2014 Volatility Outlook Final

EQUITY DERIVATIVES STRATEGY
Market Commentary
January 14, 2014
2014 U.S. Equity Volatility Outlook

Braking Bad?
Equity Derivatives Strategy
In the wake of the equity markets best year since the dotcom heydays, one would think equity investors would be
gripped with euphoria. Instead, the pervasive sentiment
seems to be that of cautious optimism grateful to be at
the markets high, but wondering if we should be.
We thus enter 2014 at a potential inflection point with the
Fed poised to tap the brakes on its accommodative
monetary policy. Despite obvious macro risks, the recent
shift towards a low correlation regime implies that volatility
this year will largely be defined by investors quest for
validation of current market valuations. As a result, we
expect to see increased incidences of market-beta
inversion in which sector and index volatilities are
catalyzed by single stock earnings.
Exhibit 1: S&P Expected Volatility Scenario Analysis
Source: Credit Suisse Equity Derivatives Strategy
Exhibit 2: A Steady-State VIX Forecast at 15
Over the course of this report, we explain the rationale for

our 2014 volatility outlook: a steady state forecast of
VIX at 15, but with increased skew convexity (i.e., vol of
skew) magnifying macro shocks that could drive the VIX
in excess of 25.
Our report is divided into four parts:
1) Volatility: In the first section, we define our level for
baseline realized volatility by analyzing relevant underlying
economic fundamentals. We then examine potential
macro catalysts such as a spike in US interest rates, EM
contagion, and a meltdown in Chinas shadow banking
sector all of which are likely to inflate the premium
accorded to implied volatility over baseline volatility.
2) Skew & Term-Structure: In the second segment, we
discuss investment trends in the derivatives markets to
determine how the supply and demand for volatility from
hedge funds, banks, institutions, insurance companies,
pension funds, and retail investors shape our views for
index volatility skew and term structure.
3) Sector Volatility & Correlations: In the third part, we
discuss developing themes within the specific sectors that
are likely to influence volatility at the single-stock level and
how these changes could affect inter-stock correlations.
4) Trade Recommendations: Finally, in section four, we
wrap up by proposing trades that best reflect our views.
Exhibit 3: Sector Volatility Outlook for 2014
Weight in
S&P
19%
16%
13%
13%
11%
10%
10%
3%
3%
2%
1Y Impl
Volatlity
16.1
17.3
15.0
16.5
17.4
18.4
13.1
14.6
17.4
14.3
Lower volatility
Higher volatility
Sector
Technology
Financials
Healthcare
Consumer Discretionary
Industrials
Energy
Consumer Staples
Utilities
Basic Materials
Telecom Services
Volatility
Outlook
Edward K. Tom
Stanislas Bourgois
Terry Wilson
Mandy Xu
ed.tom@credit-suisse.com
(212) 325 3584
Stanislas.bourgois@credit-suisse.com
+44 20 7888 0459
terry.wilson@credit-suisse.com
(212) 325 4511
mandy.xu@credit-suisse.com
(212) 325 9628
(212
(
Framework for Analyzing Volatility
Baseline Volatility: The new normal is squarely

upon as we exit 2013 with the lowest realized
volatility since 2006. Accommodative global
monetary policies, accelerating economic growth,
and record corporate earnings combine to provide
a constructive backdrop for equities. Looking
ahead, our Global Equity Strategy team has a
2014 S&P target of 1960. Using that target price,
we forecast a baseline S&P realized volatility of
10.8% for 2014.
Potential Volatility Shocks: From surging US
yields to a collapse in Chinas shadow banking
sector, there remain a number of macro catalysts
that could drive implied volatility up to 30%. On the
other hand, accelerating economic growth reduces
the kurtosis premium currently embedded in
implied volatility.
Volatility Supply & Demand: Anticipated macro
shocks will likely manifest via skew and increase its
shock sensitivity. Against this backdrop, a
forecasted decline in institutional & pension fund
overwriting, increased hedge funds' use of options
to express directional views, and the shortened
duration of insurance hedges should increase skew
convexity. Absent a liquidity event, the declining
inventory of legacy variable annuity exposures will
result in an increasingly illiquid and sticky backend term structure.
Sector Volatility & Correlations: While
correlations are determined by co-movements at
the single stock level, there are three sectors S&P
dispersion traders should focus on in particular:
Tech, Financials & Energy. We believe Financials
and Energy sector volatilities will move lower in
2014, while Tech will see an increase in volatility.
On correlation, we expect last years low
correlation regime to persist, favoring stock
selection and sector allocation to generate alpha.
Our discussion will utilize a framework that decomposes

implied volatility into 3 components:
1. Baseline volatility Our expectations for realized
volatility driven by economic fundamentals;
2. Kurtosis - The excess premium volatility traders
charge to account for the uncertainty of tail-events;
3. Skew The excess premium implied volatilities
trade above realized owing to the supply and
demand for volatility as an asset class.
Illustration of Volatility Framework

To illustrate this technique, we apply the methodology
to the VIX at three instances in 2013: Mar 14th (lowest
VIX reading), Jun 20th (height of tapering fear), and
Dec 31st (year-end).
Exhibit 4: Example Decomposition of VIX in 2013
Skew Premium
Kurtosis Premium
Baseline Volatility
25
20
VIX
Executive Summary
15
10
5
0
Lowest Vol
Fed Tapering
Dec 31st
The sample decomposition above shows two notable

developments. First, as one would expect, the premium
stemming from the supply and demand for volatility
(skew) was significantly higher during the Fed tapering
sell-off in June than it was at the other two instances.
Secondly, although we exit 2013 at a higher implied
volatility level than in March, when the VIX fell to a 6year low of 11.3, that difference is entirely due to
higher skew and kurtosis premiums (+0.9 pt and 1.4
pts, respectively). Baseline volatility remains the same.
2014 Trade Recommendations

Top Macro Ideas
EEM zero premium hedge
Europe vs. US Outperformance
Long TBT call spreads
Bullish Japan (vanilla & exotic)
Long SX5E/Euro Hybrid Call
Short Index Straddles
Top Thematic Ideas

Short energy volatility, long USO (oil) volatility
M&A basket and risk reversal ideas
Long European dividends
***Risks: The risks to buying a put, a call or a put or call spread is limited to the premium paid. The risk to selling a put can be significant. The risk of selling a
call can be unlimited. The risk to selling a variance swap or straddle could be unlimited. The risk to buying a variance swap is that variance could go to zero.
Establishing Baseline Volatility
Bootstrapped Monte-Carlo
Baseline volatility, the type inherent in a liquid, continuous

market, is largely a function of underlying economic
fundamentals. With that in mind as we look ahead to
2014, there are many reasons for equity investors to
remain optimistic.
The global economy is expected to be the most orderly in
years. A stable balance of growth, low inflation, and
accommodative policies will support a cyclical acceleration
in activity. We expect higher household wealth to drive a
pick-up in consumer spending, and an ECB backstop to
boost the recovery in Europe.
While its tempting to turn cautious after a year when the
S&P rose 30%, history is squarely on the bulls side.
Historically, previous annual rallies of 25% or more were
subsequently followed with an increase in the S&P of
11%, on average.
Calculate forecasted S&P return target
Calculate daily historical returns for S&P-500 from 1928 to

the present (21,168 data points)
Calculate rolling-window of one-year daily compounded

returns (20,916 data points)
Construct a normal density (bell-curve distribution) of the

one-year price paths centered on the forecasted index return
target
Draw 10,000 samples of the price paths from the

constructed distribution
Calculate the realized volatility of each of the 10,000 sample

paths
Baseline volatility = the mean of the sampled realized

volatilities
Exhibit 6: Expected Volatility Required for S&P to Reach 2000 =12%
For 2014, our US economics team is forecasting a real

GDP growth of 3.0%, a stable inflation rate at 1.4%, and
an average unemployment rate of 6.8% (vs. 7.4% in
2013).
2014 Baseline Volatility @ 10.8%

Against this backdrop, our Global Equity Strategist,
Andrew Garthwaite, continues to see upside in equities
with a 2014 S&P target of 1960, which is an increase of
6.0% from the 2013 closing level. To arrive at this
number, Garthwaite probability weights three distinct
scenarios ranging from a China slowdown which dampens
US growth to a bullish sunshine scenario where the S&P
reaches 2300 (bubble valuations).
Exhibit 7: Expected Volatility Required for S&P to Reach 1500 = 21%
Accordingly, to develop our estimate for baseline volatility,

we analyze the volatility of the price paths (via a bootstrapped Monte-Carlo) required for the S&P to reach
Garthwaites S&P year-end target of 1960. As shown in
Exhibit 5, the average of the required volatility is 10.8% our expected baseline for 2013.
Exhibit 5: Expected Volatility Required for S&P to Reach 1350
S&P level at 2014

S&P return
year-end
2014 Scenarios
Probability
Core Scenario
60%
2000
8.2%
Downside Scenario
20%
1500
-18.8%
Sunshine Scenario
20%
2300
24.5%
1960
6.1%
Baseline Vol = 10.8%
Exhibit 8: Expected Volatility Required for S&P to Reach 2300 =13%
Potential Tail Catalysts (Kurtosis)

While we forecast baseline volatility at a benign 11%,
there are a number of macro catalysts that may
precipitate volatility shocks in the coming year. In the
following section, we explore in detail the top 3 macro
catalysts that we believe could have a significant impact
on equity volatility over the next 12 months:
Potential Catalysts That Could Drive VIX Higher
A Spike in US Rates: Last year volatility surged to a

1-year high at the mere suggestion of tapering. This
year, we believe a bigger risk is the Fed unexpectedly
raising (or talking about raising) interest rates. If that
were to happen, we could see the VIX jump 5-8 vol
pts higher.
Turmoil in the Emerging Markets: With slowing

growth, rising US yields, and mounting political risks,
the Emerging Markets could face a bigger crisis this
year than last years taper-induced sell-off. Potential
contagion could send the VIX up 5 vol pts.
China Shadow Banking Meltdown: China has seen a

bigger credit expansion, relative to GDP, than any
other country in modern history. However, its creditdriven growth looks increasingly unsustainable. We
explore three key risks in the upcoming year that
could turn this boom into a bust and send global
volatility surging.
Exhibit 9: 2014 Steady-State VIX Forecast of 15%
1. Rising Interest Rates

Interest Rate Contagion
With the December launch of Fed tapering, interest rate
risk is the most obvious candidate for a potential macro
volatility catalyst. The question for 2014 is what is the
degree of sensitivity of the equity markets to interest rate
levels and interest rate volatility?
An analysis of last years interplay between rates and
equity volatility shows us that the cross-asset sensitivity of
the equity markets to interest rate volatility is dependent
not merely on the magnitude of interest rate volatility, but
also the level of cross asset contagion. (Cross asset
contagion quantifies the degree to which volatility from
one asset class propagates to another).
has evolved from whether it will occur to how it will

progress. Small changes to the scale of the program (e.g.
a $10bn vs. $15bn taper) may affect the VIX on the
margin, but are unlikely to cause a spike of the magnitude
we saw in May.
Rate Hike a Bigger Risk than Tapering
Instead, the bigger risk is when the Fed will raise interest
rates. CS Economics team believes that will occur in mid2015, which is in-line with the Feds own projections. As
shown in Exhibit 2 below, the vast majority of the Feds
policymakers expect the first rate hike to happen in 2015.
Only 2 of the 17 members at the last December meeting
expected a hike in 2014.
Exhibit 2: Fed Policymakers Projections for Fed Funds Rate
Exhibit 1: Interest Rate Equity Volatility Contagion
Source: Credit Suisse Research
As seen in Exhibit 1, volatility contagion between interest

rates and equities actually began increasing in the weeks
leading up to Bernankes surprise announcement in May
that the Fed was considering tapering its bond purchases.
Contagion steadily rose from 10% in April to 40% in early
May, then surging over 30 pts to a 1-year high of 71%
after Bernankes announcement.
Even though an increase in the Fed Funds rate is not

likely until next year, the Fed may start preparing markets
for it this year, especially if economic data continue to
surprise to the upside. However, talking about a future
policy change can be a policy change itself and markets
will react as we saw with the taper talk last May.
Exhibit 3: Equity & Rate Vol Reactions to Taper
Current Equity-Interest Rate Volatility Sensitivity

What is the current degree of equity-interest rate
sensitivity? As shown in Exhibit 1, while contagion risk
remained elevated for most of 2013, it has declined
meaningfully since the Fed embarked on tapering.
Volatility spillover between interest rates and equities more
than halved after the Fed announced it was reducing its
asset purchases by $10bn in December.
Because Bernanke left open the pace of future
reductions, we expect tapering to continue to dominate
headlines this year. However, because of the decline in
volatility contagion, we do not expect it to be a significant
driver of equity implied volatility. Uncertainty over tapering
Volatility reaction to talk of taper: The VIX recorded its

biggest increase of the year from 13.4% to 20.5% in
the weeks after Bernanke first mentioned the possibility of
scaling back QE (see Exhibit 3). This happened even
though Bernanke took pains to emphasize that tapering
was not imminent and would only happen after we saw
evidence of a real and sustained economic recovery. Yet
investors still panicked. Interest rate implied volatility, as
measured by the Credit Suisse Interest Rate Volatility
(CIRVE) Index, almost tripled to 114.7% in the aftermath.
Equity implied vol-of-vol, as measured by VIX implied
vol, surged over 37 vol pts to 104% in the month after.
Volatility reaction to actual taper: In contrast, when the
Fed did finally taper in December, the VIX actually fell 2.4
pts while interest rate vols declined over 7 pts that day, as
markets largely shrugged off the event after having had
over six months to prepare for it.
Will Markets Believe the Feds Dovish Guidance?
Whether we see a repeat of the volatility spike we saw in
2013 will depend on how successfully the Fed can
convince markets that tapering is not tightening. In other
words, that reducing asset purchases does not mean an
imminent increase in the Fed Funds rate. To accomplish
this, the Fed will need to be more dovish in its forward
guidance. We saw signs of this strategy at the December
meeting when Bernanke coupled the taper announcement
with a change in the rate guidance, saying the Fed will
remain on hold even if the unemployment rate falls well
below its 6.5% target. Going forward, the Fed could
conceivably move the level down to 6.0% or below.
Exhibit 4: Fed Policymakers Projections for Fed Funds Rate
Dec14 Fed Fund futures contract, increased from 10%

before the announcement to over 19% afterwards. Bond
yields also continued to climb, with the 10-year rate rising
from 2.83% to over 3.0%.
Impact on Equity Volatility
Core Scenario: Our core scenario is that the Fed, with
Janet Yellen at the helm, will continue to be extremely
dovish in its forward guidance this year even as it winds
down QE. However, especially if economic growth picks
up, the market may doubt the Feds commitment to
persistent low rates and respond by taking interest rates
even higher. But we do not expect this to cause an abrupt
jump in implied volatility. Instead, we see small increases
of 1-3 vol pts for both VIX and VSTOXX over each
incremental better-than-expected economic report (see
text box on the next page for the labor market indicators
Janet Yellen will be watching) as investors gradually refine
their expectations for the timing of the first Fed Funds
rate hike.
Bearish Scenario: In our bearish scenario, we see the Fed
making a surprise announcement that it is considering
raising interest rates sooner than expected, either
because unemployment rate is falling rapidly or because
inflationary pressures are picking up. Even if the planned
rate hike wont happen for some time (actual taper didnt
start until six months after Bernankes first mention), the
market reaction will be immediate and severe. In a paper
Bernanke co-authored, he found that historically S&P sold
off over 2.4% the day of an unexpected rate hike (see
Exhibit 5). Implied volatility is also likely to jump
significantly in this case. We expect both the VIX and
VSTOXX to rise to the 20-25% range, similar to what we
saw in May with tapering.
Exhibit 5: Historical Market Performance on Rate Hike
Source: Bernanke & Kuttner 2004 ; European Central Bank, 2007
But will markets believe the Fed? Exhibit 4 suggests

maybe not. After the December FOMC meeting, interest
rate investors actually priced in a higher likelihood of an
early rate hike, despite the dovish guidance. The
probability of a rate hike in 2014, as implied by the
6
The Yellen Indicators

In a March 2013 speech, then Federal Reserve Vice
Chair Janet Yellen highlighted the five labor market
indicators she considered most informative. As she
takes over at the Fed, the announcement of these
statistics could become volatility catalysts, as the
market tries to guess when the Fed may start raising
interest rates.
Janet Yellens Favorite Labor Market Indicators:
1. Unemployment rate
2. Payroll employment
3. Hiring rate (JOLTS survey)
4. Quit rate (JOLTS survey)
5. Real GDP growth
2. Turmoil in the Emerging Markets

Since the start of QE in late 2008, Emerging Markets
have been the beneficiary of increased foreign capital
inflows, as negative real yields in the US have forced
investors to look elsewhere for returns. CS Global Equity
Strategy team estimates that Emerging Markets have
seen total net portfolio inflows of ~3% of GDP. Thus, its
not surprising that when the Fed began its taper talk in
May, EM countries took the biggest hit. EM equities and
currencies tumbled 10-25% in the months after (see
Exhibit 1).
Exhibit 1: Emerging Markets Sold Off Across the Board
Top Interest Rate Hedge

For equity investors looking to hedge the risk of
rising interest rates, we recommend buying call
spreads on TBT (Ultrashort US Treasury 20+ Year
Bond Index). Currently, implied volatility is trading at
a 1-year low while skew is inverted, making call
spreads particularly attractive. We recommend
buying the Jun14 85-95 call spread for $1.50 (spot
ref 77.72) for a max payout ratio of over 6.5x. See
trade details on pg 34.
***The risk of buying a call spread is limited to the premium
paid.
Asian Financial Crisis Redux?

The taper-induced EM sell-off last year certainly brought
back memories of the 1997 Asian Financial Crisis. Both
were fueled by hot money and large current account
deficits. Each unraveling caused big swings in stock and
currency prices. Yet there is one significant difference.
The 1997 Asian Financial crisis caused a more
pronounced reaction in global equity vol markets, with the
VIX doubling from 19 to over 38 in the span of just a
week. In contrast, at the peak of the EM sell-off in 2013,
the VIX increased by just 4 pts to 20%. Other global
volatility benchmarks also showed no panic, with the
VSTOXX and VNKY rising 5-6 vol pts to 25% and 46%,
respectively.
Exhibit 2: Volatility Contagion Between EM vs. US Equities
Why did US equity investors largely shrug off the

Emerging Markets turmoil last year? It was not because
the US became less sensitive to EM risk. In fact, volatility
contagion between EM and US markets reached similar
extremes both times: in 1997, spillover1 surged to a high
of 80% while last year it reached 77% (see Exhibit 2).
Instead, the difference lies in the magnitude of the
shocks. At its peak in 1997, Emerging Markets volatility
increased sevenfold to a high of 42% versus 28% in
2013 (Exhibit 3). The reason for the lower volatility last
year was that EM countries have become better equipped
to handle financial shocks due to their increased currency
reserves.
Why 2014 Could Be Worse

While the impact of the EM sell-off on US equity volatility
was relatively contained in 2013, we see potential for
higher contagion this year as US yields climb higher.
Three potential volatility catalysts are:
Deteriorating current accounts: Many Emerging Markets
countries are running significant current account deficits,
which increases their vulnerability to Fed tightening. In
particular, Turkey, India, and Indonesia are projected to
have larger deficits this year than they had even in the
run-up to the Asian Financial Crisis.
Exhibit 3: EM 1M Realized Volatility 1997 vs. 2013

Exhibit 5: EM Current Account Balances: Now vs. 1997
Since 1997, EM governments have deliberately built up

their foreign reserves, which allows them to cover shortterm external debt when financing conditions deteriorate.
As shown in Exhibit 4, FX reserves are now at least twice
as large as short-term debt in these countries; that ratio
stood at less than one for most of them prior to the Asian
Financial Crisis. Low coverage of short-term external debt
was a key trigger for the 1997 crisis.
Exhibit 4: Reserve Coverage of Short-Term External Debt
Increasing sensitivity to rising US yields: Worryingly, EM

currencies have become more sensitive to rising US rates
now than at the height of the crisis last May/June (see
chart below). With the Fed winding down QE this year,
and 10-year yields projected to climb higher (CS 2014
year-end forecast is 3.35%), EM currencies are likely to
depreciate even further.
Exhibit 6: Sensitivity of EM Currencies to US Rate Increases
Mounting political risks: 2014 is an important election year

in many EM countries. Political instability could exacerbate
the capital outflow from the region. Three key countries to
watch are:
Turkey: A corruption scandal has already created

question marks about the government. Two
contentious elections (local and parliamentary)
this year will further test Erdogan and his party.
Thailand: It looks increasingly likely there will be

judicial intervention to appoint a caretaker
government. This will likely lead to further street
protests, slower growth, and more capital
outflows.
Brazil: Loose fiscal policy is expected to help

President Rousseff win reelection. This could
trigger credit downgrades.
3. Chinas Shadow Banks: a Crisis in Waiting?

Opaque financial products that promise guaranteed high
returns. Lax lending standards. And an unprecedented
credit boom fueled by surging property prices. Is this the
US circa 2004 or China in 2014? More importantly, is
China about to have its own subprime meltdown and if it
does, will it send world markets into cardiac arrest?
Since the 2008 Global Financial Crisis, Chinas economic
engine has undergone an abrupt transformation from
export-led to credit-led growth. In the last decade, China
has seen a bigger credit expansion, relative to GDP, than
any other country in modern history. Total credit now
stands at 185% of GDP. However, as shown in Exhibit 1,
much of that has come from non-traditional lenders i.e.
the shadow banks.
Exhibit 1: Chinas Shadow Banking Boom
Top Emerging Markets Hedge

Emerging Markets equities were the most impacted
by Fed tapering last year, down over 17% from peak
to trough. We believe another meltdown is possible
this year as EM countries battle slower growth, higher
US yields, and mounting political risks. As a hedge,
we like buying the Dec14 36-30 put spread funded
by selling the 44-strike call for net zero premium (spot
ref 39.78). See trade details on pg 34.
*** The risk to buying a put spread is limited to the premium
paid. The risk to selling an uncovered call is unlimited.
Volatility spillover measures the degree of co-movement between

equity volatility and another asset classs volatility. For example, a
spillover number of 80% between the VIX and EM volatility in this
case means that whenever EM vol rises, 80% of the time the VIX
will also increase.
These unregulated lenders include trusts, wealth

management products, underground lenders, as well as
traditional banks off-balance-sheet lending arms (see
Exhibit 2). Credit Suisse China Economics team estimates
that shadow banking activity has surged in recent years to
a total size of RMB 22.8T, or 44% of GDP. It now
accounts for 25% of all outstanding credit and over half of
new credit issued in the past year.
Exhibit 2: Major Players in Chinas Shadow Banking System
However, like the US in the 2000s, Chinas shadow

banking sector suffers from poor transparency, high
leverage, and exposure to frothy property markets. We
see three key risks in the upcoming year that could turn
this boom into a bust and send global volatility surging.
Rising Inflation: Our China Economics team views this as
the greatest near-term danger as higher inflation could
force the PBoC to raise interest rates. They expect
headline inflation to pick-up meaningfully this year, and
project CPI to exceed 4.0% around the summer. If rate
hikes occur, fund inflows into shadow banks will slow as
investors would be able to get higher yields elsewhere.
This could push some of the more leveraged lenders into
bankruptcy, setting off sector-wide redemptions.
Falling Property Prices: Many of these shadow lenders

are highly levered to the property market, so any
meaningful decline in price could lead to mass
bankruptcies. The resulting credit crunch wouldnt just hit
developers, but local governments too. They rely on
shadow lenders to finance infrastructure projects, and on
land sales to fill their coffers. Any decline in property
prices would thus strangle revenues and liquidity. They
would likely need the central government to bail them out
of some their debt, currently at 33% of GDP (including
both direct and contingent liabilities).
Exhibit 5: Local Government Debt Has Surged Since 2008
Exhibit 3: Inflation is Forecast to Rise Meaningfully This Year

Preemptive Deleveraging: The central government has

been trying to rein in the explosive credit growth. It let
SHIBOR rates spike twice last year (the overnight rate
almost tripled in June), in order to teach the market a
lesson and weed out the most leveraged of the
unregulated lenders. But this concern about moral hazard
could be misplaced. Whenever governments try to teach
markets a lesson, it almost never ends well. Case in point,
Lehman Brothers. Its too easy for the government to
misjudge how severe a credit crunch can be and how
expensive it can be to fix. When it comes to China, the
PBoC could semi-deliberately create a crunch in the
shadow banking sector that quickly spills over into the
traditional one.
Exhibit 4: SHIBOR Rates Almost Tripled Last June
Impact on Equity Volatility

We believe that a 2008-style unraveling in Chinas
shadow banking system is, for the moment, unlikely. The
central government will almost certainly bail out the stateowned companies to prevent an all-out panic. Even if
there were a financial meltdown, contagion would likely be
limited because Chinas banking sector isnt that tightly
integrated into the global financial system.
Instead, we believe any turmoil in the shadow banking
system would reverberate as an economic, and not a
financial, crisis. In the worst case, where the central
government has to bail out state-owned banks and
companies, there would still probably be a lingering credit
crunch. Chinas investment-led growth would take a
significant hit and so would its trading partners,
especially ones that supply it with raw materials. These
ripple effects on global growth could sink markets and
send volatility surging. Indeed, a recent IMF study
estimates that China accounted for a quarter of global
growth in 2013.
As the USs second largest trading partner, a slowdown in
China could potentially pull the US back into a recession.
In fact, CS Global Equity Strategy team believes China to
10
be the biggest risk to US growth in 2014. Recessions

typically result in some of the largest increases in equity
volatility. Over the past 70 years, US recessions have
produced on average a 19 pt surge in S&P realized
volatility.
We believe a good historical parallel is the collapse of
Japans credit-fueled asset bubble in the early 90s. At the
time, Japan was also the USs second largest trading
partner. During the first phase of the correction, NKY 1M
realized volatility surged over seven times to a high of
47%, yet S&P volatility barely reacted. It wasnt until US
economic growth slowed in response and eventually
slipped into a recession that we saw a significant spike in
US equity volatility (+13 pts to 26%; see Exhibit 6). We
believe a shadow banking crisis in China this year could
cause a similar jump in the VIX, up 12-15 pts to a high of
30%.
Exhibit 6: NKY vs. SPX Volatility at Peak of Japans Crisis
70
60
NKY 1M Realized Vol

SPX 1M Realized Vol
Volatility
50
40
30
20
10
0
Jan-90
Mar-90
May-90
Jul-90
Sep-90
Nov-90
Jan-91
11
Structural Skew Outlook
Exhibit 1: Equity Index Skew Typically Downward Sloping
Evaluating Skew Opportunities in 2014

Within the equity derivatives markets, the richness or
cheapness of skew is often a major consideration in
determining how broad market directional views are
expressed. The strategy one implements to express a
bullish view in a low volatility environment with rich index
skew may completely differ from the strategy one uses to
express
a
comparable
view
with
cheap
index skew. Due to recent changes in the behavior of
equity index skew in response to market conditions in
2013, however, derivatives traders may need to reassess
how to quantify the richness or cheapness of skew going
forward.
Skew Convexity
But Has Recently Embedded More Upside Curvature
Of the three primary aspects of the volatility surface, skew

is the one that is most inconsistently defined. Even within
the same firm, the precise definition of skew may vary
from trader to trader and can refer to one of the following:
1) a volatility differential by moneyness (e.g.: 90%-110%
strikes); 2) a volatility ratio (e.g.: 90%/110%); or 3) a
volatility differential by delta (e.g.: 25 delta put 25 delta
call).
The common feature among these definitions is that they
all involve taking the difference of 2 points along the skew
surface.
Although in relatively stable volatility
environments (i.e., low to moderate vol-of-vol and a VIX
level close to its historical average of 20), relative
differences in the determination of richness or cheapness
of skew between the varying definitions is negligible, they
are all based upon a common assumption: that equity
index skew is downward sloping. 1
Recent developments regarding the likelihood of an
upside tail-event and the current low volatility regime
may challenge this assumption going forward. Specifically:
1) last years decisive market rally, a 3-standard
deviation event with the VIX averaging 14
2) lack of interest in selling calls given the low vol
levels and opportunity cost of missing a rally
As a result, skew has become increasingly convex (more
bowed), especially in recent months.
Recall that downward sloping equity index skew has held sway since the
Crash of 87 to compensate for the empiricism that 1) large 3+ standard
deviation market moves are usually associated with market declines rather
than increases 2) portfolio managers are willing to pay a premium for
downside protection 3) investors tend to harvest yield by selling calls.
Quantifying Skew Convexity

We believe the effects of skew convexity will be especially
acute in 2013. Recall that in our framework, skew
includes the probability of 2-standard deviation moves
(daily returns), whereas 3+ standard deviation moves
manifest themselves within the tails (kurtosis). We
hypothesize that if the market has built-in expectations for
shocks arising from the previously mentioned macro
catalysts, shocks that would normally precipitate a fattailed market move in excess of 3-standard deviations
and would now have a more muted impact upon the
market, resulting in smaller, 2-standard deviation moves
instead. We therefore expect volatility markets will
experience higher rates of change in skew convexity (high
vol of skew) than in years past.
In these situations, measures of skew that reply upon
simple put-call volatility difference calculations can differ
vastly from measures that take into account its curvature.
If this effect persists in 2014 we suggest supplementing
traditional measure of skew with a probability distilled from
the implied distribution which represents likelihood of
decline below a certain level.
12
Structural/ Transient Skew Decomposition

In order to discuss the time series of skew across
different (high vs. low) volatility regimes, we reference a
definition of skew that is relatively insensitive to spot
volatility and takes into account the curvature of skew.
Specifically, we define skew using a modified form of the
variance swap calculation in which skew refers to the
premium of weighted volatilities across a range of strikes
over at-the-money implied volatility.
In this framework, the time series of skew is subdivided
into two components: 1) a structural component
representing the volatility premium attributable to implied
volatility through investors desire to hedge or generate
yield under normal market conditions and 2) a transient
component of skew referring to the volatility attributable to
implied volatility via the desire to hedge in times of market
duress (see Exhibit 2).
Exhibit 3: Estimates of Volatility Contribution by Client Type

Structured
Retail, 10%
Pensions, 5%
Vol Funds,
30%
Insurance,
15%
Long Only/HF,
30%
Source: Credit Suisse Equity Derivatives Trading
Exhibit 2: Structural Skew ~ 1.0% in 2013
While admitting that the process of translating structural

demand to volatility requires a combination of art and
science, we attempt to do so by surveying each of our
major client groups in the following sections: hedge funds,
asset managers, insurance funds, structured retail, and
pension funds. We conclude by extrapolating implications
of emerging derivatives trends.
Our survey reveals that as volatility is likely to remain low
in 2014, institutions and fundamental long-short hedge
funds will likely rein in call-overwriting and other skewsuppressing yield-enhancement strategies. Furthermore,
we expect to see an increase in option use to express
directional views. These activities should reinforce the
effects of increased skew convexity discussed earlier,
resulting in increased skew beta sensitivity relative to
spot vol.
.
13
Institutional/ Fundamental Long-Shorts

General Outlook
Since the post-Crisis recovery in 2009, the primary
derivatives strategies employed by institutional and longshort equity PMs have been premised upon 1) a
structurally elevated correlation regime and 2) a
leptokurtotic drift (rising markets likely to be subdued but
falling markets likely to be abrupt). Thus, leading up to
2013, volatility savvy accounts generally focused on index
hedges or index level volatility/skew based yield
enhancement strategies that typically returned 200 to
300bps p.a.
To Heck with Hedging: Needless to say, after last years
decisive 30% market rally and the disappointing
performance of hedges in 2012, the vast majority of
institutional hedgers have now capitulated. Although a
number of catalysts (sequester, tapering, debt ceiling) did
in fact cause volatility spikes in 2013, they were too
muted and too short-lived for hedgers to effectively
monetize. Accordingly, hedging-related flow heading into
2014 was generally either unwinds or implemented with
the purpose of hedging the hedge.
Levered Delta: The more relevant dynamic for 2014,
however, has been investors response to the decline of
equity correlation. As shown in Exhibit 1 which maps
correlation against the CS Alpha Availability Index, as
correlation declines to post-Crisis lows, the return
differential between the highest and lowest decile
performers in the S&P widens increasing the rewards
for superior stock-picking. As such, the exceptionally
strong market conditions amidst a backdrop of declining
correlation last year shifted investors away from index
level volatility arbitrage strategies towards the use of
options (mostly calls) primarily as levered delta
(directional) single stocks bets. 2
2014 Derivatives Trading Implications
Given our forecast for modestly higher equity markets and
low correlation, we anticipate 1) a re-emphasis on volatility
premium capture as a 200-300bps return is more
meaningful when market performance is modest and 2) a
focus on single stocks. This is likely to culminate in
increase in 1) sector level dirty dispersion (selling sector
straddles to buy calls on single stocks) and 2) skew based
overlay strategies to establish long delta positions (e.g.
selling puts to enter into long positions when put skew
steepens and buying calls to replace stock positions when
call skew flattens).
Additionally, as investors become more confident in their

global equity investments, we would expect to see a
return in interest for European underlyings, in particular
long delta/long vol trades such as outperformance options
or simply outright long vanilla call options which have
become increasingly popular in the last months of 2013.
At current low implied volatilities, such structures offer
cheap participation in European outperformance in 2014.
Exhibit 1: Alpha Availability Increases as Correlation Declines
Source: Credit Suisse Equity Derivatives
Exhibit 2: Options Turnover Declines as Delta Bets Increase
Source: Credit Suisse Equity Derivatives Strategy, Bloomberg
Exhibit 3: Opportunities for Skew Based Stock Replacement
The shift away from gamma towards delta has triggered a decline in option
volume as delta based strategies incur lower turnover. Exhibit 2
2
14
Investment Bank Trading Desks

General Outlook
Exhibit 1: iTraxx 5Y Spread Widens at Quarter-End
Basel III Credit and Equity Hedging Requirements3

New capital rules for global broker dealer banks under
Basel III have systematically increased the aggregate
market demand for credit risk protection and tail risk
protection for equity indices, particularly in the most liquid
indices such as the S&P500. In calculating risk weighted
assets (RWA) under Basel III, market-risk stress VaR and
the new credit valuation adjustment (CVA) require
significantly higher capital from banks. To partially off-set
some of the increased capital requirements for market
and counterparty credit risks in market-making portfolios,
banks have been incentivized to purchase and carry
greater levels of credit risk and tail risk protection.
Credit: Given the reduced liquidity in credit markets
following the London Whale incident and responses to
Dodd-Frank, we can most easily see the impact that
Basel III requirements have had on European ITraxx IG
and US CDX IG - two credit indices widely used to
mitigate credit risk exposure at broker-dealer banks.
Credit risk capital is measured via quarter-end snapshots.
Note in Exhibits 1-2 that these two credit indices have
tended to spike at quarter-ends vs. other trading days.
Equities: Market risk capital is measured using a 60-day
rolling average; thus the incremental demand for market
risk hedges is more evenly distributed across the quarter.
Moreover, as a percentage of total capital usage within
banks, equity exposures are far smaller than
corresponding credit exposures. As a result, we do not
observe corresponding monthly or quarterly lumpiness
attributed to Basel III in either S&P or VIX options.
Exhibit 2: ... as do CDX Spreads
Exhibit 3: but not VIX

Although many banks are relatively far along in adapting
to Basel III capital requirements, others are still at the
beginning of this transition. Thus, its possible that credit
indices experience even more outsized hedging demand
at quarter-end this year as more banks adopt the new
capital requirements. This could force some banks to
consider using equity index put options to hedge their
credit exposures. This dynamic suggests the possibility of
intermittent liquidity-induced increases in volatility near
quarter end for equity indices such S&P.
Dan Rodriguez, CRO Systematic Market Making Group
15
Volatility Hedge Funds

General Outlook
In a year in which the VIX repeatedly flirted with Great
Moderation lows, volatility hedge funds had a dichotomy
of outcomes. The key factor was vol of vol. Although the
median volatility in 2013 was near 2004-2006 lows, vol
of vol realized at middling (near 50th percentile) levels. For
volatility carry funds that systematically sell volatility risk
premium (i.e. capturing the difference between implied
and realized volatility), a moderate vol-of-vol environment
is actually beneficial as it allows them to opportunistically
reset their short vol positions at higher levels. Exhibit 2
shows the performance of a rolling short vol strategy over
the course of last year. It maps the VIX against
subsequent 1-month realized volatility. As you can see,
with the exception of 2 weeks in March (sequester) and
again in May (taper), a systematically short vol strategy
would have performed very well.
In contrast, volatility long-short funds typically thrive in a
higher vol-of-vol environment where arbitrage and spread
opportunities are more plentiful. This explains the
dichotomy in performance between the two groups last
year. While volatility carry funds had their second best
year since 2007 (Hedge Fund Research HFRX data),
long-short vol strategies recorded a 2.5% loss for the
year.
relative value VIX futures and options trades are likely to

be one of the few obvious ways for volatility hedge funds
to source alpha within equities. More advanced strategies
in the space, particularly those related to the vol of vol
surface skew and term structure arbitrage have remained
mostly unexplored due to lack of appropriate instruments.
Exhibit 1: Volatility Hedge Fund Performance vs. VIX Level
Exhibit 2: PnL of a Systematic Short Vol Strategy Last Year

Correlation: Earnings period may provide vol funds
opportunities to conduct sector correlation trades.
However at the broad index level, vol funds generally
consider the selling of correlation levels below 60 to be
statistically unattractive, we expect correlation to be an
opportunistic rather than systematic trade for vol funds in
2014.
Exhibit 3: VIX Vol Surface a Potential Source of 2014 Alpha
120
Vol of Vol: The rise in liquidity of exchange-listed volatility

products such as VIX options, futures & ETFs boosted the
growth of a variety of strategies. In addition to tactically
using products to express directional views and
occasionally hedge, funds have been exploring dynamic
approaches to systematic volatility investing and potential
arbitrage opportunities arising from broad-based volatility
demand/supply. With low levels of volatility across asset
strategies, higher moment directional (vol of vol) and
100
Volatility
Relative Value: With increased illiquidity in long-dated

volatility, term structure opportunities will likely be driven
by term structure inversion. If our view of higher skew
sensitivity bears out, vol funds will likely focus on
exploiting dislocations in skew & skew term structure.
80
60
40
20
150
120
1Y
100
6M
80
Strike (% of Spot)
50
1M2M
3M
Maturity
16
Insurance Companies
General Outlook
Exhibit 1: Insurers Continue to Temper VA Sales
Against a backdrop of stringent solvency requirements

and a diminished supply of long-dated vega, the insurance
industry witnessed a significant retrenchment in variable
annuity (VA) activity. Two major carriers Hartford and
Sun Life completely withdrew from the variable annuity
arena last year, while ING and John Hancock both greatly
reduced the size of their VA books.
Even insurers who nonetheless remain committed to the
VA business continue to de-emphasize variable annuities
in their product mix and have gravitated towards equity
index annuities and other products with a more benign risk
profile. Thus, although VA sales have only trended down
by an average of 4% per annum over the last two years
as shown in Exhibit 1, the potential vega footprint of VAs
have decreased (the current product mix embodies less
convexity risk as insurers continue to charge more for
products with comparatively less optionality). Compared
to the variable annuities sold pre-Crisis, current equity
variables annuities 1) are sold at a higher premium to
compensate for the excess costs of hedging required and
2) embed additional risk control features to obviate the
need for long-dated protection.
From a volatility
perspective, the upshot of this two-pronged approach
coupled with the outright sale of some legacy VA blocks is
that insurers have been able to steadily reduce their
potential vega footprint.
Source: LIMRA
Exhibit 2: Variable Annuities Sold Post-Crisis are Deep OTM4
Source: LIMRA, Bloomberg, CS Equity Drivatives Strategy
Because of the abovementioned product redesigns, the

bulk of the need for long-dated vega in 2014 arises not
from new sales but from the need to hedge legacy GMxB
structures. The extent of this demand in turn hinges upon
the moneyness of legacy guarantees.
Exhibit 3: Declining Demand: S&P Long Dated Skew At 5Yr Lows
+2 Std: 1.7%
With the market at record highs, however, the vast

majority of the implicit index put options underwritten by
insurers are currently deep out-of-the-money. As shown
in Exhibit 2, which gives an estimation of the moneyness
of the implicit index puts embedded into the guarantees,
most GMxB written over the last five years currently range
from 10% to 50% out-of-the-money.
Volatility (%)
1.7%
1.6%
Avg: 1.5%
1.5%
1.4%
Moreover, as interest rates rise, the present value of VA

liabilities will be further reduced. As a result, barring a
steep market sell-off of 30 to 50%, insurers will likely
remain net buyers of short-dated (0 to 2 year) volatility but
will be relatively elastic with respect to long-dated (7 to 10
year) vega.
-2 Std: 1.4%
31-Mar-13
.SPX Skew
Avg(.SPX Skew)
30-Jun-13
30-Sep-13
30-Dec-13
2*Std(.SPX Skew)
Source: Credit Suisse Locus
To quantify the moneyness of recent guarantees, we used the median level of the S&P for each
quarter weighted by that quarters new sales percentage contribution to produce the current average
moneyness of post-Crisis guarantees by vintage.
4
17
European Insurance Solvency Requirements
Exhibit 4: Current Capital vs SCR (per country)
In Europe, insurance companies news flow continues

to center around the application of the Solvency II
directive. Omnibus II (the update of the 2009 Solvency
II European Directive) was agreed on by European
policy-makers on November 13, confirming that
Solvency II will be implemented starting January 2016.
While the final text has not yet been made public,
Credit Suisse EMEA Structuring believes that life
insurers will be granted a 16-year transition period,
during which the Solvency Capital Requirement (SCR)
will be set as a pro rata temporis mix between Solvency
I and Solvency II SCRs. Although Scandinavian insurers
are ready for Solvency II and could opt for immediate
implementation if this is rendered possible by their
regulators, German insurers who have more long-term
rate guarantees in their liabilities are likely to choose
the slow path instead. Some technical adjustments
could also be defined in order to reduce the impact of
interest rate volatility, which will prove positive again for
German insurers.
Source: LIMRA, Bloomberg, CS Equity Drivatives Strategy
Overall, a more stringent SCR is likely to keep equity

allocations close to their current record low levels of 5
to 10% of assets across Europe (with anecdotal
evidence that allocations in Italy or Germany could be
as low as 3%). Additionally, the new regulatory
framework is expected to put a larger emphasis on
diversification and dynamic hedging strategies,
generally reducing the overall long-term vega footprint
of the Insurance sector in Europe.
Over the last couple of years, hedging activities by
European insurers have only been fractions of their precrisis levels, and as such, are only a marginal driver of
volatility. We do not expect the volatility footprint of
European insurers to increase in 2014, mainly because
as discussed above, allocations to Equity
continues to be at historical lows with little
scope for increase (with the exception of Great
Britain and Scandinavian countries)
an even lower portion of this Equity exposure is
actually systematically hedged, and
more capital has been allocated to alternative
strategies, which are typically net short equity
volatility.
18
Pension Funds
General Outlook
Exhibit 1: Pension Funding Deficit Below $100M
Back in Blackalmost. Following the Credit Crisis, US

corporates defined benefits (DB) pension plans spent
years quagmired in an industry-wide funding shortfall in
excess of $350 billion. Over the last year however,
funding levels were buoyed by two elements:
1) Stock market: the 32% S&P rally increased the
38% of plan assets linked to equities
2) Interest rates: the 84 bps increase in high-grade
corporate bond yields from 3.96% to 4.8%,
coupled with legislative reform via the Moving
Ahead for Progress in the 21st Century Act
reduced the present value of liabilities.
Source: Millliman
Exhibit 2: Corporate Pensions are Currently 93% Funded
As a result, a recent Towers Watson study finds that the

funding status of Fortune 1000 DB plans has in
aggregate risen $285 billion, increasing funding levels
from 77% in 2012 to 93% at 2013 year end. Based
upon earlier precedents, as the funding levels improve, we
are likely to see corporate plans begin to de-risk by either
1) shifting their exposures away from equities into bonds
or 2) initiate buybacks via lump sum offers and annuity
purchases for formerly vested participants.
Similarly, the increase in rates and strong equity
performance has improved pension funding levels in
Europe and notably in the UK, which traditionally has a
strong proportion of assets invested in equities (45%).
The aggregate UK funding gap based on IS19
calculations has fallen to circa 100bn despite adverse
implied inflation moves (most UK benefits are inflationlinked). Because European pension funds tend to be
more geographically diversified than US, most of the
performance in 2013 was linked to overseas equity
investments, with a clear overweight in US equities.
Source: Towers Waston
Exhibit 3: Pension Deficit Forecasted to be Erased By 2014 YE
Source: Millliman
Exhibit 4: Allocation Away from Equities Capped Returns
Although pension plans pulled back on hedging during last

years equity market rally, with the market currently at
record highs, we expect the abovementioned de-risking
as a catalyst for a pick-up in pension hedging activity in
2014. Although pensions have traditionally been open to
hedging via a range of strategies, an increasing sensitivity
to premium expenditure will probably induce pensions to
focus on short-duration, zero-premium strategies such
put-spread collars. However, given that 1) only about 1%
of pension plans actually hedge and 2) the typical putspread collar strategies utilized by pensions usually have
low vega, we expect minimal vega impact at the market
level on behalf of US/Euro pensions in 2014.
Source: Towers Watson, Milliman
19
General Outlook
The bulk of global structured product issuance continues
to be defined by the search for yield. However, the
issuance of income-bearing structures have been
complicated by 1) the low level of interest rates, which
reduces the amount of premium available to be spent in
capital guaranteed products and limits the coupon
available in income-generating notes and 2) low levels of
volatility which reduces the premium generated by selling
the embedded equity option. (A 3-year down-and-in
equity index put option with a 30% downside barrier
currently generates a coupon of only ~5% p.a., vs former
levels of 7 to 9%5). In response, issuers have been
incorporating a number of innovations to improve the
optics including 1) increased use of barriers and other
contingent structures and 2) shifting maturities further up
the term structure.
Going into 2014, however, as equity markets extend the
global rally, we anticipate 1) a shift away from income
bearing (short optionality) notes towards uncapped
participation (long optionality) structures such as buffered
leveraged notes and 2) increased callbacks on
autocallables, many of which were issued during the
range bound markets of 2010-2012.
notes thus depresses skew across all major global

benchmarks.
Long Divs: structured trading desks are typically short
long-term forwards which are hedged by going long
shorter term instruments such as futures or synthetics.
While this trade is on average expected to generate
positive carry, it also makes trading desks long implied
dividends and short repo. The latter created significant
losses in 2013 due to added friction costs (in particular
the financial transaction tax in Europe), unfavorable
funding conditions, and dividend taxation.
Exhibit 1: Low 3-8 Year Implied Volatility Reduces Note Benefits
+2 Std: 20.2%
20.0%
Volatility (%)
Structured Products
Avg: 19.1%
19.0%
-2 Std: 17.9%
18.0%
17.0%
31-Mar-13
30-Jun-13
30-Sep-13
30-Dec-13
SPX 3Y 100Pct Imp Vol

Avg(SPX 3Y 100Pct Imp Vol)
2*Std(SPX 3Y 100Pct Imp Vol)
SPX 3Y Hist Vol
Source: Credit Suisse Locus
Exhibit 2: 4Y SPX RTY Cert Plus (Short Correlation)

Given the subdued outlook for rates in 2014, we expect
the bulk of the impact of notes upon the volatility markets
to stem from the inventory of income notes. In general
the risk profile tends to make structured trading desks
long volatility, short skew, short repo, long implied
dividends and short correlation.
Volatility: as shown in Exhibit 3, issuers are short volatility
as the underlying underperforms, as long as it stays
reasonably far from the down-and-in barrier, driving
(rolling) at-the-money volatility down6. In strong equity
markets, issuers become long volatility and are exposed to
implied-realized volatility decay.
Source: Credit Suisse Equity Derivatives Structured Products Group
Exhibit 3: Vega Profile of a 1Y DOI SX5E Put (Barrier 2,000)
Skew: Income notes push down implied volatilities for

strikes lower than spot, and push up implied volatilities for
strikes higher than spot. The large footprint of income
Underlyings: Eurostoxx 50, FTSE, S&P-500, Nikkei. Maturity: 2 to 3

years in Private Banking where trading is more dynamic, 5 to 8 years for
mass retail. Autocall feature knocking out the trade if an upside barrier is
breached the barrier is typically set at 100% with annual observations
Coupon: reverse converts (5%), worst-of puts (8+%)
Source: Credit Suisse Equity Derivatives Structured Products Group
beyond a certain point however, trading desks would find themselves too
short vega, and therefore become large buyers of volatility
6
20
Systematic Investment Strategies

General Outlook
The use of systematic indices continued to grow rapidly in
2013, as investors sought to package various strategies
into index format, and achieve the transparency, liquidity
and lower costs associated with these products. The
evolution of index products took an accelerated turn post
financial crisis, when investors went beyond better stock
picking methods (also referred to as smart beta or
intelligent indices) to embed actual systematic strategies
within indices. Today, these tools have found applications
across a wide swath of users from pension funds, to asset
managers, and even retail investors.
Prevailing Themes
Based on recent flows and inquiries, we expect that the 3
areas of focus in 2014 will be:
risk premia capture
tail-hedging, and
cross-asset portfolio investment strategies.
Risk Premia
The concept of capturing risk premia today includes the
realm of structured derivatives. Once the domain of hedge
fund traders, sophisticated derivative ideas can now be
found embedded into indices which have distilled those
strategies into its essential elements, via systematic rulesbased trades. Examples of these systematic strategies
for capturing risk premia include:
volatility risk premium,
dividend yield curve, and
mean-reversion
Volatility Risk Premium: attempts to capture the volatility
risk premium of the equity markets. Derivatives traders
have long held the belief that the implied volatility used in
equity option pricing typically often trades at a premium to
its realized volatility. This is typically explained by the
natural and persistent imbalance of investors seeking to
buy protection, and the general overpricing of future
expected risk. 7
Dividend Yield Curve Arbitrage: takes advantage of the
structural imbalances in the dividend yield curves of global
indices.
Mean Reversion: captures mean reversion properties of
the market.
7
In 2009, Credit Suisse launched its Global Carry Selector Index

(Bloomberg Ticker: GCSCS), which utilizes equity index variance swaps to
capture this view, and given its strong performance, AUM in this product
increased five-fold in 2011-2012. Despite more turbulent performance in
2013, the index still experienced net inflows as investors maintained their
confidence in the strategy.
Tail Hedging
Long the bane of every nervous portfolio manager, tail
hedging has also been addressed by the growing realm of
systematic investment strategies. Amongst the greatest
challenges of installing a systematic tail hedging program
is paying for decay when purchasing options that is to
say, option premium is expensive, options often expire
worthlessly, and the net cost impairs performance to the
point where not hedging is often the path chosen.
Investment banks, exchanges, and asset managers have
all assumed the challenge and over the past few years,
tail risk indices have proliferated with various profiles and
characteristics. As the US market rose over 30% in
2013, predictably, these indices exhibited negative
performance some severe.8
Cross-Asset Portfolio Investments
As investors sensed the end of the Feds QE program,
conversations about rotating out of bonds and into
equities and other asset classes became more prevalent
throughout 2013. Moreover, there has been a growing
desire by institutions and private investors alike, to find
systematic and disciplined approaches to managing crossasset portfolios, by using either index swaps or ETFs as
components of a balanced investment strategy.
In many of these indices, the size of each constituent
exposure is determined using the core disciplines of
modern portfolio theory, and this dynamic portfolio also
has an overall volatility target to control the cost of the
options linked to it.
Packaging these portfolio strategies into a single index
product enables the investor to have a systematic, yet
active, approach to its assets, and reap the benefits of
the convenience of what is traditionally considered a
passive instrument (i.e. an index). The appeal to
investors of cross-asset portfolio indices remains
unabated, and we anticipate further growth of AUM in
such products this year.9
In order to combat the drag of decay, Credit Suisse launched its Advanced
Defensive Volatility Index (Bloomberg Ticker: CSEAADVL) in 2012 which
takes positions along the VIX futures curve where the futures roll carry is
minimized, and based on proprietary signals, the investor rapidly becomes
long volatility in times of market distress. Since its inception, this risk
hedging index remains our most talked about, and most traded index
product.
9
Credit Suisse launched its TEMPO (Tactical Efficient Markowitz Portfolio

Optimizer) index (Bloomberg Ticker: CSEATMPE) in 2013, to address the
growing desire of investors to not only achieve a dynamic cross-asset
portfolio, but also obtain exposure to the VIX an asset that provides a
built-in tail hedge in times of market stress.
21
Summary: VIX Forecast For 2014

Given our underlying positive economic outlook, our 2014
VIX forecast reflects what we see as a continuing trend
towards a low volatility regime. Our core scenario uses the
framework detailed on page 2 of this report, which
decomposes implied volatility into 3 components: baseline
volatility (see pg 3), kurtosis premium (pg 4-11), and
skew premium (pg 12-17). We then analyze the possible
range the VIX could trade in over the next year by
overlaying potential shock scenarios.
Our steady-state scenario evaluates the case where no
major macro catalysts occur and the current economic
recovery continues unimpeded. In three other scenarios,
we estimate the increase to kurtosis and skew if one of
our top 3 macro catalysts rising US yields, EM
contagion, and China shadow banking meltdown were
to happen.
Our findings are summarized below. In our steadystate scenario, we estimate the VIX will trade at an
average of 15 over the next year, representing a
marginal increase from the 2013 average. However, if
any of the negative macro shocks we outlined were to
occur, we estimate the VIX could trade in the 20-30
range.
Exhibit 1: Steady-State VIX Forecast of 15%
22
2014 Equity Sector Volatility Outlook

As we enter the 6th year of a bull market, its hard to
believe that the current streak has lasted almost as long
as the run in the mid 2000s. Since its March 2009 low,
the S&P has returned over 170% and is 17% above its
pre-financial crisis high. Yet, not everyone is in on the
party. Only 5 out of 10 sectors have regained the grounds
once lost, with Financial, Utilities, and Telecom still a ways
away. But with correlation having (finally!) broken down in
2013, the environment is geared for sector/stock
selection and fundamentally driven alpha generation.
Catching the shift from defensives into cyclicals last year,
for example, would have added 15% alpha vs. the S&P.
In this section we identify the key performance drivers for
the S&P and the major sectors that will help frame the
fundamental outlook and our resulting sector volatility
views.
Economic Outlook: CS expects the global economy to
be the most orderly in many years. A stable balance of
modest growth, low inflation, and accommodative policies
will help global GDP growth accelerate to 3.7% in 2014
after rising 2.9% in 2013. In the US, growth should
increase at a steady pace of 3%, driven by improvements
in housing and consumer spending. The key uncertainty is
the timing and magnitude of Fed taper. CS base case is
for a reduction of $10b per meeting but in reality the path
will be bumpier. Much stronger economic growth could,
ironically, be the catalyst that pushes the VIX higher as it
brings forward the Feds tightening timeline.
Earnings Growth: CS expects S&P earnings to grow
7% in 2014 to $116. Growth will be strongest for the
Energy, Consumer Discretionary, and Industrial sectors;
while Consumer Staples and Financials are expected to
lag (although still positive). We have a year-end S&P
index target of 1960 which would put the market at 17x
earnings a level we believe is reasonable given low
interest rates, strong corporate balance sheets, and
accelerating economic momentum. With margins already
at record levels, companies will need to demonstrate
topline growth in order to meet consensus expectations.
Interest Rates: CS expects 10-year Treasury yields to
increase to 3.35% by year-end. Rising interest rates was
a key reason for sector differentiation last year. Up until
May when Bernanke first hinted at tapering, the defensive
sectors such as Utilities, Staples, and Healthcare were
leading the market with YTD gains of 15% or more (see
Exhibit 1). Following the taper talk, relative performances
reversed with cyclical sectors drastically outperforming
defensives. In fact, most of the defensive sectors
recorded negative returns for the rest of the year (see
Exhibit 2).
Exhibit 1: 2013 Performance Up to May 1st
With rising interest rates and an accelerating economy,

we expect sector divergences to continue. We see the
Financial sector as one of the key beneficiaries of the
positive macro environment, especially banks (high net
interest margins) and life insurance companies (better
portfolio returns). We also expect the Industrial sector
the best performing group in 2H13 to continue to do
well as it has one of the highest correlations to US
Treasury yields. In contrast, industries with high financial
leverage and low operating leverage will underperform
(rising costs and minimal sensitivity to economy). These
groups include Utilities, Telecom, Tobacco, Beverages,
and Food.
Exhibit 2: 2013 Performance After May 1st
In general, we expect cyclical sector volatility to drift

lower, while the outlook for the defensives is more
challenged. We detail our key sector volatility views in the
next few pages.
23
Key Sector Volatility Views
Financials: We expect Financials volatility to move

lower given improving fundamentals and lower
earnings variability. It has the potential to approach its
2004-2006 lows this year.
Energy: We see an opportunity to pair a short Energy

sector vol position against a long crude oil vol hedge.
The outlook for energy companies is constructive,
despite the fact that we see downside risks to oil
prices in 2H 2014.
Utilities: With rising interest rates and competition

from renewable power sources, the utility sector could
experience more volatility than its traditional low beta
status would imply.
Technology: Disruptive technology along with the

impact of Amazons expansion in the cloud storage
business should keep a bid to tech sector volatility in
2014. We also see increase M&A as a vol catalyst.
2014: The Year of the Buyout?

Since the beginning of December 2013, there have
been 9 billion-dollar deals where the acquirers stock
price jumped higher by more than 5% on the day of
the announced (e.g. Fiat, Avago, Sysco, Textron,
Forest Labs, etc). The average increase is a
staggering 17%. This could be the much needed
positive reinforcement from investors to corporate
management for increased M&A after a long period of
muted transactions.
Exhibit 3: 2014 Sector Volatility Outlooks
Weight in
S&P
19%
16%
13%
13%
11%
10%
10%
3%
3%
2%
1Y Impl
Volatlity
16.1
17.3
15.0
16.5
17.4
18.4
13.1
14.6
17.4
14.3
Lower volatility
Higher volatility
Sector
Technology
Financials
Healthcare
Consumer Discretionary
Industrials
Energy
Consumer Staples
Utilities
Basic Materials
Telecom Services
Volatility
Outlook
While IPOs had a banner year in 2013, M&A deals are

still running more than 50% below normal levels.
Leading indicators of M&A including higher equity
markets and increasing CEO business confidence are
decidedly positive. Recent surveys indicate CEO
willingness to increase M&A in 2014. Further, FCF
yield remains significantly above corporate bond yields,
suggesting M&A should be cash EPS accretive. We
expect the recent performance of M&A stocks to help
drive an acceleration in corporate activity.
CS has a Delta One basket comprised of top analyst

picks for potential M&A targets: CSUSUSMA Index.
This index outperformed the broader market by 10
points in 2H13.
24
Energy: Shale We Dance?

The energy sector enters 2014 with an improving
fundamental outlook, albeit with downside oil price risk
emerging in the second half of 2014. 1-year implied
volatility for the energy sector, currently at 19%, is the
highest of all major sectors. We expect the sectors
volatility to compress in 1H due to improving company
fundamentals, with some upside risk from potential higher
oil supply in the second half.
Exhibit 1: Sector Scoreboard
Energy Sector
2013 Implied
Vol
21.4
2013 Realized
Vol
14.8
2014 Implied
Vol
19.1
Oil Outlook: 2014 is all about the potential return of oil

supply from constrained/offline international sources,
particularly Libya and Iran. Potential supply increases
wont occur until 2H14 which means CS expects Brent
oil prices to remain around $110 per barrel until then. If
Libyan political risks subside, export production could
double from current levels by the end of the year. In Iran,
negotiations on sanctions are expected to be completed
by the end of Q214, and exports could rise by 0.5Mb/d
by year end. Taken together, CS sees about $10/barrel
of oil price risk in 2H if all goes well with returning supply.
Depending on the path, historically falling oil prices
translates into a 2-4 point increase in realized volatility for
the energy sector.
Exhibit 2: CS Brent Oil Forecast
Despite a relatively muted outlook for underlying energy

commodities, the fundamental outlook for energy stocks
is more positive.
Integrated Oil: CS upgraded its view on the major
integrated oil companies to market weight for 2014. After
making only half of the S&Ps gains in the past five years
(trailing by 60%), CS believes the integrated oil stocks are
due for a period of outperformance and expects the key
drivers to be the following:
Cash Flow: After spending $250b per year (!) on
capex since 2011, the integrateds are approaching
the sweet spot for cash flow growth in 2015-2017.
This should pave the way for an increase in
dividends and buybacks.
Restructuring: Should the market not recognize the
progress the integrateds have made, we could see
additional breakups (e.g. between upstream and
downstream) to unlock shareholder value.
Exploration & Production: The US onshore boom from
shale continues and CS remains bullish on the outlook for
domestic E&P. They key drivers of performance for 2014
will be:
Valuation Disconnect: There is a disconnect
between the strong growth outlook for US E&P
companies and their inexpensive valuation. Trading
at 5.8x cash flow, the E&P group has the same
multiple as the major oil companies despite higher
growth and return prospects. CS believes E&P
multiples should grow to 8-14x this year depending
on the underlying assets, providing significant upside
for the group.
Efficiency: Improvements in shale technology mean
that costs keep coming down and IRR rates keep
rising. IRR rates for several regions are now through
50% with few projects generating less than 15%
returns. Improvement in efficiency, especially for oil
sensitive assets, could spur additional upside for the
group.
Source: Credit Suisse Equity Research
Natural Gas Outlook: US natural gas prices will remain

challenged as growth in supply continues at a staggering
pace from shale assets. For example, in just 4 years the
Marcellus region in the North East has grown to be the
most productive US shale asset, delivering ~13 billion
Bcf/day (from virtually zero). Gas demand wont rescue
the oversupply situation, as power and industrial
consumption remain sluggish. CS expects natural gas
prices to remain around $4/MMbtu for most of 2014.
There is however some upside to prices longer term as
new export LNG terminals come online.
Exhibit 3: E&P Trade Inline with Majors, Despite Higher Growth
25
Utility Sector vs. 10-Year Yield
220
3.50
210
3.00
200
2.50
190
2.00
180
Dec-13
Oct-13
Nov-13
Sep-13
Aug-13
Jul-13
Jun-13
1.00
May-13
160
Apr-13
1.50
Feb-13
170
Mar-13
***The risk to selling a variance swap is unlimited. The risk to

buying a variance swap is that variance could go to zero.
Interest Rates: Utilities have one of the strongest

inverse relationships to US treasury yields. CS
expects rates to rise in 2014, which will provide a
headwind for the group, especially regulated
utilities. With high financial leverage and a
structurally challenged operating model, utilities
are faced with rising costs with minimal changes in
revenue.
Jan-13
Implied volatility for the energy sector stands at 19%.

With improving company fundamentals (especially for
the integrateds) we expect the sector to realize vol
levels similar to 2013 (15%). Further, with risk to oil
prices later in the year, we would recommend a long
position in crude oil vol as a pair to our short energy vol
trade. The 1Y implied vol spread between the two is
near a 5-year high (energy vol rich, crude vol cheap)
providing both a fundamental and vol opportunity. For
details, please see pg 35.
Long viewed as a low beta sector, Utilities were in fact

the 5th most volatile sector in 2013. The increased
volatility came as a result of cylical headwinds from
higher interest rates, and structural challenges from the
long awaited cost competitiveness for renewable
energy. We expect the following factors could again
make 2014 a bumpy year for this group:
Dec-12
Trade Recommendation
Utilities Renewed Trouble?
Utility Index
Oil Field Services: The transformation from a traditional

services industry to a technology based group continues
for the OFS companies. CS expects the stocks of the
largest and most diversified companies to outperform in
2014 as increased technical capabilities lead to better
return on investment. We anticipate the shift to
technology-rich products will be recognized, pushing
stocks higher given that the group trades near historically
low P/B and P/E valuation multiples.
Renewable
Energy:
The
long
awaited
competitiveness from renewable energy is finally
upon us. While still small vs. traditional power
generation, improvements in technology have
made solar and wind energy cost competitive.
Generally, only natural gas generation is cheaper
now than wind and solar. As a result, CS
estimates that renewable energy could meet
~85% of future utility demand growth. This is
likely to hurt the earnings outlook for the
competitive power generators.
Exhibit: Solar and Wind Are Cost Competitive
Source: CS Equity Research
26
Financials: Yielding to Regulation

The impact of regulatory reform is now evident for the
financial sector. Increased capital, along with tighter risk
controls, are reducing the variability of corporate results
and creating a system better able to withstand downside
shocks. As we forecasted last year, the financial sector
broke a streak of 6 consecutive years as the most volatile
major S&P group. We expect this trend to continue, and
argue that volatility could approach something closer to
the 2004-2006 lows when the sectors vol realized an
average of 12%.
Financial Sector
2013 Implied
Vol
19.9
2013 Realized
Vol
14.6
2014 Implied
Vol
17.7
US Banks. CS remains constructive on the outlook for

banks, although the bullishness is tempered versus last
year following a 38% rally for the group. We view the
following factors as drivers of 2014 bank performance:
Capital: Five years post credit-crisis, banks have met
Basel I standards and are making progress towards
meeting stricter Basel III capital requirements. The
Fed stress test in March should again provide
additional clarity for the banks and allow them to
continue returning capital to shareholders.
Revenue: Our tempered bullishness stems from a
muted revenue outlook, as banks are facing
headwinds from slowing mortgage refinancing, and
sluggish loan growth.
2014. Recent performance of M&A deals should

fuel investor enthusiasm.
Regulations: Key headwinds from enacted
regulations (Dodd-Frank, Volcker), as well as
litigation risks (mortgages), are largely in the rear
view mirror. This should allow investors to refocus on
improving trading and banking results and reduce
the regulatory risk premium. The Fed stress test in
March is a central driver for the brokers as it could
pave the way for a significant increase in return of
capital (dividends or buybacks) for shareholders.
Valuations are supportive with the brokers trading at 1.2x
tangible book value.
US Insurance. Following a 47% return in 2013, CS
believes we are in the late innings of the re-rating trade.
However we still believe the sector is moderately attractive
given cheapish valuation and favorable macro conditions.
We see the following as the key drivers for the sector:
Rising Yield Play: The insurance sector is positively
levered to rising bond yields as it increases the
return on the investment portfolio and reduces the
present value of liabilities.
Non-Bank SIFI Rules: In mid-to-late 2014, clarity on
the new capital rules for non-bank SIFI companies
will begin to emerge. We expect the rules will favor
the P&C group over the Life companies given they
have lower leverage and less VA exposure.
Exhibit 3: Strong Correlation Between Insurance and Yields
Expense control will again a focus, and should help drive

10% EPS growth in 2014. Valuations remain supportive,
with the group trading at 10.8x 2014 estimated earnings
and 1.4x tangible book value. The key upside surprise
could come from faster than expected economic growth,
as bank results are highly levered to loan growth and
higher net-interest margins.
Exhibit 2: Large Cap Banks- Fundamentals Continue to Improve
Capital (B1 Tier Comm)

Capital (B3 Tier Comm)
Profitability (ROE)
Credit Quality (NCO)
Valuation (P/E)
2012
10.6%
8.7%
10.9%
1.2%
14.4 x
2013E
11.0%
9.6%
9.7%
0.7%
11.9 x
2014E
11.8%
10.5%
10.8%
0.6%
10.8 x
Source: Credit Suisse estimates. Peer group includes BAC, C, JPM, PNC, USB, WFC.
Brokers/Capital Markets Outlook: The outlook for the

brokers this year is bullish for the following reasons:
Banking activity: Banking transactions have
increased and CS forecasts 10% growth in M&A
deals next year. IPO volumes last year were the
second best post crisis and should stay strong in
Source: Credit Suisse Equity Research, Thompson Reuters
Trade Idea Recommendation

We recommend a long delta and short vol position for
the Financial sector. 1Y implied vol is currently at 18%,
and we expect the sector to realize below 15% this
year, with a chance of falling below 13%. Note that
due to new regulations, there are few natural sellers of
Financial sector vol, providing an edge for those who
are able to execute the trade.
27
Technology: Its a Jungle Out There

The Technology sector, along with Consumer Staples,
was the lowest volatility sector in 2013. However, we do
not expect a repeat of this in 2014. A muted IT spending
outlook, disruptive technologies, and potential accelerating
M&A are poised to keep a bid to technology sector
volatility.
Tech Sector
2013 Implied
Vol
2013 Realized
Vol
19.0
12.0
2014 Implied
Vol
16.5
IT Hardware. The outlook for IT

disruptive players (e.g. Amazon)
technology challenge incumbent
cost of providing service. We see
catalysts for the IT sector in 2014:
spending is muted as
as well as changing
business models and
the following as major
Amazon.com: Amazon is quietly becoming very

disruptive in the cloud market. Its entry into the
storage business, originally led by price, has evolved
into a sophisticated full service provider with great
value. Amazon has cut service prices 37 times since
entering the IT business in 2006 and can cut
storage cost for a customer by as much as 70%.
Further, it recently beat out IBM for a contract with
the CIA despite charging higher prices,
demonstrating its degree of knowledge and
sophistication in delivering cloud solutions. Revenue
for this division is growing at 50%+ per year and as
the scale increases, it becomes deflationary for
traditional big cap IT vendors.
Exhibit 2: Cloud Storage Growing at 30% CAGR
networking costs by 60-70% and also allow

improved security and control of a companys data.
While this is a longer term disruption, early adopters
already include Google, Facebook, and Goldman
Sachs.
Software:
CS
maintains
its
overweight
recommendation for the Software sector in 2014 given
positive long term revenue expectations and attractive
valuation. Our top things to watch this year in software
include:
SDN #2: Hardwares loss is the software sectors
gain as both traditional virtualization companies and
new entrants provide applications to more costeffectively manage networks. Software-defined data
centers represent a generational paradigm shift in IT
architecture.
Handsets: Smartphone growth is healthy but materially
decelerating in 2014. We see the following factors
affecting the outlook for global handset stocks:
White Label: Long term revenue growth is set to fall
to 4% as the high-end is essentially saturated and
growth now relies on low-end/white labels. Unit
growth in 2014 is expected to be 22%, still healthy
but below last years increase of 43%.
Penetration: With prices under pressure, the key to
growth is increased smartphone penetration.
Globally we finished at 35% last year and expect
this to rise to 80% over the next few years due to
falling handset prices.
For handsets, the long term structural thesis remains, but
materially decelerating growth and a duopoly in high end
phones create a more challenging outlook.
Trade Recommendation
Source: Credit Suisse Equity Research
With Amazon acting as disruptive player, and new

technology threatening the incumbent hardware
players, we have an upside bias to volatility for the Tech
sector in 2014. 1Y implied vol for Tech is trading at
16.5%. We believe this is both a good outright buy and
a good hedge against our core view that vol will be low
in 2014. A key risk against this view is that correlation
is very low for Technology, and has a dampening effect
on volatility.
SDN: Software Defined Networking is a relatively

new technology that allows for better optimization of
network traffic (which carries internet traffic, mobile
data, etc). SDN allows users to decouple the
software (which directs traffic) from the router
(which pushes it to users). This process can reduce
28
European Sector Outlook

The Return of Earnings Growth
With Europe finally emerging from its recession, Credit
Suisse expects the region to perform well in 2014. Our
Global Equity Strategy team forecasts a 2014 return of
16% for the SX5E (year-end target of 3,600). We see
three main drivers of this rally:
Growth: CS economists forecast GDP growth of 1.3% in
2014, mainly on the back of reduced fiscal tightening. For
the first time since the beginning of the Euro-crisis, lead
indicators (e.g. manufacturing PMI new orders) are having
a sustained recovery. Moreover, house prices are
beginning to stabilize in markets where previously they
had been falling (for example, in Dublin and the
Netherlands) and bank lending conditions have eased
considerably over the past year, especially for mortgages.
CS also sees scope for a rebound in consumer
discretionary spending.
Monetary Policy: As a result of deflation concerns
(Credit Suisse economists forecast an average inflation
of 1.1% in 2014 vs. ECB target of about 2%), the ECB
could ease further, including conducting another round of
LTRO, cutting the deposit rate, and reducing repo
requirements.
Earnings: CS forecasts Euro-area earnings to grow by
11.1% in 2014, driven primarily by margin expansion.
European margins are currently only half of USs levels.
Earnings should also benefit from an expected weakening
in the Euro against the dollar (Credit Suisse FX Strategy
has a year-end forecast of 1.24). Specifically, we
estimate that a 10% fall in the Euro would increase
earnings by 10%.
Overall, the 2014 European equity outlook favors cyclicals
and financials, while mining, oil and utilities are still
expected to underperform the rest of the market.
Key European Sector Views

As shown in the Exhibit 1, European sector options have
relatively low liquidity compared to their US equivalents.
Only two sectors have a total listed open interest notional
exceeding EUR1bn: SX7E (Eurozone Banks) and SXPP
(Europe Basic Resources). There is, however, much
deeper liquidity in the OTC market. Generally, five years
after the financial crisis, volatility has fallen back to precrisis levels across European sectors. Volatility term
structure is steep across the board, except in the case of
Oil & Gas, while skew remains slightly elevated (Exhibit
2).
Exhibit 1: Sector Liquidity Profile
Code
Name
Last
SX7E
SXPP
SX6E
SX7P
SXEP
SXEE
SXAP
SXKP
ESTX Bnk Pr
STXE 600 BsRs Pr
ESTX Util Pr
STXE 600 Bnk Pr
STXE 600 Oil&G Pr
ESTX Oil&G Pr
STXE 600 Au&Pt Pr
STXE 600 Tel Pr
147.6
390.4
248.7
200.3
337.1
323.4
480.7
299.9
Call OI
Put OI
Notional Notional
(EURmio (EURmio)
3,365
1,080
164
104
126
98
12
31
Total
(EURmio)
4,343
445
92
113
32
30
107
84
7,708
1,525
256
216
158
129
119
115
Source: CS Derivatives Strategy.
Exhibit 2: Sector Volatility Profile

Code
Name
3M Imp
Vol
SX7E ESTX Bnk

SXPP STXE 600
SX6E ESTX Util
SX7P STXE 600 Bnk
SXEP STXE 600 Oil&Gas
SXEE ESTX Oil&Gas
SXAP STXE 600 Au&Pt
SXKP STXE 600 Tel
Source: CS Derivatives Strategy.
23.4%
22.4%
17.4%
18.2%
13.8%
15.7%
20.2%
14.2%
Pct'l
3M 90110 Skew
Pct'l
1Y-3M
TermStru
Pct'l
6%
17%
17%
5%
14%
13%
11%
0%
4.5%
3.3%
4.9%
3.6%
5.2%
4.1%
5.3%
2.8%
30%
4%
63%
9%
82%
13%
86%
22%
1%
2%
1%
1%
1%
1%
1%
2%
64%
80%
45%
51%
18%
33%
51%
99%
European Banks (overweight): According to CS Research,

European banks are expected to outperform in 2014, in
particular French banks. This is primarily due to a sizeable
lag in performance vs. European indices, and also
because the ECB could surprise in 2014 with measures
expected to boost banks profitability, such as a UK-style
funding-for-landing scheme or a further easing of
collateral requirements for SME loans. Over the last 2
years, Banks implied volatility has consistently been a
good short, with negative P&L occurring only 16% of the
time. At 22.2%, SX7E 3-month implied volatility is high
versus other European sectors, and only 3% of all realized
observations for the last 3 years fall under this level.
Basic Resources (underweight): Miners, a key
underweight according to CS Research, represent over
70% of the SXPP index. Miners suffer from a large
exposure to Chinese tail risk, stretched valuations, and
low capital discipline. Falling commodity prices or a
stronger dollar could magnify the above issues. At 22.3%,
3-month implied volatility is cheap relative to history (17th
percentile versus last years observations, see Exhibit 2),
and more than 20 points lower than 2008 pre-Lehman
levels).
Utilities (benchmark): with the exception of UK power
generation, European utilities suffer from high financial
leverage at a time when interest rates are expected to
rise, falling power prices in a context of over-capacity and
high political and regulatory risk after a decade of rising
electricity prices. This defensive sector ranks high in
implied skew (50% percentile over the last year), although
reasonably cheap in implied volatilities.
29
Correlation Outlook
With the dissipating influence of macro catalysts, the shift
to a lower volatility regime last year has brought about a
corresponding shift to a lower correlation regime in both
the US and Europe. Aside from two occasions, the taperinduced sell-off in June and the debt ceiling crisis in
September, 3M Top-50 S&P and Eurostoxx-50 realized
correlations remained below 15-year average levels of 38
and 49 respectively.
Exhibit 1: S&P Rolling 3M Realized Correlation (Top 50)
Anchored by not just low levels of realized correlation, but

also volatility of correlation, implied correlation has now
also begun to fall back to its pre-crisis levels. Although on
an implied-realized basis, it still appears rich. As shown on
Exhibit 2, the spread between 1-year implied and realized
correlation has now reached a decade high of ~25
correlation points, making S&P correlation an apparent
sell into 2014.
Risks in Shorting Correlation in 2014
However, short correlation trades implemented via
dispersion could be complicated by the following two
factors:
1) Due to the tendency for correlation to mean
revert, the assessment of the expected
profitability in selling correlation via a dispersion
trade is formed not merely upon observations of
the spread between implied and expected
realized levels but also the absolute levels of
implied correlation, volatility, and skew. As
shown in Exhibit 3, the PnL of a systematically
short 1Y dispersion strategy depends on the
absolute level of implied correlation. The optimal
window appears to be when implied correlation
levels are in excess of 60. In contrast, selling
correlation at current levels of ~50% typically
yields flat or negligible PnL.
50%
45%
40%
35%
30%
25%
3M Realised
1997-2013 Average
2013 Average
Sep-13
Nov-13
Jan-14
Correlation and Alpha Opportunities: Low realized

correlation helped US long-short investors thrive in 2013,
since that increases dispersion among single stock
returns and allows better stock picking performance. It
also benefitted vol arbitrage hedge funds that still had
legacy short correlation or were able to go short S&P
correlation at over 60% at the beginning of the year,
potentially landing a profit of 2.5 vega in a vega-flat
dispersion trade.
Exhibit 3: PnL of S&P 1Y Dispersion Trade (100k Vega)

800
700
600
500
PnL
20%
Jan-13
Mar-13
May-13
Jul-13
400
300
200
100
Exhibit 2: S&P 1Y Implied-Realized Correlation Spread
0
-100
50%
-200
40%
0.2<<0.4
0.4<<0.6
0.6<<0.8
0.8<
30%
20%
10%
0%
-10%
-20%
-30%
1997
1999
2001
2003
2005
2007
2009
2011
2013
2) Typically, transaction costs for trading the index

and single stock legs in dispersion trades (around
0.5 vega for the index and 1 vega for the single
stocks) mean that the effective level at which
correlation is shorted is much lower than mid
estimates. In times of low volatility and (still)
elevated correlation such as now, this impact is
magnified. We calculate that transaction costs
30
knock out up to 15 correlation points in a

dispersion trade, implying an effective correlation
level of slightly under 40. Only in 2011/2012
were transaction costs higher, but that was also
during a time when correlation itself was also up
to 20 points higher.
Correlation-Induced Market Beta Inversion
Typically the level of correlation follows as a response to
overall index level trends and volatility. For example, when
the market falls and volatility rises, correlations tend to
increase. With the market now at record highs, equity
investors will be seeking to validate current levels. With
the dissipation of most major macro overhangs and
correlation remaining at low levels, the source of that
validation will come from company earnings. Individual
company earnings releases from industry leaders will likely
become mini-volatility catalysts. As a result, we are likely
to experience a market beta inversion in which rather than
stocks moving in response to the S&P, the S&P (and by
extension S&P vol) will move in response to individual
stocks.
With fundamental drivers in focus, the market will
extrapolate new information onto applicable market,
industry, and company views. The magnitude of the
response will depend on several intersecting factors.
Exhibit 4: Strength of Information Read-Through
Correlation Forecast for 2014

Our implied correlation forecast is constructed using our
index implied volatility forecast (VIX at 15, see pg 21) and
our sector level implied volatility forecasts (see pg 23). In
contrast, our realized correlation forecast is based upon
the Monte-Carlo scenario analysis described on page 3.
Based on these two techniques, our 1Y median implied
and realized correlation forecast for the S&P-500 is 38%
and 33%, respectively.
As a result, dispersion trading activity in 2014 is thus
likely to be either 1) opportunistic: selling dispersion on
market events such as the ones discussed in the Volatility
Catalysts section on page 4, or 2) selective: going short
index versus going long a cherry-picked basket of single
stock volatilities.
First, the information can be characterized as having a

broad market impact, an industry specific importance, or a
company specific read-through. The more powerful the
micro data point, the higher the volatility risk for the
broader market. For example if a company such as Alcoa
reports better than expected results, the broader market
could rally on the potential for an accelerating economic
backdrop.
Second, the source of the read-through can come from a
company peer or from a vertical supply chain partner.
News from a peer can be a powerful read through for
certain industries such as Financials, Energy, and
Materials, where sectors tend to trade as a group. Recall
recently when Lennar reported better results, the entire
homebuilding sector rallied by 3%.
Supply chain analysis can also catalyze stock specific
stories, especially in sectors such as Technology, where
correlation is low. The intersecting factors can be
summarized in the following response matrix.
31
Dividend Outlook
The dividend swap and futures markets provide investors
with a quantifiable measure of dividend expectations for
the S&P, SX5E, FTSE and Nikkei. It also allows investors
to monetize their views regarding the certainty of a future
dividend cash flow stream: sell the dividend swap (future)
to lock-in the desired dividend stream for the S&P for a
desired time horizon. Buy the dividend swap if the current
implied dividend appears too low as a result of muted
expectations of futures earnings growth and payout ratios.
Imbalances can also stem from structural supply and
demand for dividends (for a more complete guide on
dividend trading, please refer to The Dividend Risk
Premium).
The Ever-Depressed SX5E Dividend

Although in 2013, dividends paid by the S&P, FTSE or
Nikkei grew by at least 7% versus their 2012 levels,
SX5E dividends remain materially below 2009 levels.
Dividends paid by the S&P have seen a cumulative growth
of 25% since 2008, while FTSE and Nikkei dividends
have grown by 33% and 28%, respectively since 2010.
By contrast, SX5E dividends have fallen by 31%
Historically, the SX5E has been the underlying

index for an active structured product market.
Because most of the products offered to
institutional or retail clients (continuous flow from
retail to sell downside risk through knock-in puts,
large trades from US investors going short longterm vanilla puts) incorporate a long equity
exposure, European banks have developed a
systematic short SX5E forward axe. This axe was
historically hedged through liquid, shorter-term
instruments like SX5E futures, which left banks
trading desks with a structural long SX5E
dividend axe. The size of this SX5E dividend
overhang is manifesting itself through a
depressed SX5E dividend term structure, adding
alpha to systematic long dividend positions. With
earnings expected to grow 11% in Eurozone, we
expect upside in the dividend curve.
Exhibit 2: Realized and Implied Dividends (2007-2020)
Exhibit 1: Global 2012 and 2013 Realized Dividends

* Cumulative growth since 2010
Looking at dividend expectations priced-in by dividend

futures or swaps, this unique SX5E situation will likely
continue, with SX5E dividends expected to fall by another
5% by 2020 (compare to S&P and Nikkei dividends
which are priced to rebound by 55% and 45%,
respectively). We see the following reasons for the SX5E
divergence:
The Eurozone has passed through a period of

deep economic crisis, heavily impacting company
earnings and capacity to pay dividends.
The SX5E index has been significantly
remodelled over the period, with high dividend
paying sectors such as banks losing weight and
being replaced with lower dividend paying sectors
such as capital goods.

* Cum growth since 2010
Japanese Inflation and the Nikkei Dividend

Boom
Dividends are often referred to as an inflation hedge, and
the recent dynamics of Nikkei dividend futures market
perfectly exemplifies this point.
Up until recently, markets were pricing in falling dividends
for Japan as a result of the deflationary challenges facing
the country. See Exhibit X.
That all changed in December 2012 when the BoJ
surprised the market with an aggressive expansionary
monetary policy, with the stated aim of sparking inflation
in Japan. Since then, the Nikkei dividend term structure
has drastically changed. Dividend futures are now pricing
32
in a 35% growth in dividends over the next 4 years versus

a 10% decline previously.
Exhibit 3: Implied Dividend Term Structure
Earnings: According to CS Global Strategy, S&P

earnings are expected to grow 7% in 2014 to $116, after
growing 11% in 2013. Growth will be strongest for the
Energy, Consumer Discretionary, and Industrial sectors;
while Consumer Staples and Financials are expected to
lag (although still positive). Growth is also expected to be
strong in the Eurozone: company earnings should grow by
11%, helped by 1) an improvement in profit margins; 2) a
weaker Euro against the dollar (a 10% decrease in the
Euro could increase earnings by 10%); and 3) continued
policy accommodation from the ECB.
Dividends: The outlook for 2014 global dividends is as
follows:
2014 Dividends: Stable Payouts & Higher

Earnings
With stable payouts and growing company earnings,

dividends are expected to post positive performance in
2014.
Payouts: the payout ratio corresponds to the proportion
of company earnings that are paid out to shareholders.
Companies are more likely to hold dividends steady as
earnings fall, and are slow to increase dividends when
profits initially rise, creating convexity in dividend
payments versus earnings (Exhibit 4). Under our current
view of stable macroeconomic conditions, we expect
payout ratios (around 30% on the S&P and 60% on the
SX5E) to remain stable in 2014. As a result, the growth
in dividends should reflect the growth in underlying
earnings.
Exhibit 4: Payout Ratio vs. Earnings Growth
S&P: the current implied growth rate from 2013

(+12%) is roughly in line with the earnings
growth for 2013. Assuming a 30% payout ratio,
2014 dividend should be about $39, in line with
the current dividend swap.
SX5E: 2014 dividends are expected to reach
113.3 (based on a bottom up aggregation of
analyst forecasts) or 112 on a more conservative
estimate versus current dividend future of 109
(up to 4% upside). With a stable payout ratio and
an 11% growth in earnings for 2014, we
estimate 2015 dividends of EUR 121.5. This is
in-line with analysts forecasts of 122, and
suggests 11% upside to 2015 dividends versus
current futures prices.
SX5E Long-Term Dividends: Credit Suisse
Derivatives Strategy sees up to 40% upside in
Eurozone earnings over the next three years,
suggesting up to 40% growth between 2013 and
2017 dividends. This is in contrast to the current
depressed SX5E dividend term structure, which
prices SX5E dividends to fall 2% over the same
period, and would put SX5E in-line with other
global benchmarks such as S&P or Nikkei
(potential trade: SX5E 2015/2017 dividend
steepeners).
Exhibit: S&P and SX5E 2015 Dividend Scenarios

33
Trade Recommendations for 2014
34
Top Macro Hedges

Rising Rates: Buy TBT Upside
Zero Premium Emerging Markets Hedge
Interest Rate Hedge: Buy TBT Jun14 85-95 call spread to hedge against rising rate risk
Interest rate risk was the biggest cross-asset driver of equity volatility last year. Just mere talk of taper caused 10-year yields
to almost double and the VIX to surge over 8 pts to a 1-year high of 21%. As the Fed winds down QE in 2014 (and
potentially begins to prepare for rate hikes), we recommend equity investors hedge rising rate risk with TBT call spreads. TBT
(2x short Treasury 20+ Year Bond Index) has a 94% correlation with 10-year Treasury yields and very good option liquidity
(650k total open interest). 6M implied volatility has fallen to a 1-year low (Exhibit 1) while skew is inverted (Exhibit 2), making
call spreads particularly attractive. We recommend buying the Jun14 85-95 call spread for $1.50 (spot ref 77.72). Upside
participation starts +9.4% from current spot while the trade has a max payout ratio of over 6.5x.
*** Risks: The risk to buying a call spread is limited to the premium paid. ***
Exhibit 1. TBT 6M Implied Vol at 1-Year Low
Exhibit 2: TBT 6M Skew is Inverted as Calls are Bid
36
26
TBT 6M Implied Vol
TBT Skew
34
25
Implied Vol (%)
Implied Vol (%)
32
30
28
26
24
23
TBT skew is inverted
24
22
Jan-13
22
Mar-13
May-13
Jul-13
Sep-13
Nov-13
Jan-14
90%
95%
97.5%
100%
102.5%
105%
110%
Strike (%Moneyness)
Emerging Markets Hedge: Buy EEM Dec14 36-30 put spread funded by the 44-strike call
Emerging market equities were the most impacted by Fed tapering last year, down over 17% from peak to trough. We
believe another meltdown is possible this year as EM countries battle slower growth, higher US yields, and mounting political
risks (see details pg 7-8). We recommend buying the EEM Dec14 36-30 put spread funded by selling the 44-strike call for
net zero premium (spot ref 39.78). Protection starts from down 9.5% until down 24.6% while the trade has a 10.6% buffer
on the upside.
*** Risks: The risk to buying a put spread is limited to the premium paid. The risk to selling an uncovered call is unlimited ***
Exhibit 3. EM Equities Most Impacted by Tapering
Exhibit 4: Stock + Option Trade Payoff Diagram
105
100
95
90
85
80
SPX
EEM
EWZ
FXI
75
5/7
5/14
5/21
5/28
6/4
6/11
6/18
35
Top Thematic Ideas

Sell Energy Volatility; Buy Crude Oil Volatility
Sell Risk Reversals on Potential M&A Candidates
ENERGY SECTOR: Sell XLE 1Y variance swap and buy USO (oil) 1Y variance swap
Implied volatility for the energy sector currently stands at 19% and is the highest of any major S&P sector. Last year the
sector realized a volatility of 14%, and we are positive on the outlook for energy stocks this year. However, one key risk is the
timing of the return of oil supply from Libya and Iran, which could pressure Brent oil prices by $10 per barrel. As a result, we
recommend a long position in crude oil as a hedge. Currently, the vol spread is heavily in our favor for this trade, with XLE vol
trading near a 5-year high vs. crude oil vol.
*** Risks: The risks to selling a variance swap is unlimited. The risk to buying variance is that variance could go to zero***
Exhibit 1. XLE Implied Volatility is Highest

Sector
1Y Implied Vol
Energy
19.1
Financials
17.7
Materials
17.7
Indutrials
17.6
Discretionary
16.8
Technology
16.5
S&P 500
15.3
Telecom
15.1
Healthcare
14.9
Utilities
14.9
Staples
13.3
Exhibit 2: XLE 1Y Implied Vol is Rich vs. USO Implied
M&A IDEAS: Since the beginning of December13, there have been 8 billion dollar deals announced where the acquirers
stock jumped higher by more than 5% on the day and by a staggering average of 17% (e.g. Fiat, Avago, Sysco, Textron,
Forest Labs). We beleive this could be the needed positive reinforcement from investors to corporate management for
increased M&A after a long period muted transactions. Below we highlight 13 stocks that CS fundamental analysts view as
takeout candidates. We recommend using risk reversals to play the M&A theme, as a way to neutralize the vega exposure,
while capturing the upside on an uncapped basis. Below we show the the number of 110% calls that can be bought by
selling one 95% put. We also have delta one basket, CSUSUSMA available, which has outperformed by 10% since Q413.
*** Risks: The risks to selling a put unlimited. The risk to buying a call is limited to the premium paid. ***
Exhibit 3. CS Delta One M&A Basket vs SPX Performance
Exhibit 4: M&A Risk Reversal Ideas
36
Yield Play: Short Index Straddles

Sell Dec14 Straddles on Global Indices
Opportunity: Capture volatility premium while positioning for equity outperformance in 2014
Global equity markets are expected to continue to outperform in 2014 for the following reasons:
o Valuation: Equities are the cheapest asset class with a US equity risk premium of 6.4% on consensus earning
vs 5.2% on Global Equity Strategy earning forecast. Equities will become expensive relative to bonds only if
yields rise above 3.5%.
o Excess liquidity: Monetary easing remains supportive for equities. Developed market central banks balance
sheets are set to grow by 19% by the end of 2014 according to CS economists estimates, including a 3040% increase for JGB holdings in Q1. The ECB could also ease further, including introducing a negative
deposit rate (-0.1%) and further LTROs.
o Funds flow: Long-term positioning still look supportive for equities. Inflows into equity funds are close to an 8month high ($80bn over the past 6 months) while bond funds are experiencing outflows ($150bn).
Steep Term Structure: Across global indices, steep term structure provides opportunity for selling longer-term volatility.
The 1Y-3M implied vol spreads are in their 66th, 66th and 73th percentile over past 5 years for SPX, SX5E and FTSE,
respectively (Exhibit 2).
Attractive Yields and Break-Evens: The straddles generate yields ranging from 13% on SPX to 21% on SX5E with
attractive break-evens. The trades are expected to generate positive PnL as long as the indices do not fall by more
than 5-6% and do not appreciate by more than 19%, 25%, and 37% for SPX, FTSE, and SX5E, respectively. For
reference, our Global Strategy team expects gains this year of of 7%, 10%, and 16% for SPX, FTSE, and SX5E,
respectively.
Exhibit 1: 2014 Year-End Price Targets

Index
Spot CS Target Price
S&P 500
1837
1960
EURO STOXX 50 3111
3600
FTSE 100
6722
7400
Exhibit 2: Steep Term Structure (1Y-3M Spreads)
% Spot
106.7%
115.7%
110.1%
Source: Credit Suisse Global Equity Strategy
2,5%
Volatility (%)
0,0%
-2,5%
-5,0%
-7,5%
30-dc.-08
SX5E
30-dc.-09
SPX
30-dc.-10
31-dc.-11
30-dc.-12
FTSE
Derivatives Strategy Idea
Trade: Sell Dec14 SPX 1960 Straddle, SX5E 3600 Straddle, FTSE 7400 straddle
We suggest selling Dec14 straddles centered on Credit Suisses price targets for the three indices. The premium generated
ranges from 13% on the SPX to 21% on the SX5E (Exhibit 3). The trades are expected to yield positive P&L as long as the
indices do not decrease by more than 5-6% and do not appreciate by more than 19%, 25% and 37% for SPX, FTSE and
SX5E respectively.
*** Risks: The risk to selling a straddle is unlimited.***
Exhibit 3: Short Straddles Summary

Index
Spot
Strike
S&P 500
1837
1960
EURO STOXX 50 3111
3600
FTSE 100
6722
7400
Strike %
106.7%
115.7%
110.1%
Premium
231
642
1001
Premium %
12.6%
20.6%
14.9%
Implied Vol
13.0%
15.7%
12.2%
Breakeven % Spot
93.9.% / 119,5%
94.1% / 137.4%
94.9% / 125.3%
Delta
43.1%
71.2%
66.4%
37
Top Macro Idea: Europe vs. US Outperformance

Buy Dec14 SX5E/SPX Outperformance Call Options
Opportunity: Get leveraged exposure to SX5E via outperformance call options
Credit Suisse Global Equity Strategy team believes that the SX5E will outperform the SPX in 2014 (forecast return of
16% for SX5E vs. only 7% for SPX) and overweights Continental Europe relative to the US:
o Monetary policy: While the US has started tapering its bond purchases, monetary policy is likely to surprise on
the dovish side in Europe. Because of deflation concerns, the ECB could ease further, including introducing a
negative deposit rate (-0.1%) and further LTROs.
o Rising bond yields have historically been associated with US equities underperforming global markets.
o Stronger dollar: The US Dollar is expected to strengthen against the Euro which will likely be a drag on US
earnings and favour Continental Europe export companies.
o SX5E has lagged SPX significantly: While SPX has rebounded over 165% in the past 5 years and made
new all-time highs, SX5E has only gained 72% from its 2009 lows and is still trailing more than 30% from its
pre-crisis levels. (Exhibit 1).
Attractive pricing: Low implied volatilities and high implied correlation provide attractive pricings for the outperformance
options. As shown in Exhibit 2, implied vols for both indices have fallen back to their 2007 lows, while implied
correlation is still elevated at 85%.
Outperformance overlay for long SPX: SX5E/SPX outperformance options can be a compelling overlay to an existing
long SPX position, making the investor long the best of both the SPX and SX5E at year-end.
Exhibit 1: Normalized Price (From 02/01/2006)
40,0%
Volatility (%)
Price
125
Exhibit 2: 1Y Implied Volatilities Have Fallen Significantly
100
30,0%
75
20,0%
04-Dec-06
SX5E
03-Dec-08
03-Dec-10
30-dc.-04
02-Dec-12
SX5E
S&P
01-juil.-07
30-dc.-09
30-juin-12
S&P
Trade: Buy Dec14 USD quanto SX5E vs. SPX outperformance conditional on SPX above 1800 at expiry for 1.89%
The payoff of the outperformance call at maturity is:
Out
C1
SX 5E1 SPX 1 if SPX trades above the 1800 barrier at expiry, 0 otherwise.
Notional Amount x max
,0
SX 5E0 SPX 0
The trade is long 46% delta on the SX5E, short 45% delta on the SPX for the vanilla outperformance, while the conditionality
reduces the long SX5E delta to 27% or 21% depending on the barrier level, and the SPX delta to under -16%.
*** Risks: The risk to buying an outperformance option is limited to the premium paid.***
Exhibit 3: Indicative prices for conditional outperformance

Option
Premium Delta SX5E Delta SPX
Vanilla Outperformance 3.85%
45.58%
-45.22%
Conditional SPX > 1800 1.89%
26.69%
-16.47%
Conditional SPX > 1900 1.48%
20.80%
-10.29%
Vega SX5E
0.21%
0.29%
0.26%
Vega SPX
0.06%
-0.17%
-0.15%
38
Dividend Trade: Long Euro Dividends with Catalyst

Go Long SX5E Dividends Futures in Q1
Opportunity: Up to 3.5% upside left in 2014 dividends
As discussed in our report The Dividend Risk Premium, SX5E dividend futures are priced conservatively versus dividend
expectations, pricing-in a relatively large risk premium which erodes away as uncertainties around dividend policies are
lifted through dividend-related newsflow (earnings, announcements, payments).
The announcement calendar for SX5E dividends is highly concentrated with close to 50% of dividends being
announced between January and February (Exhibit 1). By the end of February, a significant portion of the dividend
futures risk premium will have therefore dissipated.
January is the best month to be long the Credit Suisse Dividend Alpha Index, up 3.4% on average since 2010 and with
continued performance in February (up 1.5% on average).
4% upside in 2014 dividends: Although the 2014 dividend future rallied 9.5% from July and mid September last year,
it has been stuck in a narrow range since then, trading between 108 and 109.5 ips. An aggregation of MarkIT dividend
forecasts shows a 113.3 ips estimate for SX5E 2014 dividends, leaving 3.5% upside versus current offer of 109.5
or 2.2% upside versus a more conservative estimate of 112 (Exhibit 2). A significant portion of the upside is expected
to be captured following the dividends annoucements in Jan and February.
13% upside in 2015 dividends: alternatively, investors looking for potentially more upside could go long 2015
dividends, currently priced conservatively at 109.8. Based on MarkIt estimate for 2014 and applying a 10% growth rate
(consistent with Credit Suisse Equity Strategys forecast of 11% growth in Eurozone earnings in 2014, assuming a
constant payout ratio), 2015 dividends could realise as high as 124ips, for up to 13% upside versus current bid.
Exhibit 1: SX5E Div Announcements & Ex-div Calendar

(2012)
Announced
Dec-12
Oct-12
Nov-12
Sep-12
Jul-12
Ex-div
Aug-12
Jun-12
Apr-12
May-12
Mar-12
Jan-12
Feb-12
Dec-11
Oct-11
Nov-11
Sep-11
Jul-11
Aug-11
Jul-11
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Exhibit 2: DEDZ4 Div Futures vs Conservative 2014

Estimate
114
112
110
108
106
104
102
100
98
96
94
92
Jan
Feb
Mar
Apr
May
Jun
Jul
SX5E 2014 Dividend Futures
Aug
Sep
Oct
Nov
Dec
2014 Dividend Estimate
Trade: Long SX5E Dec14 Dividend futures (DEDZ4) in Q1

We recommend going long SX5E Dec14 dividend futures in Q1 as we believe the majority of the upside left will be captured in
the early months of 2014. SX5E dividend is currenlty offered at $109.5 and we see 4 points of upside over the next two
months.
One risk factor to consider is Spanish banks dividend cuts: in last November, the IMF recommended that the Bank of Spain
should maintain the 25% cash dividend cap implemented in 2013. However, we believe that 1) a final decision on this is
unlikely to occur before the middle of the year, and 2) at current prices, 2014 dividends futures already assume that Spanish
banks could cut as much as 40% of their dividends in 2014.
*** Risks: The risk to going long futures is significant.***
39
Top Cross-Asset Idea: Long SX5E/Euro Hybrid Call

Go Long Dec14 SX5E Call Conditional on Weaker Euro
Opportunity: Capitalize on weakening Euro to get leveraged exposure to SX5E
Credit Suisse Global Equity Strategy expects the SX5E to perform strongly in 2014 with a target price of 3600, an
increase of 16% from current levels.
Weaker Euro: The combined effect of the Fed tapering and a dovish ECB should result in a weakening of the Euro
against the US dollar - our FX Strategy team forecasts 1.24/$ by 2014 year-end. A weaker Euro will further help
European companies to outperform, as every 10% decline in the Euro is expected to increase earnings by 10%.
Negative SX5E/Euro correlation: As shown in Exhibit 1, the typical (pre-2007) correlation between SX5E and the Euro
is negative (a strong Euro implying a weaker SX5E and vice versa). While the Global Financial Crisis and the ensuing
European Sovereign Debt crisis (2008-2012) induced a temporary dislocation in this relationship, correlation has since
fallen significantly. We expect the old-normal regime of negative correlation to come back in 2014. In contrast, the
market is currently pricing in a zero implied correlation for SX5E/Euro.
Exhibit 1: Rolling 3M FX/Equity Correlation (Smoothed)
Exhibit 2: Rolling 3M FX/Equity Correlation
100%
100%
80%
NKY/JPY
SPX/EUR
80%
60%
SX5E/EUR
60%
40%
FTSE/GBP
40%
20%
20%
0%
0%
-20%
NKY/JPY
SPX/EUR
SX5E/EUR
FTSE/GBP
-20%
-40%
-40%
-60%
-80%
Oct-00 Apr-02 Oct-03 Apr-05 Oct-06 Apr-08 Oct-09 Apr-11 Oct-12
-60%
Mar-12
Jun-12
Sep-12
Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Trade: Buy SX5E calls conditional to EUR/USD trading below 1.35 at expiry
The payoff of the strategy at maturity is:
SX 5E1
C1 Notional Amount x max

1,0 if EUR/USD trades below the 1.35 barrier at expiry, zero otherwise.
SX
5
E
0
The trade is long 21% delta on the SX5E, short 24% delta on EUR/USD, short SX5E/EUR correlation, long vega on the SX5E
and slightly short vega on EUR/USD. The major risk of the trade compared to a vanilla call would be a strengthening of the Euro
against the US dollar, which would cancel any profit even if the SX5E increase sharply during the year.
*** Risks: The risk to buying a conditional call option is limited to the premium paid.***
Exhibit 3: Trade Summary
Option
Vanilla Call
Conditional EUR/USD < 1.35
Premium
5.78%
2.78%
Delta SX5E
47.40%
20.73%
Delta EUR/USD
-23.78%
Vega SX5E
0.38%
0.18%
Vega EUR/USD
-0.05%
40
Japan: Bullish with up to 8X Payoff

Nikkei Upside Through Vanilla and Exotic Structures
Opportunity: Go Long Nikkei on the back of further QE and cheap valuation
Despite a strong run in 2013 (+57%), we expect the Nikkei rally to continue this year. Credit Suisse Global Equity
Strategy has a 2014 year-end target price of 18,400, up 14% from current level, driven by the following factors:
o Weaker yen: CS economists believe that to meet its inflation target of 2%, the BoJ will have to devalue the Yen
by 10-15% by the middle of next year and will thus accelerate QE in Q1 2014. The weaker Yen and expanded
QE should help equities to outperform (see correlation between NKY and USD/JPY in Exhibit 1).
o Allocation to equity: While Japanese investors remain positioned for a deflationary environment (over 60% of
financial assets in cash and bond), rising inflation could spark a meaningful asset allocation shift to equities.
o Valuation: Japanese valuations are reasonable and earnings revisions are the strongest of any region
Dislocated Volatility Surface: Nikkei implied volatility is expensive compared to other global indices (1Y implied vol at
~22.3% vs 15% for SPX and 17.5% for SX5E). We suggest buying a call spread on NKY to limit vega exposure, but
also benefit from flat upside skew. Bullish expectations and idiosyncratic market dynamics (Uridashi knockouts) have
combined to push implied vol for higher strikes to levels at odds vs. other global benchmarks (Ex. 2).
Exhibit 1: NKY and USD/JPY Performance
Exhibit 2: NKY Upside Skew is Flat
35,0%
15000
100
90
Volatility (%)
12500
USDJPY
NKY
30,0%
25,0%
20,0%
15,0%
10000
80
50Pct
31-dc.-11
NKY
30-juin-12
30-dc.-12
30-juin-13
USD/JPY
NKY
75Pct
SX5E
100Pct
125Pct
150Pct
SPX
Trade #1: Buy Nikkei Dec14 17,000/18,500 call spread

We suggest going long Nikkei Dec14 17,000/18,500 call spreads for 410 (or 2.5% of spot, ref 16,121) for a maximum
payout ratio of 3.7x at maturity. The upside strike is set roughly in line with the CS 2014 year-end target price of 18,400.
*** Risks: The risk to buying a call spread is limited to the premium paid.***

Index
NKY
Strike 1
17000
Strike 2
18500
Premium
410
Breakeven % 108.0%
Spot
Strike 1 %
Strike 2 %
Premium %
Delta
16121
105.4%
114.8%
2.5%
15.4%
Trade #2: Buy EWJ Dec14 12-strike call with knock-out barrier at 14.50
For US investors who dont want to actively manage Yen exposure, we suggest going long EWJ Dec14 12-strike call with a
continuously observed knock-out barrier at 14.50 for $0.30 (or 2.49% of spot, ref 12.04), representing over 63% in cost
savings versus the vanilla 12-strike call (at $0.82). Upside participation starts immediately with a max payout ratio of over 8x.
Meanwhile, the knock-out barrier is set at over 20% over the current spot level.
*** Risks: The risk to buying a call with a knock-out barrier is limited to the premium paid.***
ETF
EWJ
Strike
12.00
KO Barrier 14.50
Premium $ 0.30
Breakeven $12.30
Spot
12.04
Strike %
99.7%
KO Barrier %120.4%
Premium % 2.49%
Breakeven %102.16%
41
Contacts
James Masserio
Head, US Equity Derivatives
+1 212 325 5988
james.masserio@credit-suisse.com
Credit Suisse Equity Derivatives Strategy and Structuring
Grace Koo
Head, Equity Product Strategies
+1 212 325 4755
grace.koo@credit-suisse.com
Edward K. Tom
Head, Equity Derivatives Strategy
+1 212 325 3584
ed.tom@credit-suisse.com
Credit Suisse Derivatives Sales

Tim Scanlon
Head, Equity Derivatives Sales
+1 212 325 4755
tim.scanlon@credit-suisse.com
Michael Clark
Head, Structured Retail Products
+1 212 325 5909
michael.g.clark@credit-suisse.com
Credit Suisse Derivatives Trading

Khoa Le
Head, Equity Derivatives Flow Trading
+1 212 325 5988
james.masserio@credit-suisse.com
Robert Sowler
Head, Equity Derivatives Structured Trading
+1 212 325 7281
robert.sowler@credit-suisse.com
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42

2014 Volatility Outlook Final

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2014 Volatility Outlook Final

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EQUITY DERIVATIVES STRATEGY

2014 U.S. Equity Volatility Outlook

Exhibit 1: S&P Expected Volatility Scenario Analysis

Source: Credit Suisse Equity Derivatives Strategy

Exhibit 2: A Steady-State VIX Forecast at 15

Over the course of this report, we explain the rationale for

Source: Credit Suisse Equity Derivatives Strategy

Exhibit 3: Sector Volatility Outlook for 2014

Source: Credit Suisse Equity Derivatives Strategy

EQUITY DERIVATIVES STRATEGY

Framework for Analyzing Volatility

Baseline Volatility: The new normal is squarely

Our discussion will utilize a framework that decomposes

Illustration of Volatility Framework

Source: Credit Suisse Equity Derivatives Strategy

The sample decomposition above shows two notable

2014 Trade Recommendations

Top Thematic Ideas

EQUITY DERIVATIVES STRATEGY

Establishing Baseline Volatility

Baseline volatility, the type inherent in a liquid, continuous

Calculate forecasted S&P return target

Calculate daily historical returns for S&P-500 from 1928 to

Calculate rolling-window of one-year daily compounded

Construct a normal density (bell-curve distribution) of the

Draw 10,000 samples of the price paths from the

Calculate the realized volatility of each of the 10,000 sample

Baseline volatility = the mean of the sampled realized

Exhibit 6: Expected Volatility Required for S&P to Reach 2000 =12%

For 2014, our US economics team is forecasting a real

2014 Baseline Volatility @ 10.8%

Source: Credit Suisse Equity Derivatives Strategy

Exhibit 7: Expected Volatility Required for S&P to Reach 1500 = 21%

Accordingly, to develop our estimate for baseline volatility,

Exhibit 5: Expected Volatility Required for S&P to Reach 1350

S&P level at 2014

Baseline Vol = 10.8%

Exhibit 8: Expected Volatility Required for S&P to Reach 2300 =13%

Source: Credit Suisse Equity Derivatives Strategy

Source: Credit Suisse Equity Derivatives Strategy

EQUITY DERIVATIVES STRATEGY

Potential Tail Catalysts (Kurtosis)

A Spike in US Rates: Last year volatility surged to a

Turmoil in the Emerging Markets: With slowing

China Shadow Banking Meltdown: China has seen a

Exhibit 9: 2014 Steady-State VIX Forecast of 15%

Source: Credit Suisse Equity Derivatives Strategy

EQUITY DERIVATIVES STRATEGY

1. Rising Interest Rates

has evolved from whether it will occur to how it will

Exhibit 1: Interest Rate Equity Volatility Contagion

Source: Credit Suisse Research

As seen in Exhibit 1, volatility contagion between interest

Source: Credit Suisse Research

Even though an increase in the Fed Funds rate is not

Current Equity-Interest Rate Volatility Sensitivity

Source: Credit Suisse Equity Derivatives Strategy

EQUITY DERIVATIVES STRATEGY

Volatility reaction to talk of taper: The VIX recorded its

Dec14 Fed Fund futures contract, increased from 10%

Source: Bernanke & Kuttner 2004 ; European Central Bank, 2007

Source: Credit Suisse Equity Derivatives Strategy

But will markets believe the Fed? Exhibit 4 suggests

EQUITY DERIVATIVES STRATEGY