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Eulogy for XIV

This week we lost a truly special financial product. XIV was an Exchange Traded Fund (technically ETN but who cares) that sought to provide a daily return equal to the inverse of the daily return in the vix index. The vix index is an index constructed from the implied volatility of SPX options. So, basically vix is a measure of how volatile traders expect the stock market to be, or alternatively how nervous people are about stocks.  When volatility or expectations of volatility of general nervousness went down then XIV went up and vice versa. That seems pretty boring until you consider the unique features of volatility as a trade-able instrument.

I. Behavior Of Volatility

Unlike a stock or commodity that can go up forever or down to $0, volatility spends most of the time being low and occasionally and temporarily spikes.  Over the long run we see that vix tends to hang out around 12 or so. Sometimes it can be higher for an extended period of time, like during the 2008-2009 financial crisis, its floor seemed to be elevated to more like 20. Sometimes it spends a few years never getting much above 10. When there are big market moves or events, it can spike up into the 30s, 40s or even I think 90 at the peak of the financial crisis. But every time it goes up it crashes right back down again in a short period of time. Now, naively you might think that if it never gets much below 10 and occasionally goes way higher then the smart and obvious strategy is just to buy it when it’s low and then wait and sell when it spikes. After all, if you buy for 10 and a year later its 10, you haven’t lost anything right? Actually that’s wrong and that is part of the magic of XIV.

II. Volatility Term Structure

XIV and other volatility-linked ETFs relied on vix futures listed on the CBOE to get the exposure they wanted. Vix futures have the feature that they expire on a monthly basis so if you want to constantly stay short or long vix you have to frequently roll from the future that is expiring to the next future. XIV would move a fraction of its position from the closest to expiration future to the next future every day. So right now if it was still operating it would be moving a few% of its portfolio from the February future to the March future. When February ended it would start moving the March futures to April etc. By moving I just mean it would need to buy some of the February futures that it was short and sell the same number of them in the March contract. The very interesting thing about the vix futures is that when volatility is low the further out contracts are always priced higher than the closest to expiration contract. Why would this be? Well, it has to do with the difference between median and mean. Median is the value that a variable spends half its time above and half its time below. Since volatility is low most of the time, the median value of the vix is pretty close to its lowest values. The mean is just the average of the values that the variable takes on over time, so the mean value of the vix is higher than the median because sometimes you get those big spikes. The longer a future has before it expires the more likely it is to be worth the mean (in a stationary process like the vix). So when volatility is below the mean (which it is most of the time) the further dated futures will be higher than the closer dated ones. When vol spikes up then you see just the opposite. The long dated futures don’t diverge too much from the long term mean but the short dated ones really rip higher to reflect the short-term spike.

III. The XIV Strategy

So when XIV constantly rolled its exposure from the front month to 2nd month future, it would constantly be buying at a lower price than where it sold. The difference between the months was substantial. In 2017 typically the front month was around 10 and the 2nd month was around 11. So each month as long as volatility and the term structure remained constant XIV would earn about a 10% return just from rolling its position. Over the course of the year XIV earned almost 150%. And for any extended period when volatility stayed low it could earn these amazing returns. Overall from 2012 until the day before it blew up it earned nearly 1000%, vastly outpacing the stock market. So you could buy it and hold it and have a great ride but you had to be aware that the ride was going to end with it crashing into a brick wall at some point. Volatility always spikes eventually and eventually it would have a big enough spike to wipe out all its capital. The long term probability of that occurring was 100%. So, what do you do with a product like that? Its not really that difficult. Suppose that you  put $5,000 into XIV a few years ago, and then whenever your XIV position reached $10,000 you sold off half of it. Over the course of the last 5 years or so you could have sold half your position at least 3 times. So, even though your original $5,000 investment is gone now, you would still have the $15,000 in cash. That still beats most other investments including the stock market over that period.

IV.  The Real Magic of XIV

Now you might say, sure XIV is gone now but there are still vix futures and there is still VXX which is an ETF that positively tracks the vix. You could sell futures or sell VXX. That’s true but its just not as good. Suppose that you are short vix futures on Friday afternoon and they are trading for 10. On Sunday Kim Jong Un’s iphone crashes while he is about the answer the 15th question right on HQTrivia so he decides to Nuke San Francisco.  You can imagine any horrible event you wish. On Monday morning the stock market is down 30% or whatever and vix is up to 100. Now you have not just lost the notional value of your future on Friday, you have lost 9 times that much!  If you don’t have enough capital to cover your losses you could be forced to get out of other positions. If you had 10% of your money in XIV you could go to bed knowing that no matter how much volatility spiked that was all you could lose. If you had 10% of your money short VXX or vix futures you could potentially lose most or all of your net worth.  That is what made XIV a truly magical product.

V. So Who Would Have Ended Up Paying? 

XIV had about $2 Billion of exposure when it blew up. Considering the scenario where vix closed at 10 on Friday and opened at 100 on Monday it would have lost $18 Billion. The holders of the ETFs would be out their $2 Billion but who would absorb the rest of the loss? Someone would have to! I’m not 100% sure of the answer, but it seems like it would either have to be the exchange that offers the vix futures or the financial institution which managed XIV, or some combination of the 2. In any case, those companies were making tiny amounts of money in exchange for shouldering that enormous risk. While an XIV holder could make 10%/month in a low volatility environment, the management company (Credit Suisse) was making something like 0.5%/year! The CBOE was only making the transaction fees on the futures trades which are something like 0.01% of the value of each future. Because of this potential for explosive harm, its amazing that this product ever existed. And now that its gone and Credit Suisse will probably spend most of the money it ever made from it defending lawsuits from people who owned it. So, I’m sad to say that I don’t expect it to come back any time soon.

What to do about Stagnation

For the last 6 years or so my expectation of the future direction of humanity has been dominated by “The Great Stagnation.”  In it Tyler Cowen clearly lays out the empirical case that economic growth has slowed significantly since the mid 20th century. While Cowen believed that growth would eventually return to the levels of the 20th century I was less sanguine. We know that 2% exponential growth cannot continue forever.  In 10,000 years at 2% average real growth we the world economy would be 10^86 times larger than it is now. 10^86 is around the number of atoms in the visible universe, so each atom would have to be producing as much economic output as the whole world does now. I find that implausible. So, the simplest model is to draw a line from our current level of growth down to 0. There should be some volatility around that downward sloping line but there is no reason to assume that it will ever return for a long period of time to the highs that we have achieved in the past.

When I put it that way, I still find it fairly persuasive. In the very long run we simply cannot have fast exponential growth. My personal and emotional takeaway from this fact was that I and my progeny should focus on zero-sum status games. In the long run, zero-sum games have to be much more important than progress. There is an infinite amount of fighting that can be done about how the pie should be divided but the size of the pie will always be finite. So doesn’t it make more sense to focus on doing well in the fight rather than trying to grow the pie? I’m not so sure anymore.

Consider Elon Musk’s accomplishment yesterday. He inspired the world by launching a car into space on a rocket that isn’t nearly as powerful as ones that existed 50+ years ago.  The main innovation that SpaceX has accomplished is to get rocket stages to do controlled descents that allow them to be reused. Its amazing to watch the booster rockets land and it should, in theory, lower the cost of delivering cargo to space, though not to the point where we can do a lot more useful things. Its not the kind of innovation that is going to add a lot to global growth, but it might inspire some people to buy Tesla’s and that would be a big win for Musk.  Innovation inspires people. It gives people hope. Its a great strategy for getting yourself a bigger piece of the pie. And beyond its effectiveness as a cynical mode of separating hopeful people from their money, its personally satisfying to feel like you are contributing to human progress. Waking up every day feeling like my only mission was to redirect resources to me and my kids was getting pretty old frankly. Time to start trying to actually make the world a better place.

 

Star Wars: The Last Jedi thoughts

1. The opening title crawl says the republic has been defeated and now the First Order are running shit and the resistance are basically dead too. So, I guess they blew up starkiller base a little too late? It seems like that didn’t accomplish anything. It didn’t seem to slow down the First Order at all.

2. In the opening battle scene Poe shoots off all the exterior cannons from a “dreadnought” which is a powerful First Order ship. It doesn’t seem that hard to do. Then he says we have use the opportunity to take out the dreadnought even though the First Order controls the entire galaxy and presumably has a shitload of ships. So destroying one when the rebel fleet is tiny and they could all just escape doesn’t make much sense. But they decide to go ahead and a bunch of comical b-52 bomber spaceships fly over the dreadnought and attempt to release their payloads in an overly complicated way. Rather than having a button that the pilot can just press, it seems that someone in the “bomber bay” has to open the doors (why doesn’t the air rush out?) and then someone else has to press a garage door opener to make the silly looking spherical bombs fall down.
All but one of these bombers get blown up before they can release their bombs and somehow none of their payload makes it to the dreadnought or has any effect on it. Then the last bomber manages to release its bombs and somehow, even though they say the dreadnought has extremely tough armor, the bombs manage to blow up the entire massive ship. What kind of bombs are these? Why can’t they shoot them at the ship from a distance rather than using nonexistent gravity to carry them there?

3. After the disastrous kamikaze mission to destroy the dreadnought, the rebels (or resistance or whatever) decide to escape. Unbeknownst to them, the First Order has developed the ability to track them through light speed travel so when the rebels slow down the first order are right behind them. This shows that the first order seem to be the only innovators in the galaxy because aside from BB-8 everything else looks exactly as it did in the original trilogy. Finn and Poe and a girl named Rose come up with a complicated plan to disable the light speed tracking based on many unproven assumptions. Finn and Rose then escape at lights peed In an escape pod for some casino planet. Why don’t they get as many of the rebels as possible out of there at light speed in tiny escape pods since the first order seems to have no interest in following those? They all have to die together even though they are the last hope for the galaxy?

4. Finn and Rose are going to the casino to find the one code breaker in the galaxy who can get them onto an imperial destroyer. They see the guy across the room but before they can get to him they are tased and imprisoned for illegally parking on the beach?!?Luckily, sharing a cell with them is an equally skilled code breaker who just opens the cell door when he feels like it. That’s just where he hangs out waiting for code breaking jobs I guess.

5. The criminal code breaker guy is the best character in the movie. He makes it clear that no one gives a shit about the first order or the republic or the resistance. They make money selling weapons to both sides somehow but otherwise they seem to have no interaction with any supposed galactic government. I get the sense that the average person in that galaxy interacts with the galactic government only slightly more than the average person on Earth in 2017 interacts with the government of the  Milky Way.

6. Interspersed with the resistance stuff is Rey hanging out with Luke Skywalker on an island with many amusing CGI creatures. Skywalker has decided that the Jedi should die out even though he knows that there are 2 powerful Sith running the First Order. He doesn’t think the force is too dangerous for anyone to mess with. He just thinks the dark side should win.

7. At some point Luke agrees to give Rey a Jedi lesson. She closes her eyes to feel the force and immediately sees the island’s hairy butthole calling to her. Luke is very alarmed by this. Rey then goes and finds the hairy hole and falls in it and swims to a weird mirror thing that is supposed to show her her parents but just shows her her own reflection. I am betting none of that will be further explained in episode 9.

8. Rey gets angry and leaves to go hang out with Kylo Ren. Luke then decides to burn the ancient Jedi texts which he has stored in an empty tree trunk. But he hesitates so Yoda shows up and hits the tree with  lightning and cackles maniacally. At this point I thought Yoda was evil and maybe they would reveal that he was Darth Plagius/Snoke the whole time and just trained Luke to kill his main Sith rivals. But no, he just destroyed the sacred texts because they weren’t fun to read.

9. The Finn/Rose/Poe plan to stop the first order from tracking the rebellion fails, so then almost all the rebels end up on slow moving transports trying to get to an abandoned planet with the First Order picking them off. The rebel 2nd in command stays on the cruiser because someone has to pilot it even though all that involves is standing around, and she makes her decision while C-3PO is standing right there. No one says “you’re the 2nd in the command. You’re too valuable. Lets just have a droid do it.” But luckily for the ploy she gets the idea to turn the cruiser around and shoot into the First Order fleet at light speed. This maneuver causes more damage than any other weapon in star wars history except maybe the Death Star/Starkiller base. And all it required was a mass and a hyperdrive which was established tech in the prequels. But somehow no one ever thought of using it before and probably they will never use it again.

10. A few rebels get to the planet and many events of varying levels of logic occur. My favorite part is that they keep calling their allies for help and even though the First Order was severely weakened by the light speed ramming, no one shows up because no one cares. The resistance is basically a terrorist cult and the First Order is just trying to exterminate them so people can go about their lives.

A new vision for UBI

Being a US citizen is inherently valuable. It gives the right to work in the richest major country.  We can travel to much of the world visa free and very few countries want any harm to befall American citizens within their borders. The US has a very high standard of living and good infrastructure and its relatively easy for citizens to take advantage of that. Its not uniquely good. Being a British citizen or German citizen is comparable and better in some respects. But its better than being a citizen of many countries and so there are always a lot of people who want to immigrate to the US.

At the same time, there are a lot of US citizens who have trouble utilizing their status to its full potential. For a variety of reasons there are just 10-15% of the population that can’t seem to make it work. They have this great asset but its just not producing a return for them. So what would happen if we allowed these people (or anyone) to sell their citizenship. Imagine if the only way for a non-citizen to become a citizen was to buy another person’s citizenship. There would be millions of people who would be happy to do that.

Furthermore, lets imagine that instead of taxing citizens and then distributing that money to other (mostly) citizens in arcane ways, the US government taxed at the laffer max and then distributed most of that money as a “citizenship dividend.” That’s essentially a UBI but rather than setting its level and then seeing how crazy high taxes have to be, you set taxes to what will give the greatest NPV of revenue and pay out whatever you can from that. Like a corporation not a charity!

Combine those 2 ideas. The only ways to become a citizen or legally work in the US are either to be born a citizen or to buy a citizenship. Citizenships also pay a reasonably fat dividend (Got to be at least $5K/year if not more like $10K given current taxing and spending). How much would a citizenship be worth on the open market? Given the stability of the dividends, the impossibility of bankruptcy, and current low interest rates a multiple of 40-50 would be extremely reasonable. Plus some premium for the value of working in the US, and you can see how a citizenship could easily be worth $300-500K. Maybe more. Get rid of worldwide taxation and rich foreigners would buy them “for a rainy day.” Think about the value to low income people of being born with a $400K inheritance. It would be immense. That pays for college + a good start in the world.

Selling your citizenship would have to have consequences. You’d lose the right to vote. You’d lose the dividend but as long as you were born a citizen you should retain the right to live and work in the US and your kids (if born in the US) should still be citizens. We could pay out a decent dividend while still having a safety net for those who really need it so even if some unfortunate people sell their citizenship and then blow it on smack or whatever then they wouldn’t end up starving in the street. Real actual welfare for people who really need it is just not that expensive. To protect minors make it illegal to sell your citizenship before 18. That way parents can’t have kids as a way to get rich, though they would still get the dividend.

The total level of immigration might decrease, and particularly low skill immigration. But skilled workers would probably still be able to afford it. If they are going to be able to make a decent living, then they should be able to borrow to buy a citizenship. They can pay it off using the dividend + part of their earnings. It would be slightly painful but well worth it for smart people coming from poor countries, and of course their kids could get the massive benefit of being born citizens. More importantly, immigration would now be guaranteed to benefit American citizens since it would keep the value of their citizenship up, and would allow citizens in poverty the chance to escape.

Universal Basic Income

The Universal Basic Income (UBI) has come back into public consciousness with Switzerland holding a referendum on the idea and I think some dbag from a tech incubator is “researching it.”

The Swiss referendum was pretty bad. I think 22% of people voted for it but supporters of UBI declared that a victory. I think they underestimate how many people would come out to be against it if it were more likely to pass though.

Most of the articles about UBI focus on the idea that AI is going to take everyone’s jobs and then a UBI will be necessary for actual people to have any money. Maybe that will happen but So what? If it happens we can vote for a UBI then! AI could take over a lot of things that humans do now without destroying many net jobs as long as people still value having people do things. Ever seen a sign outside of an ice cream parlor advertising their “hand-dipped” cones? People like a human touch, so as long as humans own the companies with the AIs and therefore make the money and can spend it, its very likely that they will spend it on having other humans do things for them. Already most people work in the service sector.

Another pro-UBI argument is that the current welfare state has high implicit tax rates for certain people, meaning like if a single mom on TANF gets a job she might lose nearly as much in benefits as she gains in earned income. That can be a problem, but it effects a fairly small number of people for a fairly small amount of income. If she starts making a decent amount of money her marginal tax rate will go back down. On the other hand, paying for a UBI at a level high enough for people to live on would require really high taxes on everyone so instead of a few people facing a high marginal tax rate on a small amount of income, everyone else would face a really high marginal tax rate on all their income.

UBI proponents like imagine that if people are free from the need to work they will do more innovative or creative things instead. There are a couple of reasons to disbelieve this. One is that in the US, most young people already have the equivalent of a basic income. Its called living at their mom’s house. See the movie “Stepbrothers” for an example. Since that’s available to the top half of the income distribution at least, giving it to everyone wouldn’t add a ton. Another reason why you should not expect to see a creativity boom if there was a UBI is the example of Saudi Arabia. For decades the Saudi government has employed most Saudi citizens in undemanding, well paying jobs. They could afford to do it because of their enormous oil wealth. What’s been the result? Saudi Arabia is not a tech hub. Culturally its backwards. They have to import people to do the actual work. No one will talk about Saudi Arabia or the other gulf states in the context of UBI but they are much closer to the real experience than most small scale western experiments.

Finally, UBI advocates say that we can get rid of a lot of the existing welfare system, including social security and maybe medicare with one simple program. That would be nice but here is the thing, what about people who squander their UBI payments? What about people who need more help, due to disability? We’d still need a welfare system on top of a basic income to avoid people starving in the streets. In my next post I will lay out an alternative vision for a basic income that also solves the immigration issue and everyone will hate it!