Correlation, Crowding and Convexity

There’s been some decent ink spilled recently on the “dispersion trade” which has profited from the epically low level of realized correlation among stocks. If winning trades attract capital and erode the margin of safety in the process, is this exposure crowded and vulnerable to an unwind?  In this short pod, I lay out a 5-part, informal framework for thinking about risk-off episodes. In the process, we consider the pricing of vol and correlation. While the spill-over risk from dispersion trades gone wrong doesn’t appear to be high, the pricing of index volatility that results from never seen before levels of implied correlation offers a uniquely attractive cost of macro insurance.I hope you enjoy and find this useful.

Earning a Ph.D. in financial economics is no small feat. And not only did Garrett DeSimone do just that, but he would unknowingly embark on his future career in the process of doing so. His dissertation from the University of Delaware involved the study of event risk premia in single stocks ahead of earnings. And to perform the analysis he engaged with OptionMetrics, a firm specializing in implied volatility data. Now the Head of Quantitative Research there, Garrett leads the firm’s efforts to deliver carefully constructed data sets to its client base, while generating original empirical studies of option pricing and trading strategies. Our discussion considers some of his work, starting with his dissertation and the finding that the earnings event risk premium for single stocks makes straddles punitive to own. We liken this to a more recent phenomenon at the index level – the inflated one-day S&P 500 implied vol levels that have occurred in days before 3 macro events – the CPI, the Nonfarm payrolls report and FOMC meetings. We talk as well about one day options and the risk of a blowup. At least at this point, Garret sees flows that are reasonably mixed, with no obvious risk of instability resulting from positioning. Lastly, we discuss recent work he’s done on implied dividends using a novel approach. Relative to years earlier, he finds that there is currently very little risk premium implied in dividends. That is, the market is charging almost nothing for bearing the risk that dividends wind up disappointing on the downside. It’s interesting work and a good example of the rich information that can be extracted from derivatives markets. I hope you enjoy this episode of the Alpha Exchange, my conversation with Garrett DeSimone.

The study of correlation is valuable, informative and, likely an over-indulged in activity on Wall Street. That said, there are important risk considerations when it comes to how significantly assets move together or do not. The task at hand in this short podcast is to illustrate and contemplate the diverging paths of two important correlations: that between the stock market and bond market and second, between equities themselves. If the stock market is diversifying itself in real-time, there are reasons to think it cannot last indefinitely.  I hope you enjoy.

With option prices in the doldrums, your host provides some thoughts on why and in the process reflects on the skinny levels of risk premia a decade ago. I finish with some cautionary observations around what might go wrong. I hope you enjoy this short pod!

It was a pleasure to welcome Raghuram Rajan back to the Alpha Exchange. Raghu is currently a distinguished professor at the Chicago Booth School of Business and is the former head of the Reserve Bank of India. With a deep understanding of the intersection of markets, the economy and policymaking, he is among the most important voices on Central Banking.With this in mind, our discussion explores his recent book “Monetary Policy and Its Unintended Consequences”, the title alone of which is entirely through provoking. Raghu shares his assessment of the tendency for policy towards increasing asymmetry – where the Fed acts as a lender of last resort during a crisis but finds itself unable to achieve normalization during non-stress periods. We talk as well about the distortions that result from forward guidance and asset purchase programs during non-emergency periods.Lastly, we talk about policy spill-overs, specifically the impact that the Fed’s actions can have on emerging economies. As head of the RBI a decade ago and as India experienced the impact of Bernanke’s 2013 taper tantrum, Raghu has much to say on this subset of unintended consequences. He argues that the Fed’s remit will continue to target domestic growth and inflation, consideration of the international impact of policy decisions should conceivably be a part of the policymaking conversation.The second half of our discussion focused on Raghu’s most recent book, “Breaking the Mold”, in which he reviews the progress and challenges in India. Here, he documents the diverging paths of India and China and makes recommendations for how India can learn from what China has done while recognizing both the constraints and opportunities associated with today’s global economy. He argues that India is uniquely positioned to provide high value-added services in a digital and remote work economy.I hope you enjoy this episode of the Alpha Exchange, my conversation with Raghuram Rajan.

Corporate Fraud is an unfortunate, costly and seemingly never-ending aspect of the world of business. In the best case, fraud is prevented or, at least caught before harm is done. All too often, however, these cases of deception lead to large financial losses, impacting the lives of many - shareholders, individuals and certainly those that are courageous whistleblowers.A little more than 15 years after the unwind of the Madoff Ponzi scheme, I invited Harry Markopolos back to the Alpha Exchange. Harry is often simply referred to as “the Man Who Knew”. He chased Madoff for years, serving up a comprehensive slew of evidence to the SEC that was mind boggling in its degree of logic, rigor and scope. Our conversation looks back on the lessons of this Ponzi scheme and also zooms out to consider other examples of corporate fraud including Theranos and FTX. Throughout our discussion I seek to gather Harry’s insights on the commonalities in these cases, how to detect them and also, importantly, how to prevent fraud. He points to a few areas of progress on the enforcement front but makes a strong case that the penalties associated with being caught need to be considerably larger.I hope you enjoy this episode of the Alpha Exchange, my conversation with Harry Markopolos.

It was a pleasure to welcome Kris Kumar, CIO of Goose Hollow Capital, to the Alpha Exchange. Our conversation starts with Fed policy and the manner in which the 500bps of policy tightening is impacting the economy. To this, Kris argues that the propitious starting position for households and corporates in this cycle has been quite different than in previous ones, thus blunting the impact of rate hikes. He points as well to loose fiscal policy with the unemployment rate so low. For Kris, what happens next depends more on fiscal than monetary side.We next consider the backdrop for valuations, starting with fixed income. Kris sees safety that comes from a coupon on 2’s that approaches 5%, noting that there are positive real yields generally in most of the world.  From an earnings yield perspective, however, US equities have zero premium to bond yields and Kris points to the concentration of earnings growth coming from the top of the SPX, which, in turn, is a bet on generative AI.  Should this growth not materialize, the lofty multiples currently awarded these stocks could be re-rated.Within equities, Kris makes the argument that we’ve invested a lot in bits but not in atoms and, going forward, investment dollars may move away from tech into areas associated with energy demand. How else to satisfy all of the incremental power to run all of the data centers built?We finish the discussion with an assessment of the price of vol. Kris points to the epically low implied correlation on the SPX, a result of the bifurcated market in which a small but valuable subset of the index is a bet on AI. He sees scope for the still elevated level of rate vol to come down but upside in vol on commodities like copper as a function of all the spending on infrastructure that will ultimately come as a function of the AI boom.I hope you enjoy this episode of the Alpha Exchange, my conversation with Kris Kumar.

The “rule of 72” tells us that a good approximation for the time it takes to double your money can be arrived at by taking 72 and dividing by the interest rate that capital can compound by on an annual basis. Implicit in the calculation is that the initial stack is left untouched and is not vulnerable to a drawdown. In this context, it was great to welcome Jerry Peters, the Managing Partner of Smithbrook to the Alpha Exchange. Providing a risk-managed equity solution to its high net worth clients, Jerry and team are focused on managing downside risk, utilizing an option overlay strategy to mitigate some of the invevitable swoons in equity prices.Our conversation walks through how index put options – when acquired at the right price – can create gains that help offset portfolio losses during times of stress. Acknowledging that the long term expected value of buying insurance ought to be negative, Jerry walks through how a protective strategy can interact with long risk exposure to create long term return enhancement. Here, he points to how gains from insurance during sell-offs can underpin the “rebalancing bonus”, where capital is moved from winning to losing assets on a systematic basis. We also talk about some of the subtle aspects of financial asset taxation and efforts to maximize not just the pre-tax but also the after-tax return of investment decisions. Jerry walks through some straightforward tax loss harvesting strategies that can add meaningfully to investment outcomes on an after-tax basis.I hope you enjoy this episode of the Alpha Exchange, my conversation with Jerry Peters.

After a 13-year career at CSFB where she would ultimately head the firm’s equity derivative strategy effort, in 2023 Mandy Xu moved to the CBOE where she’s now Head of Derivatives Market Intelligence and swimming in interesting, complex data sets. Our conversation surveys product innovation, going back to the first option trade ever on the CBOE, call options on July 1973 Xerox, through today’s vastly electronified ecosystem of trading in cross-asset risk exposures.We briefly review the unbelievable short squeeze in GME from 2021, and here Mandy asserts that today’s exposures are considerably more balanced than the Meme episode in which the retail stampede engorged on call option premium. Our discussion moves to the present-day backdrop for option pricing and the potential impact of mechanical flows resulting from vol being bought and sold in the market.Noting the substantial increase in AuM for overwriting and option income generating funds in both the mutual fund and ETF complex, Mandy is skeptical that this growth is solely responsible for the low clearing price of measures like the VIX and put skew. Instead, she points to low risk readings in other asset classes, including credit implied vol, as more likely driven by stable macro fundamentals.We spend the remainder of the conversation on the much debated topic of ODTE and whether there’s an accident waiting to happen. In Mandy’s role at the CBOE, she sees option flow data with great granularity and in the ultra-short-dated category, she sees considerable balance in use cases across hedgers, income generators and intraday traders. The result is a healthy mix of buyers and sellers and, at least for now, a low risk of Volmaggedon 2.0. I hope you enjoy this episode of the Alpha Exchange, my conversation with Mandy Xu.

Kieran Goodwin’s roots go back to the early days of both distressed debt investing and the credit default swap market, two classes of risk he has seen experience significant change over the last 25 years. Our conversation gets underway by exploring the notion of alpha decay in the distressed market, a diminishing opportunity set that has resulted from smarter capital entering the space, equipped with an understanding of the often complicated process around bankruptcy and reorganization. Kieran frames out the option characteristics of distressed investing in an interesting way, suggesting that the short or long profile of the exposure is about whether time is on your side or not while also arguing that it is arming yourself with a margin of safety in price that creates this runway, leaving the trade with more long vol attributes.Distressed investing today, in Kieran’s view, is an adult swim only business, rife with creditor-on-creditor violence and requiring a large balance sheet to be in the room as indentures are changed or portions of a capital structure are being primed. We spend the remaining part of the discussion on the CLO business and the potential for a credit-widening cycle. Kieran describes the CLO machinery as a captive buyer base for loans that has served effectively as a quasi-index product that has facilitated market growth. While noting that the product has indeed been effective over the years, he points to concentration risk that can lead to a rapid rise in correlations and spreads. He also points to at least some early signs of an uptick in defaults.Lastly, we touch on the electronification of credit trading and the factorization of credit exposure that technology has increasingly enabled. Involved as an investor in some of the initiatives to facilitate electronic trading, Kieran sees further growth here, accompanied by more continuous trading and price discovery.I hope you enjoy this episode of the Alpha Exchange, my conversation with Kieran Goodwin.