Hyperinflation - The "Other" Tail in Equity Derivatives

Wikipedia defines hyperinflation as a situation "when a country experiences very high and usually accelerating rates of monetary and price inflation, causing the population to minimize their holdings of money." With Zimbabwe as a recent example, the idea of extreme inflation is not anything new. However, a few fund managers have put forth a novel means of expressing a view on long inflation through equity derivative products. In an interview from The Invisible Hands by Drobny, fund manager Jim Leitner describes implementing a view on hyperinflation by buying 10-year S&P500 10'000-Strike Calls. He draws upon Turkey as an example of a country where large rallies in the stock market correlated with periods of high inflation because equities acts like a "real asset" in many cases; to be precise, Leitner hypothesizes that high inflation causes high equity markets. To quote him: "The Turkish stock market (ISE 100) started at one in 1986. Today it is at 55,000. But if you chart that in real terms from 1988 to today, it's basically flat. THe ISE 100 with CPI subtracted out has not gone anywhere." In fact, the same happened in Zimbabwe as well as Israel in the late 1980s.

Comments

When pondering US inflation in the next 10 years [in the shower or while waiting for the subway], there some basic facts to consider:

1. The last few years of QE has given us a unnatural period of 0% US interest rates. We should not expect this type of environment can not continue indefinitely
2. In the late 1970s and early 1980s, the US did undergo a period of high interest rates (home mortgage interest rates in the U.S. reached 16.55% in 1981)

And then some aggressive opinions to consider:

1. The Fed taken very strong measures akin to almost manipulating certain segments of the bond market. These actions may result in extreme reactions.
2. As U.S. increases exponentially the amount it borrows each year, there will come a day when investors start to doubt the credit-worthiness of the US resulting in a sell-off of Treasuries and elevated inflation. 

At the end of the day, price determines if a trade is in fact interesting. Leitner mentioned that one could pay 14 basis points for 10-year 10'000 calls, which sounds like a very fair price to me. What's nice also about buying cheap options is that it doesn't require one to post collateral or use leverage (as opposed to selling options). Nonetheless, long-term options only trade Over-The-Counter, so then again one would have counterparty risk.

Rethinking Equity Volatility Skew

We can also discuss the converse of hyperinflation: is it valid for long-term index options (say 10y S&P500) to be pricing a downside skew (downside volatilities higher than upside volatilities)? One exotic trader (credit to M.C.) suggested that long-term skew existed simply because all traders are used to pricing a short-term skew. Short-term downside skew on indices makes a bit of sense, since in a sell-off, the correlation of the index increases, hence exacerbating the downside move; in general, indices slowly march up but can experience a violent move down. One-sided flow in index option markets also contribute to skew, since Insurance Companies and Pension funds tend to always buy downside puts for annuity programs, causing volatility to be bid up. But logically, you have to ask yourself, 10 years from now is it more likely for the S&P to be up 30% or down 30%? Is there more risk to the downside or to the upside?

The Wisdom (or Danger) of Crowds

As noted, at least 2 sources besides Leitner describe possible hyperinflation and to implement such a view via long-dated out of the money equity index call options. Hence, we could say that the cat is definitely out of the bag. (I will give Leitner credit for the idea because his interview was published first).

Artemis Capital Management also published in interesting research piece in 2012 detailing the same trade:

http://www.artemiscm.com/wp-content/uploads/2012/04/Artemis-Capital-Q12012_Volatility-at-Worlds-End1.pdf

In their article, Artemis took the extra step of discussing Central Banker's tendencies and hypothesizing that all central banks would do whatever it takes not to have deflation, regardless of the side effects.

Another mention of Leitner's trade came in an interview with Jamie Mai in Hedge Fund Market Wizards by Schwager. Mai's traded involved buying 10-year calls on the Dow Jones Industrial Index, which is not the best representation of the equity market since DJI is price-weighted (as opposed to S&P500 which is market-cap free-float weighted). By the way, Jamie Mai's interview was one of the best interviews in the book, there is some good discussion over the pricing of long-term options as well as a very interesting perspective of worst-of options.