speaking of all these blow ups, and another one of your podcasts, you mentioned, maybe a bit tongue in cheek, this idea of the rule of 11. With respect to all these major market crashes, right, when you go through 1987, LTCM, GFC, 2020, they all happened 11 years apart from each other. Now, you know, I don’t think a global pandemic is really necessarily timed perfectly with the last crisis. But I did start to think about do you think there is perhaps a behavioral reason we see this sort of time period between maybe not specifically 11 years? But, you know, is there something to this idea that you have to wait long enough for a new crisis to emerge? Or do you think it’s just sort of a fun pattern and randomness?
Dean Curnutt 45:55
I think it’s a little bit of randomness. And don’t think I didn’t try 10 first and see if I could make that work. But yeah, 87 9809, it was really, oh, 809. But you know, we can say the s&p at the, you know, near all time low in March of oh nine. And then 2020, I guess what I would say is, there are behavioral bias, components of this, meaning we just are prone to forget, we overweight the here. And now. we extrapolate forward, good times, or bad times, especially good times, we think that the good times will roll on forever. Risk taking tends to be incredibly procyclical. So we size our trades in a way that reflects the here and now of the realization of vol. So trades can get much, much bigger, when volatility is concurrently low, without necessarily respecting the fact that circumstances do change. And the very low vol that were experienced leads to the consumption of trades, as we’ve been talking about that can reflexively feed back into the system. And then I think regulatory regimes come and go as well. The UBS building in Stamford was the largest trading floor in the world for a period of time. I remember going there and 2000 2000 to 2004, or five, just absolutely flooded, row by row of professionals. And then I remember going back in 2012, and 13. And thinking, Boy, this is a ghost town. And the US embraced finance as religion. I certainly did. I thought that finance was an end in itself, I still love the business and think that our way out of this is really to respect in some ways, the laws of finance, but the way in which I think we embraced it from a regulatory standpoint, was pretty unique. You know, in that period, Greenspan was extremely light touch. And so maybe that regime will come back, I don’t know. So I think that these periods kind of come and go, from a regulatory standpoint, let’s just talk a little bit about 2020. It’s not an area in which I spend time on day to day, but if you go back to the faltering of the bond market in 2020, and the blow up of these bases, trades, of the cheapest to deliver versus the cash bond, and how that spread just got so gigantic, that even a trade that was set up in a pretty risk minded way, just got so dislocated, and so negative on a mark to market basis, those trades themselves threaten the system. And I think, you know, some part of the rescue plan in backstop in the government bond market, it did save certain counterparties from eventual ruin or near ruin, just based on that intervention, those trades got so big in the period preceding the COVID. As a function of regulatory change, as well, it was banks not able to warehouse, the same degree of government bond exposure. And so the ultimate owners wound up engaging in relative value strategies, a lot of hedge funds and so forth. And so, again, the setup of the trades in the market can very much be a function of the regulatory response to a blow up like the GFC. So you know, these things evolve in a significant way.
Corey Hoffstein 49:30
Another quote, I’ve heard you say a number of times on your podcast is that quote, nothing bad happens in markets when realized vol is below 15. What do you mean by that? And why do you think 15 Is the line in the sand?
Dean Curnutt 49:43
You know, listen, markets. Don’t lose 20% When vol is extremely low. I’m not even suggesting that realize volatility has any predictive power. I think this is a concurrent observation. So far. Just bucketed periods when realized vol is below 10. When it’s between 10 and 15, you know, from 15, to 25, and so forth. What you observe actually, is that market outcomes, let’s just say for the s&p market returns are fine, generally, consistently positive, when realize vol is below 15, they start to become a little bit more negative, when you’re kind of above 20 to 25, you know, certainly 30 Negative, it’s really when you get past 50, when the wheels truly come off the bus. But it’s only to say, look, so long as realize vol is behaving, markets may not go up a lot, but they’re not going to go down a lot. It’s just an empirical fact. And I think it just, it jives with how we think about market risk as well.
Corey Hoffstein 50:49
So we touched on this a little bit earlier, but I really want to drill into it a little bit more. After 2020 There’s been a growing discussion about the derivative tail wagging the underlying dog, particularly in equity markets. At the index level, you’ve heard all about these covered call programs, suppressing volatility. On the other side, you have the mean stocks, where you’ve got reflexivity to the upside. Curious how much credence you give to this thesis.
Dean Curnutt 51:15
Not as much as what I would argue is the narrative out there. I feel like everybody’s pointing a finger at all times and saying, it’s the gamma that did it. In the limit. Again, this is a thread throughout our discussion, market risk taking can overwhelm the market at 798. It was late August of 1998. And I look to your s&p Vol on my Bloomberg screen, it was at 45. And that’s because there was a Counterparty on its knees trying to buy it back. So the trades in the market can dictate market prices, in a big way. And when it comes to the aggregation of hedging activities, I think there’s an incredibly good economic argument for how a long vol profile for folks that are trading derivatives can mute volatility. And a short vol profile can do the opposite, right? You catch someone who’s delta hedging, a put, and the underlying goes down a lot. Well, now their Delta went from, you know, minus 20 to minus 50. And now they got to sell a bunch of futures. And that might make it worse. So yeah, I think that makes a ton of sense. I think you have to find instances where you can be convinced that the size of the trade is substantial enough, that enough people are the same way that it’s gonna matter. And, you know, look, I’d also say that the attribution is very hard. I see a lot of shorts with gamma by strike. And I just asked myself, How do you know how they’re trading it, you know, an override or sell something, let’s just say, okay, and an override or sells calls to Goldman Sachs. So Goldman Sachs is now long vol. The over writer has sold them outright. Really do we really know that they’ve sold them outright, if you’re an over writer, and you sold the 110, call the stocks at 100, and then your stock goes up to 108. And you’re very quickly losing all your delta exposure, you absolutely could be buying stock in the market, who wants to just forget about their long position, it’s not a strategy to have a trade on and then just get called away and have nothing. So even the over writer can be evolved trader, we just don’t really know the degree dispersion traders, folks that sell s&p options, but buy single stock options as a really quantitative implied correlation trade. They’ve got a much different reaction function in their Greeks than someone that just sold the vol. So I make this point only to say that the attribution is very difficult. There are instances where we’re supposed to absolutely watch it, you know, the Unwind of equity, vol and COVID, was profound. It was very clear that those risk recycling trades went horribly wrong. We know many of the stories Malikai AIMCO, which is Alberta investment management company, some of the other Ontario pension funds got caught short in their risk recycling. There’s a number of folks of course, the Allianz program went horribly wrong. So that’s on the short vowel side. And I think the opposite side is also potential and I think this meme stock episode in 2021 is just boy you really got to respect markets. You got to respect the stampede effect. We talked about LTCM. I flipped the LTCM around and called it MC TL, which is the mighty call trading Legion. It’s the man on the street buying one contract, but two or 300 1000 of his friends doing the exact same thing at the same time. That’s how you get a GME. And what I find, again humbling and just fascinating is that GME event which I’m going to say is January 27, of 2021, Vic’s got the 37. And that was a near systemic risk event for the market. If you think about why these things occur, a short squeeze, is one of the most dangerous things you could ever come across. Our system is not set up to resolve a short squeeze. And I just want to make this point Thomas petrify. Thinks made some incredibly interesting comments. He founded Interactive Brokers, they’re at the center of this thing. It’s a very interesting guy, older gentleman, worth $15 billion. And he was interviewed in the days after this epic event, and basically was saying that Jimmy got the 300 or so people own the 500, call the 600 call, suppose they just exercised the calls, forget about it being in the money or even close to the money, just exercising the call and forcing the delivery of the stock could have created such a market malfunction. Who knows where that stock could have gone? I think that’s a really interesting thing to step back and contemplate so that’s sort of reflexivity on the long side of optionality.
Corey Hoffstein 56:23
I remember I was sitting at an airport. I think I was at January, very early morning, and I opened up my phone and I was flipping through different stock prices. And I and I saw that GME was trading pre market at four 20.69. Exactly. And I took a screenshot of it. And I said the fact that someone traded it precisely to this price, that’s just very amenable price. I was like this just tells you how wild markets have become particularly in some of these names.
Dean Curnutt 56:53
Let me just make a quick comment. I got to bring my son Liam in here. So he’s my 11th grader. And it had to have been in 2015, I wanted to teach them a little bit about the markets and sort of a video game aficionado. And back in the day, we would go to Gamestop and pick up a cartridge. And so I said, Listen, let’s buy a stock. Well, by GameStop. How’s that sound? So we bought seven shares of GameStop. At $30. It goes down to $3. I completely forgot about it. And suddenly this thing’s at, you know, $60 $80 $100. And we sold out at probably $150. You know, it’s just a total random, total random. And you know, he’s not super interested in the markets, but got very interested in that and of course, forced me to give him all the profits from our foray into
Corey Hoffstein 57:43
I’m not sure the lesson learned was the one you intended No, not at all. So getting back on track, you’re in our pre call, there was a quote you said that I want to ask you about which was that market risk is very endogenous risk taking is a big part of the fabric of what happens, I was hoping you can maybe expand on that idea for me.
Dean Curnutt 58:02
I think when I step back, and I try to understand the why of a market risk event, I just can’t get away from the set of trades that lives and breathes within the market at that time. Let’s talk about the systemic risk event that be sent the UK last year it was short, it was protracted and ultimately solved with not a tremendous amount of ongoing intervention, but it absolutely required the Bank of England to step up in a moment’s notice. So what was the setup was this LDI hedging program utilizing duration to match liabilities for insurers, very long dated liabilities, and there not being enough duration in the gilts market, to enable these hedging protocols to be established through just the cash market. And so derivative schemes were created swaps. And anytime you use a swap, you’re going to use leverage. And they’re all one way, they’re all doing the same thing. And the market just malfunctioned. And in days, you could have had the bankruptcy of a large share of the pension universe. It’s just an incredible thing to experience a mark to market event that’s not made hedge funds exposed, but the pension community, right. So again, that’s another example of the trades themselves created the problem, the risk taking or the set of exposures, the way they were constructed, becomes a part of the accelerant that just causes a mark to market event that required, you know, ultimate government intervention.
Corey Hoffstein 59:47
One of the interesting things that I learned about that, and this is my recollection of how the trade was structured, I apologize if I get this wrong, but it wasn’t just the swaps is that they were pooled vehicles of swap. So you had Multiple pensions that were investing in the same pooled vehicle. And even if one pension on its own would have been able to meet the collateral needs of another pension didn’t, it brought down the whole pool vehicle. And so it’s always very interesting to me to think about, well, then there’s the trade. And then there’s the structure of the trade. And in many ways, the structure of the trade by putting in a pooled vehicle of all these pensions to access simultaneously made it just as dangerous, if not more dangerous, right, than if all these pensions were able to navigate it on their own and a separately managed account. So again, this idea of that the risk is endogenous to the market, and sometimes it’s endogenous to the structure.
Dean Curnutt 1:00:39
Yeah, and let me just say that one of the things, I think implicit in what you’re saying there is crowding, you’ve got to know who’s in there with you, and what their mark to market tolerance is, as well. That’s a big part of a lot of these crisis events, as well as just crowded exposure. Of course, folks that are marked to market sensitive, you know, Famous last words, I’m not a mark to market sensitive Counterparty. Not everybody is ultimately. But I think crowding is a critical thing to study as well.
Corey Hoffstein 1:01:09
So you’ve spent a huge part of your career covering equity vol markets, I want to as we get sort of, towards the end of this episode, take a step back and ask you to sort of reflect upon how these markets have evolved over the years, both with respect to the participants that are in these markets, how they’re being traded, and ultimately how they behave.
Dean Curnutt 1:01:32
So I’ll point to a couple of different things. The first is technology. And again, I’ve said that, I think that equity derivative markets equity option markets in the US, to me are a blueprint for what you want. Not getting in the weeds on various fee structures maker taker, there’s a lot of argument on that. Gary Gensler is very focused on payment for order flow, all I know is when I load up a fidelity or Robin Hood screen, I got a nearly locked market with a lot of depth. That’s fantastic. Instantaneous fills these things clear, automatically. It’s excellent, you know, you get a lot of choice there. So I think the technology has enabled us to trade on a self directed basis, that might not necessarily be great for the broker, in some ways, it’s good for the electronic broker costs have come down, spreads have come down. And so it makes access really easy to come by, as I said, the weighted average maturity has come down a lot. I don’t know if that’s just our obsession with just watching this pinball machine at every turn. There’s, you know, tremendous focus on data events. As we record this, we get CPI tomorrow. This is the July report. It’s not nearly as interesting a report for markets as let’s just say, last July’s report was, you know, at that time, and into the fall markets were increasingly worried about these prints. And the price of the one day option was extraordinarily higher than that it is now probably a good thing, though, at least to have one that price discovery. And listen, if you want to do something about it and hedge your book over the course of one day, even if it’s expensive, at least you have that option to do it. I think risk taking is dispersed in a good way. So, you know, here, I’ll sort of use the words from the Fed and the IMF from that pre crisis period where I do actually think that equity vol risk is more dispersed than it was in a good way. I don’t think they’re sitting there on the sheets of banks in his larger way. They’re kind of more dispersed, you have a lot of market makers making prices now. It’s more two way, I would say. And I think that’s a good thing. And I look, I think the markets went through a period of being very retail oriented in the late 90s, to increasingly institutionalized. And now for better or for worse, retail volumes are important, you know, so much so that they can actually create a meme episode. I think it’s always good when you have a lot of people doing different things for different reasons. That’s what creates a market and I think the equity derivative market, you know, has a lot of that feature at this point in time.
Corey Hoffstein 1:04:25
After a long and successful career on Wall Street, you ultimately stepped out to launch your own firm, macro risk advisors, which you have described as a, quote, smart brokerage model that you can talk about a little bit about what made you want to step out and do your own thing and what it means to be a smart broker.
Dean Curnutt 1:04:45
Well, nothing more motivating than getting fired and told that my time was ending at the VA. So that kind of gets you to really contemplate new opportunities. I always had an entrepreneurial bent and I thought specifically that my own version vision of strategy, which some of our conversation has touched on, studying trades, really thinking about trade construction. You know, I’m no economist, I’m following this stuff. But for me trying to understand the markets, fabric within the system of risk taking, and in that period in Oh, seven, things were getting funky, you know, you really had to appreciate these cross asset dynamics, and I didn’t think people did. So I thought there was room for an independent provider of strategic insights, specifically in quantity, stuff like derivatives, I also saw that the banks were pretty compromised, they had books of bad exposures at the wrong price. And it’s very difficult to continue to be a bonafide liquidity provider to your clients, when you’re nursing mark to market risk. That is scary when vol was in the 50s, and 60s. And so I thought that there was a chance to start an independent firm that was an agency broker that didn’t have capital itself. But again, back to the moving business, not the storage business knew how to arrange trades and find liquidity, and then just try to be good at one or two things. And I think, you know, what I would say about macro risk advisors is we’ve tried to stick to our knitting of helping people think about whether the VIX is too high or too low, you know, what are the factors moving it around, helping people construct trades that do what they want them to? I always would get emails from clients saying, Hey, I just got shown this one buy to put spread from a bank or a competitor, and they’re telling me this is a hedge. And I’d say, so you’re buying one put, but selling to downside puts against it. Let’s see, let’s shop prices down, you know, by x and vol up by x. And let’s see how this thing looks at a mark to market basis. No, that’s not a hedge. So I think arbitrage is a really hard thing to come by. But I do think you can find ways to get the trade to do what you want it to do. And that is specific to each Counterparty. So it’s getting to know your clients. And then I always say, take what the vol surface gives you. There’s term structure, there’s SKU, there’s cross asset proxies, maybe using other instruments than the s&p maybe the hyg is a good proxy. So it’s just trying to be creative and thoughtful about how you might spend option premium or how you might implement a trade that’s programmatic, you know, a bit mechanical, how do you think about unwinding trades? And then the second part is just trust, and hustle, it sales trading. So you know, the folks that I’m lucky enough to work with are experts with using technology, you know, you got to be an expert at implementing the systems, split second judgment on whether to use the screens or to call three counterparties. And see if you can get a price. Sometimes it’s doing both of those at the same time. So could be a two to three man process of, you know, really representing your clients order in the best way you can. And when, as an agency broker, you really can’t represent that order. Just tell them if you’re not the best call on a trade, and you don’t think you can do a great job, it’s your obligation to tell your counterparty Listen, thanks for the look. But I want to send you away because you’re going to do better elsewhere. I think those are the kinds of things that breed trust over the long term. And another thing is, because we don’t have our own prop book, we’re following each and every trade we do religiously, as if it’s our own. So we have a system once the trade is done, it goes in our system. Our head of trading, Adam Knuth monitors, these trades exhaustively, maybe the client did a put spread, and the lower leg has decayed in value, and you could get it back for seven cents, and point that out. Right, just be on the ready. Sometimes these folks have a ton to do. So you’re really an outsourced source of trading, you’re their eyes and ears, trying to find levels, it’s really trying to help them with their day to day and that could be you know, any number of things. But it’s really to work alongside your counterparties. And again, I think a lot of the backbone of this is trying to earn and keep trust. That’s what keeps the client to me coming back.
Corey Hoffstein 1:09:23
In our pre call, you mentioned to me that the one question you spend the majority of your time thinking about and maybe the only single question that really matters, when you think about the price of volatility is to quote you, is volatility worth it? How do you think about quantifying whether volatility is a good deal or not?
Dean Curnutt 1:09:46
Yeah, so let me just first make the point that there’s two vix ETFs etps that have both effectively gone bankrupt. They do the exact opposite thing. So the VXX by all accounts, I think launched into those in a leaven, you know, it splits so many times, it’s effectively gone bankrupt. And then the XIV we know, was delta, very rapid death in Feb of 18. So these two things that they traded with each other, would effectively earn the risk free rate, which wasn’t much for a long time, but they both got under. So I asked myself, is it better to be long or short? Vol? And it’s just a question to really, it’s really difficult to answer. I think most of the back tests will tell you there’s a VRP of all risk premium. But I really do believe in the value of trying to find cheap optionality. And I think it’s no easy task, I don’t think you can systematically find it. But I do think that there’s alpha to be had in trying to figure out if there are clever trades to be done, whether there’s optionality that’s just gotten too cheap. For some reason, you know, there are times when, again, hindsight can be 2020. But I do think, you know, really pushing back and trying to get clients to consider when there’s opportunities to expand option premium. Give me a quick example, again, hindsight is 2020. But the price of one year options, depth of 5% of the money puts on Apple was the cheapest of all time, in the week before the earnings, the stocks down a fair amount, since the earnings follows up. So with the stock at an all time high, and the puts prices at an all time low. And these aren’t one day options. These are one year options. And not a lot of people bought those options, right. So it’s a hard question to answer in terms of whether vol is cheap or rich, I would say that sometimes. It’s both the most cheap and most rich at the same time. Let me explain. In October of 2017, on the 35th anniversary of the 87 crash, I did a dinner. And going into that dinner, the price of a one month straddle on the s&p was 1.5% of spot. So over a one month period, if the s&p went up or down a percent and a half, over the course of an entire month, you’re gonna make money. No one was buying that straddle, they were selling that straddle, because the realized vol going into it was something like four or five. Right. So when markets flatline like they did in late 17, you know, Vall is going to get super, super cheap, it becomes so difficult to carry. It’s like anything, you know, you focus a lot on the value factor, the, you know, kind of time variation of factors. And we know that that value factor got its cheapest relative to the expensive stuff at a time when people were finding new reasons not to embrace value, right? It’s a new paradigm, everybody’s got to own a peloton, zoom. It’s tough stuff. So I mean, when you talk about richness or cheapness, you could talk about carry, I tend to really try to think about when you can find that rare combination of when options are carrying at a pretty interesting level. But also, the implied vol is low. In historical context, it’s hard to find that doesn’t happen that often or even when it does happen, it doesn’t stay that way, for that often. But that’s how I would think about, you know, the combo of trying to find favorable realize to implied spreads, but also low implies, at the same time,
Corey Hoffstein 1:13:31
I had the distinct pleasure of attending your macro minds conference earlier this year. And in part in closing us out, I really wanted to give you the opportunity to talk about your macro minds Foundation, what it is, why you started it, and maybe a little bit about the great work you’re doing. I appreciate
Dean Curnutt 1:13:48
that. It is a very simple idea. It is to try to bring the street together for a day of really differentiated content I Love You know, that’s why I love the doing the podcast, I love engaging with clients. So this idea of trying to crowdsource ideas and intelligence. I think financial markets absolutely require us to lean on others in the industry, even our competitors to get smarter, right? I mean, who the heck knows a lot about the debt ceiling. You’re gonna require others to learn more about that. Or you know about the XIV event or you know, things like this inflation. So we’re all learning from each other. And so I love hosting events and macro minds is effectively a charitable endeavor, where we host this event each year, we’re raising money for children’s education, student education, which I can’t speak enough about about how critical that is you have a young child, I’ve got three, two in high school, went to college. You know, education is everything, right? That’s what we want for our kids. And it’s a luxury that many parents are just afforded, the pandemic made it so much worse. So to have a chance to bring the buy side and the sell side and the allocator community together, raise money, we do it for three different charities per year that are engaged in student education in the New York tri state area. And we just try to host the great event with panel discussions. So we did our third this year, always have to take up a little bit of time off afterwards, but you know, start to gear it up. And hopefully, by June of next year, we you know, pull off another great event with some quality speakers. Cory, you have an invite, I hope you can make it again. And yeah, thanks for asking about it, it’s been a real joy to be able to bring this together, we’ve raised $1.3 million. So far across our three events. So far,
Corey Hoffstein 1:15:46
that’s really phenomenal. And it really was a phenomenal speaker lineup that you had, as well as the folks in the crowd. You know, the opportunity just to converse with some people over coffee was unbelievable. So I would recommend everyone who can, should attend, and I look forward to hopefully being able to make it next year. So last question of the episode, it’s the same question. I am asking everyone this season, I’m making everyone do this ridiculous exercise of combing through tarot cards and picking a card that speaks to them to help design the cover of their episode. And you chose a unique one, which is the star. And I was hoping maybe you could explain what stood out about that card and why you chose it.
Dean Curnutt 1:16:28
Well, I looked at all of them. And it took me a while to find one. And as I was looking through this, I was certainly thinking about market risk and a little bit of my market risk philosophy. And I came to this and I saw, I saw this person with their hands out. And for some reason, it just evoked some thoughts around the chaos of markets. So that’s kind of what’s above and things are kind of coming down. And it looks like there’s kind of two cups out. And I thought about this as sort of the Fed. And the Fed just trying to sop up everything I’ve sometimes said the Fed is in the business of crowd control. And this just somehow got me thinking about, you know, we’ve got this central bank, that means well, but is really focused on trying to control the chaos around it. And these cups are just trying to, in some ways, hold everything up. So that was that was how I got there.
Corey Hoffstein 1:17:25
That is probably the most unique interpretation. I’ve heard this season. Well that’s fantastic. Dean, thank you so much for joining me. It’s been a real pleasure. I really enjoyed it. And once again to everyone listening make sure you go check out the Alpha exchange. It is a phenomenal podcast. You will not regret it.
Dean Curnutt 1:17:44
Thanks a lot Corey, I appreciate it. It’s a lot of fun.