Credit Suisse - 2010 Vol Outlook

Derivatives Strategy
Europe
Market Commentary
Stanislas Bourgois, CFA

+ 44 20 7888 0459
Raymond Hing
+ 44 20 7888 7247
2010 Equity Derivatives Outlook
Key Points
!
21 December 2009
Following the strong market performance in

2009, we believe that most risky assets are now
fairly priced to expensive. However there remains
a few pockets of mispriced factors such as Equity
volatility skew, cross asset correlation or tail risk.
The market is waiting for a confirmation of the
economic recovery before getting involved. With
risks still hovering over the second half of 2010,
and given that exit strategies are likely to cap
the upside for Equities, investors looking for
superior risk-reward will have to look outside of
pure Delta-One exposures.
With Equity index volatility now generally back to
pre-2008 levels, selling volatility may prove a risky
strategy. Based on a proprietary macro model, we
see SPX realized and implied volatilities around
24% in drifting markets in 2010, or over 30% in
a double-dip scenario.
However, we believe that Equity volatility skew,
intra-Equity
correlation
and
cross-asset
correlation, currently at decade highs, are likely to
start converging in 2010.
There are a number of ways for Equity investors
to profit from this trend. We suggest vanilla option
structures to decrease the cost of Equity
exposure or Equity hedges for the long-only
investor. We also give a few trading ideas on
volatility skew or cross-asset correlation for the
more exotic trader.
However, whether long delta, short volatility, short
skew or short correlation, most of the strategies
discussed in this outlook have this in common that
they would suffer large drawbacks in the event of
a new systematic risk a possibility which cannot
be completely excluded. We suggest buying back
tail risk at low cost through deep out-of-themoney put options.
Out of steam heading into 2010

Record rally in Economy and Risky Assets
2009 has been a year of extremes. We entered 2009 in the middle of
the largest bear market since 1929. By the beginning of March Equity
markets had shed almost 50%. Vigorous fiscal, monetary and public
credit policy easing everywhere put a floor to financial markets plunge
and the consecutive rebound in the global economy saw risky assets
jump back, with Equities in particular rebounding almost 70%.
Underlying this spectacular reversal of trends was another spectacular
increase in the volatility of macroeconomic variables which saw the
Global economy move out of a deep and synchronized recession to an
expected 4.3% growth in 2010. 2009 also put an end to the
orderliness of economic life in the last quarter century, known as The
Great Moderation.
Exhibit 1: Risky asset returns around market trough
160
SPX
MSCI Emerging
SPX Implied Vol (inverted)
140
3.5
Commodities
BAA - AAA Spread (rhs)
120
100
2.5
80
60
1.5
40
18/01/08
1
11/04/08
04/07/08
26/09/08
19/12/08
13/03/09
05/06/09
28/08/09
20/11/09
Source: Credit Suisse Derivatives Strategy
Risk appetite fuelled by the weak dollar

However, as we noted in our prior reports (see our trade idea
FX/Equity Correlation Trades, dated 15 June), we also find that a
strong proportion of the performance of risky assets in 2009 can be
explained by a new carry trade: borrowing in low-yielding dollar to
finance risky positions such as long Equity, short volatility or long
Emerging markets. 2009 saw the dollar strongly depreciate while all
risky assets rebounded, pushing the correlation between the Dollar and
risky assets to the limit, as shown on Exhibit 2 next page.
Since the market collapse in 2008, quantitative easing and low base rates (in particular in the US,
see Exhibit 3) have fuelled the strong economic rebound, of which risk appetite and the global
market rally is a consequence. Since September 2009 however, economic momentum has
slowed, leaving the dollar as the main driver of financial markets. Correlation staged one last,
spectacular jump from 20% to almost 60% as opportunistic buy on dip strategies resulted in
strong dollar offering at times of market rebound. Has the weak dollar been the only force
sustaining financial markets when consensus thought that a mild correction was overdue?
Exhibit 2: Avg Correl of $ to SPX, Credit, Commos and Vol
Exhibit 3: Global 3M LIBOR rates
80
60
BBUSD3M
BBGBP3M
40
BBJPY3M
BBEUR3M
20
BBCHF3M
0
01/07/99
-20
28/12/00
27/06/02
25/12/03
23/06/05
21/12/06
19/06/08
3
2
-40
1
0
23/11/06
-60
23/05/07
23/11/07
23/05/08
23/11/08
23/05/09
23/11/09
Risky Assets are no longer cheap

Following the strong market performance in 2009, Credit Suisses strategist Andrew Garthwaite
finds that Equity appears to be neutrally valued today, with the US Price to Earnings on trend
earnings in-line with its long term average of roughly 13 (Exhibit 4). This also extends to Credit
where the bulk of the fall in Credit spreads has now occurred after shooting to decade highs in
March. The CDX High Yield index now stands at around 700bps: assuming a risk premium of
250bps and a recovery rate of 30%, credit spreads are discounting a 5-year cumulative rate of
28% over the next 5 years, which is only slightly above the 20-year average of 25%, and below
levels reached in the last two recessions in the early 1990s and 2000s (Exhibit 5).
As discussed later in this report, this is the result of a deep credit and liquidity healing currently at
play. Also note that Credit Suisses Credit Strategist William Porter still believes that Credit is
attractive with the limitation that its attractiveness depends on the small probability of a bad
outcome and needs continuous reappraisal.
Exhibit 4: US P/E on trend earnings
Exhibit 5: 5-year cumulative default rate
The impact of the 2009 rally on valuations was strongly felt on two asset classes which in late
2008/early 2009 suffered the bulk of the selling pressure: convertible bonds and dividends (see
our previous reports on dividends dated 16 February and 14 October 2009, and on convertibles
on 1 December 2008). Immediately after risky assets touched a low in March, Dividends and
Convertibles rallied spectacularly. The trade-off of dividends against Equity (as proxied by the
implicit risk premium of the index level versus dividend futures) fully recovered in just a few weeks
leaving us undecided as to whether going long Equity or Dividends (Exhibit 6 however note that
we have a long preference for 2011 dividends as explained in our report Lower risk reward for
dividends, dated 14 October 2009).
Similarly, convertibles yield advantage (the difference between the convertibles yield and its
underlying Equity for convertibles trading at a high delta) has collapsed from 550bps in early April
to roughly 250bps today (Exhibit 7).
One illustration of the lack of cheap instruments over the last months: based on Credit Suisse
Prime Services data, Relative Value hedge funds (which typically try to create low volatility returns
from the mispricing of different asset classes) had to increase their leverage from 4.0x in June
(close to levels prevailing in December 2008) to over 6x today in order to preserve absolute
returns.
Exhibit 6: SX5E dividend future implied risk premium
9
Exhibit 7: Equity-switch convertibles yield advantage

600
500
400
6
5
300
200
3
2
100
1
0
04/01/05
04/10/05
04/07/06
04/04/07
04/01/08
04/10/08
04/07/09
0
14/04/09
28/05/09
13/07/09
31/08/09
16/10/09
08/12/09
A market in waiting
Exhibit 8: Hedge fund long bias
Fair or expensive risky asset prices (or the perception of it) could explain why financial markets
have been showing signs of exhaustion over the last few months now that the most striking long
opportunities have faded. The SX5E index has been stuck between 2,700 and 2,950, a 10%
range, since 21 August. The probability of such a range is less than 30%.
The first phase of the rally was mostly driven by fast money: as shown on Exhibit 8 hedge funds
were fast in increasing their long exposure on strong valuation signals in March but have been
less active since Summer.
Source: Credit Suisse Prime Services
Traditional investors who have missed the initial phase of the rally (and we believe that most of
them have) are now left with disappointing risk rewards compared to only a few months ago. With
the brutality of the recession still present in investors minds it is no surprise that trading volumes
are below volumes observed in the last recoveries (Exhibit 9 next page) and that traditional
investors Equity allocation is still at depressed levels (Exhibit 10). The market is waiting for a
confirmation of the economic recovery (what we call Phase 2 in the remainder of the report)
before getting involved.
Exhibit 9: SPX daily volume now vs 2003 Exhibit 10: US Insurance Equity holdings (%)
Source: Credit Suisse Research
The Delta outlook bullish or range-bound?

The Bullish case
In his 2010 Outlook published on 4 December, Credit Suisse Equity Strategist Andrew
Garthwaite suggests that 2010 should see strong Economic growth (4.1%, slightly below our
economists forecast of 4.3% - Exhibit 11), muted inflation, and still reactive policy. However, by
late 2010/2011 he foresees a potential government bond funding crisis caused by a switch from
Banks from financing public deficits (banks holding of government securities grows at a 10%
rate, see Exhibit 12) to financing private sector credit growth. However the risk of a double dip
recession can be met by continuing quantitative easing, which according to us would also alleviate
the risk of a government funding crisis (Central Banks are currently the largest buyers of
government debt). The Fed is not expected to tighten rates before end 2010. In late 2012
onwards sustainable growth would return, albeit at a lower trend.
Exhibit 11: Global GDP growth since 1870
Exhibit 12: US banks holding of govt debt (%)
In accordance with his macro scenario, Andrew Garthwaite is 5% overweight on equities,

targeting a return of 12% by mid-year. He cites the following factors supporting equities: 1)
Better growth/inflation trade-off than expected; 2) 2530% earnings growth in 2010; 3) Major
credit and macro variables are back to levels they were at when the S&P 500 was at 1,280 (in
particular Equities have rallied far less than Credit, see Exhibit 14); 4) Equities are neutrally valued
on trend, but cheap on consensus earnings; 5) Investors are still skeptically positioned in equities
(see our own comment on page 3).
Exhibit 13: Consensus 12 mth forward EPS
Exhibit 14: Equities vs High Yield
Last, Andrew Garthwaite believes we could re-enter a bear market in late 2010 if a government
bond funding crisis unfolds; in particular, the UK has the highest probability of a government debt
crisis in the G7, which could potentially force an expansion of quantitative easing programs and
lead to currency crisis.
Stronger Eurozone and China

Andrew Garthwaite also revised up Continental Europe from a 5% underweight to 5% overweight
(to be overweight for the first time since 2007) for the following reasons:
a) stage of the cycle: Europe typically starts to outperform nine months after the trough in global
lead indicators (Exhibit 15);
b) Europe tends to outperform when interest rate expectations start to rise, owing to its low
financial leverage in corporates and high levels of fixed debt amongst consumers;
c) European lead indicators now suggest the same GDP growth as in the US;
d) Europe has much lower leverage in aggregate and in the consumer sector than the US, Japan
or UK;
e) valuation: the sector-adjusted 12m forward P/E in Europe is 14% below that of the US
compared with a norm of 2%;
f) Credit Suisse Strategy is not dollar bear near term.
Exhibit 15: Europe outperf. Vs lead indicators Exhibit 16: Europe outperf. Vs EPS revisions
Within Continental Europe Germany looks particularly attractive. Its recovery has been stronger
than the rest of Europe, aided, in particular, by its large manufacturing and capital goods
exposure. As the worlds second-biggest exporter after China, it is particularly leveraged into the
rebound in global trade and gets additional benefits from a low leverage: it has a structural primary
budget surplus, a household savings ratio of 11% and consumers are net floating-rate creditors.
As a result, Germany is the European market most resilient to rises in rates/bond yields. On
valuation, Germanys forward P/E relative to Europe is 11% below average.
Exhibit 17: Indicative Dec10 ATM This leads to our first derivatives trade idea for 2010: go long SX5E or DAX outperformance
options versus the SPX, FTSE or Nikkei which are all rated a benchmark or underweight by
outperformance option prices
Andrew Garthwaite. Indicative prices are shown on Exhibit 17. Outperformance options are an
Long/Short Offer
OTC derivative that pays the outperformance of a given index versus another, if positive.
SX5E/FTSE
5.10%
Outperformance options are therefore long volatility (a high volatility increases the likelihood of a
SX5E/SPX
4.90%
positive payout) and short correlation (a strong correlation reduces the likelihood of a major
SX5E/N225
5.10%
difference in the underlyings performance). Outperformance options currently enjoy superior
pricing due to a low implied volatility and high implied correlation environment and it may be an
interesting tactical moment to enter such trades (see page 15).
The end of Phase 1 of recovery

Phase 1 of economic recoveries is usually sharp, brief, and followed by a renewed decline. But
normally, that's the base for a second, more sustained rise if and when retail sales/final demand
growth picks up ("Phase II of recovery"), on which most bullish scenarios for 2010 concentrate.
Markets have had to digest more evidence over the last few months that Phase 1 has come to an
end. New orders fell for a number of key indicators, including ISM, the most important leading
indicator for global production momentum. According to Credit Suisse's strategist Jonathan
Wilmot, that is strong confirmation that global growth momentum hit its peak in October and is
now slowing.
Exhibit 18: Global IP momentum
Exhibit 19: US Retail Sales
A strong rise in US retail sales breaking out of the 2% range that has been prevalent for a year
now may suggest that Phase II is coming closer. Before thats fully apparent, however, ISM
New Orders are likely to trend lower, leaving markets in the difficult interim between Phase I and
Phase II of recovery for some time.
Will poor Equity risk reward continue in early 2010?

This Phase1/Phase2 inter-phase is typically associated with weaker, choppier returns. With risks
still hovering over the second half of 2010 according to Andrew Garthwaite, and given that the
three stages of the exit strategy (winding down QE, raising interest rates and fiscal
consolidations) are likely to cap the upside for Equities even in H1 2010, investors looking for
superior risk-reward will have to look outside of pure cash Equity exposure. With Convertibles and
Credit apparently expensive and Dividends grinding higher but on faint volumes, highlighting
liquidity risk, we think 2010 should bring Equity volatility products into the spotlight giving the
potentially high return that could be generated by selling volatility skew or asset correlation.
Can volatility tick higher in 2010?

Have Implied and Realised vols come down too fast?
Mirroring the speed of the rally in Equities, Equity volatilities have come down fast, from a peak of
55% on 20 November for 6-month implied SPX volatility to 23%, and from a peak of 58% on 12
March for 6-month realised SPX volatility to 19%. However, if we applied the rate at which
implied and realized volatilities converged in the months following the market trough in
2002/2003, 6-month implied volatilities should now be 30% higher, at 29%, while 6-month
realized should be no less than 60% higher, in the low 30s (Exhibits 20 and 21).
Implied and realized volatilities are today only a couple of volatility points higher than at they were
on the same day following the 2002/2003 credit crunch. This may surprise given that the scope
of the macro crisis in 2003 was perceived as far less acute, and that the turn of Equity markets in
2003 marked the beginning of a 4-year bull market a situation that can hardly be compared to
todays.
Exhibit 20: SPX 6M implied vol now vs 2002/2003
Exhibit 21: SPX 6M Realised vol now vs 2002/2003

100
100
2003
90
90
2009
2003
80
2008
80
70
60
70
50
60
40
50
40
20/11/08
30
20/02/09
20/05/09
20/08/09
20/11/09
20
12/03/09
12/06/09
12/09/09
12/12/09
The end of Market stress as a driver of volatility
Exhibit 22: Ted spread + OIS diff
However the quick fall in Equity implied and realized volatility should be understood in the light of
the unique levels of market stress reached at the peak of the crisis in 2008, and the non-less
spectacular healing observed in the early months of 2009. This was evident in the large scale
return of the real money buyer for credit instruments and the lower haircuts on riskier credit
instruments in the repo market.
One measurable indicator is the return of funding liquidity, as seen in the normalisation of Ted
spread and the Libor OIS differential (Exhibit 22). We are now in a situation where traditional
drivers of Equity volatility (Equity and macroeconomic factors rather than liquidity factors) have
regained their prevalence, which should keep realized volatility within bounds in 2010.
Equity vol in 2010: slightly higher than currently?

To identify the traditional drivers of Equity realized volatility, we looked at the history of the SPX
realized volatility since 1990 and picked the factors that exhibited the highest and most stable
correlation with volatility: the SPX 6-month return, OECD leading indicators, the BAA minus AAA
Credit Spread and the number of upwards earnings revisions. Controlling for the multicolinearity of
these variables, we put together a linear model for 6-month realized volatility that has an rsquared of 80%. According to this model (which ignores liquidity factors over the long run), the
SPX realized volatility over the last 6-months should have been north of 22% when it was 19%
(Exhibit 23 next page).
In a recovery scenario which should see leading indicators come back to pre-crisis levels, the SPX
index increase by 10% over the next 6-months, the BAA/AAA credit spread fall down to its
average level of 2.3% since 1991 and upwards revisions rise to 200, the SPX realized volatility
may fall to as low as 14%. However, imn our favourite scenario of an incomplete recovery, in
particular where Equity returns would be flat and credit would stay unchanged, the realized
volatility over the next 6 months may actually rise to 24%. It may rise to 32% in a double-dip
scenario - not to mention the risk of another Equity crisis which is addressed later in this outlook.
Given the low probability of the full recovery scenario we believe that the risk to realized volatility is
actually to the upside, in particular for the beginning of the year with a less supportive macro
background and, according to our US colleague Ed Tom, the risk of an active US political agenda
in banking, healthcare or industrials.
Exhibit 23: SPX 6M realised volatility model
Exhibit 24: Scenarios for Equity volatility in 2010
70%
Scenario
60%
SPX 6M change
Leading Indicators
Credit
Upwards Revisions
Realised Volatility
50%
6M Realised Vol
40%
Fitted
30%
Current
198
96.25
2.9
191
22.7
Recovery
100
100
2.3
203
14.1
Incomplete
Double Dip
recovery
0
-200
95
90
3
4
150
100
23.7
31.9
20%
10%
0%
21/06/91
17/12/93
14/06/96
11/12/98
08/06/01
05/12/03
02/06/06
28/11/08
Implied volatility fairly priced

Exhibit 25: % Companies losing
money vs default rate
Using the same factors, and dropping in realized volatility, we also built a linear model for the SPX
implied volatility with an r-squared of 86% (Exhibit 25). According to this model, implied volatility
is currently fairly priced around 24%, but could increased to 30% in a mild double-dip scenario
where as the potential fall in vol from a full recovery would be 5 volatility points only.
We find that the main driver of a larger fall in implied volatilities would be credit a fall in the
credit spread to 1.5 would bring SPX volatility closer to 15%. However following the 2002/2003
credit crisis Credit spread fell back to that level only two and a half years later. Additionally,
according to Credit Suisses Credit Strategist William Porter, the percentage of companies losing
money on a yearly basis currently does not support a substantial fall in defaults, and hence not
credit spreads (however, he also note that macro profit trends do support a narrowing of spreads).
We would therefore believe that SPX implied volatility is likely to remain in the low 20s in 2010,
with potential for peaks towards 30%.
Exhibit 26: SPX 6M implied volatility model
Exhibit 27: Scenarios for Equity volatility in 2010
60%
Scenario
50%
SPX 6M change
Leading Indicators
Credit
Upwards Revisions
Realised Volatility
Implied Volatility
6M Implied Vol
Fitted
40%
30%
20%
10%
0%
04/09/98
02/03/01
29/08/03
24/02/06
22/08/08
Current
198
96.25
2.9
191
19%
23.7
Recovery
100
100
2.3
203
18.5
Incomplete
Double Dip
recovery
0
-200
95
95
3
4
150
100
24.3
29.3
Naked short volatility is a dangerous bet

Based on the above calculations, we see only one scenario where going short volatility (going
short puts, short calls or short straddles) would yield a positive P&L at current prices: that of a
complete recovery which would see realized volatilities fall down to 15%. Should the position be
held to maturity, the potential P&L would be of up to 9 volatility points. Given that our central
scenario of an incomplete recovery would bring no loss to the trade, we understand why investors
with significant risk appetite are currently thinking about selling volatility.
However, in the event of a double-dip recession, we see realized volatility going up to 30% (1.9%
average daily move) and maybe more in line with previous mild recession experiences. Losses
there could be very large. We believe that selling short term volatility is too dangerous a bet for a
very limited potential P&L see Exhibit 28 for a backtest of systematically selling 6-month at-themoney straddles on the FTSE, SPX and SX5E indices, that show a flat P&L since June 2009.
Selling long term volatility (Exhibit 29) has performed even more poorly.
Exhibit 28: Short 6M Delta Hedged straddles in 2009
10,000,000
8,000,000
6,000,000
Exhibit 29: Short 2Y Delta Hedged straddles in 2009

10,000,000
FTSE
8,000,000
STOXX50E
SPX
6,000,000
4,000,000
4,000,000
2,000,000
2,000,000
0
31/12/08 11/02/09 25/03/09 06/05/09 17/06/09 29/07/09 09/09/09 21/10/09 02/12/09
FTSE
STOXX50E
SPX
0
31/12/08 11/02/09 25/03/09 06/05/09 17/06/09
-2,000,000
-2,000,000
-4,000,000
-4,000,000
29/07/09 09/09/09 21/10/09 02/12/09
If anything, sell long term forward-starting variance
45%
40%
35%
30%
However we would also note that we are less negative on selling long dated volatility than short
term. First, pricing is currently interesting, with the 2-year to 3-month implied volatility spread in
the top 25% of observations over the last 5 years. Second, banks are expected to become very
Exhibit 30: 2Y/1Y SPX forward
long volatility if the market continues to rebound, from large call spread positions or even light
variance
exotic structures such as knock-out calls having been traded by clients in search of leverage. A
strong supply of implied volatility on behalf of banks may benefit the mark-to-market of long-term
volatility exposures.
25%
20%
15%
10%
5%
0%
24/05/01 24/05/02 24/05/03 24/05/04 24/05/05 24/05/06 24/05/07 24/05/08 24/05/09
Last, some more structured products such as forward-starting variance still show interesting
pricing. Forward starting variance is an exotic derivative that will make its holder short (or long)
realized variance for a specified expiry, at a specified time in the future. As shown on Exhibit 30,
the 1-year in 1-year forward starting variance has not corrected in-line with vanilla volatilities and
still trades above the previous peak level reached in 2002.
The Happy Few go Short Skew

Short Skew outperformed in 2009
Selling the skew means selling downside volatility while buying upside volatility, in a volatility
neutral trade. In flow terms, this is typically done by selling puts while buying call options (a risk
reversal). Selling the skew is an interesting trade when downside implied volatilities are high
versus the upside, as is the case now (Exhibit 31) but a risky one when an adverse market move
creates a strong demand for put protection and implied volatilities are remarked up.
As shown on Exhibit 32 (backtest of systematic, delta hedged 3M risk reversal rebalanced every
month), selling vanilla skew has been one of the great trades of 2009. Since September, rangebound markets have actually increased the attractiveness of short skew trades while cash
Equities risk reward plummeted with the exception of early November for the SPX, where an
adverse move on SPX volatilities created temporary mark-to-market losses (more on this later in
this report).
Incidentally we note how risk reversals have outperformed even as the Dubai and Greek credit
story unrolled over the last few weeks. The reason for this outperformance is that in our backtest
risk reversals were taken in time to enjoy a small rally, making the position long gamma and
benefiting from the increased volatility during the brief market correction. This shows the
importance of timing when trading the skew and how such positions should be traded only after
market dips.
Short skew strategies include risk reversals, put spreads, knock-out options and more elaborate
conditional variance strategies.
Exhibit 31: SPX and SX5E 6M 90/110 vol skew
Exhibit 32: Delta Hedged risk reversal in 2009
9.0%
4,000,000
SPX
8.5%
3,500,000
SX5E
8.0%
3,000,000
7.5%
2,500,000
7.0%
2,000,000
6.5%
6.0%
1,500,000
5.5%
1,000,000
5.0%
500,000
4.5%
4.0%
20/12/04
20/09/05
20/06/06
20/03/07
20/12/07
20/09/08
20/06/09
FTSE
STOXX50E
SPX
0
31/12/08 11/02/09 25/03/09 06/05/09 17/06/09 29/07/09 09/09/09 21/10/09 02/12/09
-500,000
Investors are still underinvested or fully hedged

One reason for the good performance of short skew in 2009 and why it may continue to do well
in 2010 is that Equity markets still behave as if underinvested/long protection. As discussed on
page 3 we believe that most of the market rally has been driven by fast money, while institutional
investors decided to stay on the sideline and are likely to continue doing so until the observed
risk reward of Equity has increased, despite the fact that Equities now often offer higher yields
than bonds.
Open interest for SX5E call options, which surged in early Q2 because of put spread collar
trading, has been roughly unchanged since then (Exhibit 33 next page). Conversely, the total put
open interest has gradually increased as put positions were rolled up as the market rallied, leaving
long-Equity investors well protected and limiting the risk for panic volatility buying on market
weakness. We believe that most put positions have been rolled into 2010, in particular in the
10
SX5E which tends to see higher risk aversion heading into year-end (see our report Higher SX5E
risk aversion in December, dated 1 December).
Exhibit 33: SX5E Dec09 call open interest
Exhibit 34: SX5E Dec09 put open interest

6,000,000
6,000,000
5,000,000
'1800
'2000
'2200
'2400
'2600
'2800
'3000
'3200
'3400
5,500,000
5,000,000
'1800
'2000
'2200
'2400
'2600
'2800
4,500,000
4,000,000
4,000,000
3,000,000
3,500,000
3,000,000
2,000,000
2,500,000
1,000,000
2,000,000
0
08/12/08
02/03/09
25/05/09
17/08/09
09/11/09
1,500,000
08/12/08
02/03/09
25/05/09
17/08/09
09/11/09
Underinvested/overhedged markets result in lower realised volatility, vol of vol and vol/equity
correlation, an environment in which short skew positions typically thrive (see our detailed analysis
Trading the Volatility Skew, dated Nov 2008). The SPX experience in November shows that
selling the skew starts being dangerous only on days when Equity markets fall by almost 3% close to 50% realized volatility when Equity indices currently realize roughly 20%.
Sell skew to receive cheaper upside exposure
Exhibit 34: Payout of an SX5E

Jun10 90/105 risk reversal
25%
20%
Outright Long
15%
Long 90/105 Risky
10%
5%
-25%
-20%
-15%
-10%
-5%
0%
0%
-5%
5%
10%
15%
20%
25%
-10%
-15%
-20%
-25%
For investors looking to receive leveraged exposure into a market rally, we would suggest using
risk-reversal, that is financing the purchase of a call option by selling an out-of-the-money put
option basically the same trade as Exhibit 32 but without delta-hedging. As shown on Exhibit
35, March, June and Dec10 90/110 risk reversals can all be put on at a credit, meaning that you
get paid to enter the trade, while for investors looking for more upside participation the 90/105
risk reversals can be put on for very low initial premiums. Exhibit 34 shows the expected P&L in
percentage of notional at expiry of the SX5E Jun10 90/105 risk reversal. The SX5E is a
peculiarity: given that most dividend payments occur before the June expiry, this has the effect of
depressing the price of the risk reversal to a large discount to other indices (vanilla options do not
pay dividends).
Exhibit 35: Indicative risk reversal prices

SPX
SX5E
FTSE
N225
Mar10 90/110 Jun10 90/110 Dec10 90/110

-1.0%
-1.4%
-1.9%
-0.8%
-2.3%
-2.7%
-0.6%
-0.9%
-1.1%
SPX
SX5E
FTSE
N225
Mar10 90/105 Jun10 90/105 Dec10 90/105

0.2%
0.2%
0.1%
0.6%
-0.7%
-0.8%
0.7%
0.7%
0.8%
Another, more exotic way of selling skew to receive leveraged exposure are double knock-out call
options. Knock out options are an exotic derivatives which gives the same payoff as a vanilla
option, provided that the underlying stays between specified boundaries during the life of the
trade. As shown on Exhibit 36, the addition of a knock-out feature can significantly decrease the
premium paid for the option, with the premium of a Jun10 80/120% double knock out at-themoney call option being 3.1% only when the vanilla call option would be 5.7% (indicative).
Another interesting trade is double knock-out put options which could provide the investor with
limited protection on Equity downside at an even larger discount: the SX5E Jun10 80/120%
knock-out at-the-money put option would fully protect you for less than 20% slide in the SX5E
index, at a premium of 2.5% versus 8.2% for the vanilla put. For more details on knock-out
options, see our report Knock Out Puts and the market normalisation, dated 14 January 2009.
11
Exhibit 36: Indicative double knock-out option prices (at-the-money)
STE
SPX
Double Knock Out Call

Double Knock Out Put
Mar10 80/120 Vanilla Call Jun10 80/120 Vanilla Call Mar10 80/120 Vanilla Put
Jun10 80/120 Vanilla Put
3.90%
4.70%
3.10%
5.70%
2.60%
4.90%
2.50%
8.20%
3.80%
4.00%
4.00%
5.90%
2.70%
4.50%
2.40%
6.80%
Superior hedging with put spread collars

As we noted in our report Consolidate with Put Spread Collars, dated 30 April 2009, there are
various ways for an investor to receive portfolio protection: buying a straightforward put option,
buying a put spread (which involves buying a near-the-money put option while selling an out-ofthe-money put option), going long a collar (buying a put option and selling a call option) or going
long a put spread collar which involves going long a collar and financing it with an out-of-themoney put that is, selling some skew. Collars and put spread collars, unlike outright put options
or put spreads, can be put on at zero cost provided that the different strikes are properly selected.
We believe that put spread collars offer a more interesting risk-reward than alternative bearish
vanilla option trades for investors willing to hedge against a potential market correction in 2010:
* Pricing: although an SX5E Jun10 90% put or an 80%/90% put spread would cost you an
estimated 4.4% and 2.2%, respectively, put spread collars can be entered at close to zero cost
or even at a credit. We calculate that the Jun10 80%/90%/110% put spread collar is 0.3% (see
Exhibit 38 for indicative prices).
* Upside participation: compared to simple collars, put spread collars receive extra financing by
selling some skew. This means that in order to obtain zero cost, you could sell a call option with a
higher strike than for a simple collar, allowing you to participate in more upside. This could prove
important in current markets if Equity indices surprise on the upside at the beginning of 2010. In
order to obtain zero cost on a collar with a Jun10 90% put, you would need to sell the 103% call
option, therefore sacrificing almost all potential upside from current levels. You could reach zero
cost on the 80/90% put spread by going short the 109% call and keep some upside exposure
(see Exhibit 37).
* Backtest: backtests we ran for our put spread collar report in 2009 showed that put spread
collars beat other vanilla hedges since 2001 if we exclude the September/October 2008 market
crash which has a fairly low probability of happening again, making it our instrument of choice for
hedging Equity positions into 2010.
Exhibit 37: Payoff profile: hedging with risky vs put spread collar Exhibit 38: Indicative Prices
Jun10
Jun10
Jun10
80/90/110% Put
80/90% Put 90/110%
Jun10
Spread Collar
Collar
90% Put Spread
SPX
3.4%
1.9%
1.7%
0.2%
SX5E
4.4%
2.2%
2.5%
0.3%
FTSE
N225
3.6%
2.0%
1.2%
-0.5%
30%
Outright Long
Long 90/103 Risky
20%
Long 80/90/109 Put Spread

Collar
10%
0%
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
-10%
-20%
-30%
12
Long Knock-In variance

Knock-in variance swaps are a product that makes you long index variance swaps provided that at
a specified date the underlying index trades above or below a certain level. Knock-in variance are
also a short skew product and currently enjoy interesting pricing, trading at a significant discount
to vanilla variance. Please call for more information.
Positive carry with conditional variance

While knock-in variance swaps are a leveraged play into a stable/increasing volatility and market
rebound, it is also possible for investors with a higher risk appetite to structure a positive carry
trade selling skew through corridor variance swaps. Conditional variance swaps are similar to
vanilla variance or knock in variance but the variance exposure is limited to a predefined range of
underlying levels. The payoff at expiry is:
Payoff = Multiplier x (Realised Conditional Variance - Strike) x Percentage of Occurrences
Where Multiplier is the traditional adjustment to convert desired vega exposure into variance units,
Realised Conditional Variance is the variance observed on days where the condition was satisfied,
and percentage of occurrences is the ratio of number of days where the condition was realized to
the expected number of days over the life of the trade.
Assume you are long the Jun10 SX5E 80% Up variance swap at an indicative strike of 26.5%. If
before expiry, the SX5E realized a variance of 30% on days where it traded above the barrier, you
will net a profit of Multiplier x (30%2 26.5%2) x Percentage of Occurrences.
Going long the Jun10 80% variance/short the Jun10 110% down variance is a way to go short
SX5E skew. Provided that the SX5E stays between -20% and +10% of current level, you will
every day realize a carry equivalent to 30.7 26.5 = 4.2 volatility points.
Exhibit 39: 6M SX5E varswap history vs exotic variance Exhibit 40: (Very) indicative Prices
70
60
6M Vanilla Var
105% Knock In
UpVar
50
DownVar
Mar/Sep 105% Knock- Jun10 80% Jun10 110%

In
UpVar
DownVar
Jun10 Vanilla
SPX
24.1
23.9
26.6
26.0
SX5E
25.2
26.5
30.7
29.8
40
30
20
10
11/02/0011/02/0111/02/0211/02/0311/02/0411/02/0511/02/0611/02/0711/02/0811/02/09
13
Is Equity correlation too expensive?

Short inter-index correlation
A consequence of the strength of the Equity rally, inter-index correlation has reached decade
highs, as shown on Exhibit 41, helping passive/beta investors thrive (provided that they were
long) while hurting stock/sector/country pickers. Comparatively, 2010 is expected to be a year of
de-correlation. With Equities now fairly valued (our discussion page 3), we believe that investors
will start looking at relative country or sector bets. Non-Japan Asia is expected to strongly
outperform, while Continental Europe and Germany in particular should see better returns than
Japan, the US or the UK. Last, Dubai and Greece have reminded the investment community that
country specific risk should not be ignored.
This change in the inter-index correlation environment is not yet fully reflected in options prices,
with inter-country implied correlation typically above 80%. We suggest buying SX5E, HSCEI or
DAX outperformance options versus the SPX, FTSE or Nikkei which are all rated a benchmark
or underweight by Credit Suisse Strategist Andrew Garthwaite. Indicative prices are shown on
Exhibit 42. Outperformance options are an OTC derivative that pays the outperformance of a
given index versus another, if positive. Outperformance options are therefore long volatility (a high
volatility increases the likelihood of a positive payout) and short correlation (a strong correlation
reduces the likelihood of a major difference in the underlyings performance) fitting nicely in our
volatility scenario for 2010.
Exhibit 41: SPX realised correlation with MSCI EAFE and EM Exhibit 42: Indicative Outperformance Option Prices
80
70
Long/Short Offer
SX5E/FTSE
5.10%
SX5E/SPX
4.90%
SX5E/N225
5.10%
Overseas
Emerging
60
50
40
30
20
10
0
01/07/04 27/01/05 25/08/05 23/03/06 19/10/06 17/05/07 13/12/07 10/07/08 05/02/09 03/09/09
Single Stock volatility as a Beta/Credit hedge

As shown on Exhibit 43 next page, what stands for inter-index correlation is also true of intraindex correlation. SPX and SX5E implied correlations (a measure of the trade-off between an
index and its constituents volatilities) have not really converged back to their pre-2008 levels and
have actually increased over the last few weeks although implied volatilities have not.
This situation is unusual since implied volatility and implied tend to move in unison (Exhibit 44).
Based on all observations since 2001 where implied volatility was in the low 20s, implied
correlation actually seems almost uniquely high heading into 2010, indicating that either index
volatilities are too expensive, or that single stock volatilities have fallen too much and are now
cheap. Given that our implied and realized volatility models tell us that implied volatility is trading
close to fair, we believe that single stock volatilities are cheap.
14
Exhibit 43: SPX and SX5E 6M Implied Correlation
Exhibit 44: SPX 6M Implied Correl vs 6M Implied Vol

70%
75%
70%
SPX 6M Implied Correlation
65%
65%
SPX 6M Implied Correl

SX5E 6M Implied Correl
60%
55%
50%
45%
40%
All obs since 2006

Last
60%
55%
50%
45%
40%
35%
35%
30%
10%
30%
09/01/06 09/07/06 09/01/07 09/07/07 09/01/08 09/07/08 09/01/09 09/07/09
15%
20%
25%
30%
35%
SPX 6M Implied Volatility
40%
45%
50%
55%
60%
Exhibit 45: Cheap single stock

volatility screen
3M ATM
Model
10D Realised
RIC
Implied Vol Volatility
Vol
PRU.L
39.5%
43.3%
29.47%
DAIGn.DE
34.9%
37.8%
25.78%
UBSN.VX
38.8%
41.3%
31.57%
IBR.MC
23.1%
25.3%
11.51%
EONGn.DE
25.1%
27.2%
15.42%
ENI.MI
24.4%
26.5%
15.29%
ALVG.DE
30.9%
33.0%
20.92%
HEIN.AS
24.3%
25.8%
17.59%
AXAF.PA
38.8%
40.2%
32.83%
SAN.MC
32.7%
34.1%
28.06%
ISP.MI
32.9%
34.2%
15.95%
STAN.L
37.1%
38.3%
39.82%
TLIT.MI
28.7%
29.7%
17.78%
SAB.L
24.3%
25.2%
18.70%
BATS.L
20.4%
21.2%
9.99%
RWEG.DE
22.3%
23.2%
12.89%
CRDI.MI
40.3%
41.1%
27.47%
TSCO.L
21.5%
22.1%
21.73%
TOTF.PA
24.9%
25.4%
14.15%
DGE.L
21.2%
21.6%
18.73%
We show on Exhibit 45 a list of European stocks where implied volatility is particularly cheap
based on our proprietary methodology (see our report The Factors behind Single Stock Volatility,
dated 17 December), with the most common factors for mispricing being Credit and Beta. Based
on Andre Garthwaites 2010 outlook, European banks with high leverage and where Credit
spreads have already significantly fallen, and European Capital Goods which are now exposed to
competitive threat from China, seem interesting for a long single stock volatility position. Overall it
seems that single stock volatility may be a good hedge for a potential correction in Equity markets
or Credit.
Short Cross-Asset Correlation

Equity/FX correlation at odds with fundamentals
As explained on pages 1 and 2, we find that a strong proportion of the performance of risky
assets in 2009 can be explained by a new carry trade: borrowing in low-yielding dollar to finance
risky positions such as long Equity, short volatility or long Emerging markets. 2009 saw the dollar
strongly depreciate while all risky assets rebounded, pushing the correlation between the Dollar
and Equity to the limit, as shown on Exhibit 46.
Since September 2009 however, economic momentum has slowed, leaving the cheap dollar as
the main driver of financial markets. This lead to Dollar/Equity correlation staging one last,
spectacular jump from 20% to almost 60% as opportunistic buy on dip strategies result in
strong dollar offering at times of market rebound.
The common (ex-post) justification for high FX/Equity correlation is the impact an expensive
currency has for firms deriving a significant proportion of their earnings from overseas. However,
as shown on Exhibit 47, this proportion tends to be relatively small, with a minimum of 30% of
earnings derived from overseas for US firms. Additionally, any negative impact on output prices
may be at least partially compensated by a positive impact on input prices.
Exhibit 46: Equity/FX 6M realised correlation
Exhibit 47: Country exports as % of GDP
60
50
40
30
20
10
0
01/07/04
-10
07/04/05
12/01/06
19/10/06
26/07/07
01/05/08
05/02/09
12/11/09
-20
15
Overall, we find no statistical evidence of a relationship between exchange rates and company
earnings. We provide in Exhibits 48 and 49 scatterplots for 3-month changes in SX5E and SPX
aggregate FY1 earnings versus changes in the EuroDollar exchange rate (Euro/Deutsche Mark
prior to the Euro launch), which show no clear relation. We found R-squared in linear regressions
to be below 1%.
Exhibit 48: 3M change in SPX earnings vs Eurodollar
Exhibit 49: 3M change in SX5E earnings vs Eurodollar

30%
5%
0%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
-5%
-10%
-15%
-20%
30%
3M Change in SX5E Earnings
3M Change in SPX Earnings
10%
20%
10%
0%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
-10%
-20%
-25%
-30%
3M Change in Eurodollar
-30%
3M Change in Eurodollar
Source: Datastream, Credit Suisse Derivatives Strategy
Although FX/equity correlation is clearly unstable, Credit Suisses FX strategy team found that
equity-FX correlation goes through distinct regimes depending on equity performance. When
equities are rising or falling strongly relative to trend, FX tends to be highly correlated with
equities. However, when equities drift, FX decouples almost entirely from equities and interest
rate spreads become more important for FX determination (see Exhibit 50). This analysis
suggests that selling FX/Equity correlation in 2010 could yield interesting P&L should markets
start drifting (our favourite scenario), but could suffer losses in the event of another major rally or
renewed Equity stress.
Exhibit 50: 3M change in SPX earnings vs Eurodollar
Source: Credit Suisse FX Strategy
How to sell Equity/FX correlation through Quanto options

Quanto forwards and options are derivatives whose payout is in a currency (the payout currency)
other than the currency of the underlying security (underlying currency):
"
Quanto Forward: payoff in payout currency: FX0*(Indext Index0)
"
Composite forward: payoff in payout currency: FXt*Indext FX0*Index0
A consequence of the payout dynamics, Equity forwards need to be adjusted for correlation, as
shown on Exhibit 51.
16
In Quanto world, in Exhibit 50 denotes the correlation between the underlying, and the currency
pair calculated as the number of underlying currency units per payout currency units. For an
SX5E Quanto USD forward, that would be the correlation between SX5E and the EURUSD
currency pair. A positive here would imply that a fall in SX5E would normally coincide with a rise
in the dollar, making a short Quanto forward position more interesting for the Eurozone investor: a
fall in SX5E would create a positive P&L in USD, which would in turn benefit from the
appreciation of the Dollar versus the Euro. In order to avoid arbitrage opportunities, the Quanto
forward has therefore to be adjusted downwards versus the forward: with positive , exp(stockFX t) will be inferior to 1.
Exhibit 51: Quanto/Composite pricing adjustments
Vanilla
(in underlying
currency)
Quanto
(in payout currency)
Composite
(in payout currency)
Forward
Fstock
Fstock *exp(-stockFX t
Fstock * fFX
Implied
Volatility
stock
stock
2
2
FX
+ 2 FX stock + stock
(like basket option, wts = 100%)
Discount
Rate
runderlying
rpayout
rpayout
Quanto dynamics therefore suggest the following trades which match our delta scenario of an
outperformance of SX5E versus SPX in 2010:
Exhibit 52: SPX/SX5E quanto vs
vanilla forwards
SPX Forward
SPX Quanto Forward
Yield dif (annualised)
SX5E Forward
SX5E Quanto Forward
Yield dif (annualised)
Jun-10
1,092
1,098
1.10%
2,810
2,803
-0.50%
Dec-10
1,084
1,096
1.11%
2,798
2,783
-0.54%
"
For a European investor willing to hedge Equity exposures in 2010, a better pricing could
be obtained by selling some FX/Equity correlation by going long puts, or short forwards,
on the SPX index quantoed in Euros. As shown on Exhibit 52, the calculated price of the
Dec10 SPX forward assuming 35% implied SPX/USD correlation is 1,084 while the
quanto forward is 1,096 a 110bps savings if you believe that correlation should be 0.
"
Conversely an investor interested in generating yield by overwriting Equity in 2010 may

decide to sell SPX calls quantoed in Euros
"
A US investor interested in going long Equity could decide to go long SX5E futures or
call options quantoed in USD with potential annual savings of 50bps for selling
SX5E/USD correlation at an implied rate of 16%. Alternatively, the same investor could
decide to sell SX5E put options if willing to sell some volatility in 2010.
"
Going short SPX Quanto Forwards while going long SPX forwards would give you
exposure to stockFX t, and make you short (almost) pure FX/Equity covariance.
However, this would also be a dangerous trade should FX/Equity correlation stay
unchanged while volatility increases. Investors willing to do a pure FX/Equity correlation
trade may consider buying back some Equity volatility (more on this later in this report).
For more information on Quanto products and trading FX/Equity correlation please refer to our
previous report FX/Equity Correlation Trades, dated 15 June 2009.
17
Short Cross Asset correlation with ETFs

Exhibit 53: SPX correlation with
Credit, Commodity and USD
80
60
Commodities
Credit
USD
40
20
0
01/07/04
16/06/05
01/06/06
17/05/07
01/05/08
Looking at the correlation of Credit or Commodities to the SPX, we come to the same conclusion
as for FX/Equity correlation: the strength of the economic rally and the Dollar carry trade has
pushed cross-asset correlation to extreme levels that would be difficult to sustain in the long run.
Following the convergence in Credit volatility since June, Equity/Credit correlation has fallen back
to its long-term average of 0, leaving Commodity/Equity correlation as the most interesting short
play. We believe that Commodity/Equity correlation has now risen to unjustified extremes given
the expected impact of high commodity prices on input prices and long term inflation.
16/04/09
-20
-40
-60
The emergence of Exchange Traded Funds, some of which now enjoy liquid options markets (see
Exhibit 54), would allow an investor to trade this theme within an Equity framework, for instance
by going long SPX versus Oil outperformance options in a scenario where Oil prices, driven higher
by Chinas impressive economic rebound, would eventually decorrelate from a drifting SPX index.
A detailed report on cross-asset correlation and correlation trades with ETFs is forthcoming in
January 2010.
Exhibit 54: Liquid ETF options markets

Name
SPY - Standard & Poor's Depositary Receipts
XLF - Financials Select Sector SPDR
QQQQ - Powershares QQQ
EEM - iShares MSCI Emerging Markets Index Fund
IWM - iShares Russell 2000 Index Fund
GLD - SPDR Gold Trust
UNG - United States Natural Gas Fund
FXI - iShares FTSE/Xinhua China 25 Index Fund
EWZ - iShares MSCI Brazil Index Fund
XLE - Energy Select Sector SPDR
DIA - Diamonds Trust, Series I (DJIA)
IYR - iShares Dow Jones Real Estate
USO - United States Oil Fund
SLV - iShares Silver Trust
Underlying ETF Volume (3m avg.) Options

Index
Shares ('000) $ Amount Open Interest
SPX
58,973
5,330
9,474,902
IXM
45,526
532
5,157,069
NDX
125,934
4,414
5,123,746
NDUEEGF
23,206
728
3,968,684
RTY
12,886
641
3,829,409
N/A
4,070
373
2,070,399
N/A
8,478
121
1,634,714
XIN0I
7,940
287
1,499,194
NDUEBRAF
8,462
435
1,275,644
IXE
5,608
273
1,133,071
INDU
3,981
335
824,859
DJUSRE
9,473
308
806,797
N/A
3,581
122
760,253
SLVRLN
1,737
24
733,614
Multi-asset ETF Basket Option

Exhibit 55: Cross Asset Call vs
Call dispersion trade
SPX
SX5E
USO
GLD
Individual Call
Basket Option
sensitivity to a 1 Individual Call option notional
pt chge in vol
option Vega needed
8,669
3,888
2,229,906
8,015
3,802
2,108,348
9,359
3,877
2,414,361
7,620
3,914
1,946,773
In order to exemplify how to go short cross-asset implied correlation, we look at a quanto call
option on an equally-weighted basket of SPX and SX5E on the Equity side and the USO and
GLD ETFs on the commodities side. USO and GLD are liquid ETFs traded in the US
benchmarked on Oil and Gold prices. An indicative offer price of the Dec10, ATM Basket call
option is 9.8%. The trade will make the option shorter short SPX/SX5E correlation around 80%,
Equity/Commodities correlation around 30%, and FX/Equity correlation around 30% - basically
playing 3 of our 2010 themes in one product only.
We suggest buying back vega on the individual names to cancel the sensitivity to volatility and
only keep the correlation exposure basically doing what is called call vs call dispersion: for
$10m notional an indicative premium would be 9.8% or $0.98m. The sensitivities of the options
price to a 1 vol point change in SPX, SX5E, USO and GLD volatilities are 8.7k, 8.0k, 9.3k and
7.6k respectively, which we hedge by going long options on individual indices or ETFs as
calculated in Exhibit 55.
18
Buy back tail risk

The pricing of tail risk
The recent events in Dubai and Greece serve as a useful reminder that the recovery in risky
assets is still fragile and that the risk of another market dip should not be discarded. Additionally,
Equity markets have tended to price tail risk inconsistently, as shown by the strong volatility of the
VIX index recently.
As discussed by our US colleague Ed Tom in his report Unraveling the Recent VIX volatility, dated
12 November, changes in the VIX (which can be understood as a proxy for a variance swap
written on the SPX index) can be split between the following three components:
"
"
"
VIX chg due to chg in baseline volatility

VIX chg due to chg in skew
VIX chg due to chg in kurtosis
From a practical standpoint, changes in baseline volatility, skew, and kurtosis can be intuited by
observing the volatility differentials in 50, 30, and 10 delta options respectively. Note that
although increases in baseline volatility and skew both play a role in the surge, the entire 4 point
differential between the actual vs. expected reaction of the VIX during the last week of October
can be explained by the change due to kurtosis. The effect of kurtosis can best be discerned by
comparing the SPX implied volatility smiles for Oct 22, Oct 30, and Nov 2. On these days, the
VIX closed at 20.69, 30.69, and 29.78 respectively.
Exhibit 56: Decomposition of VIX changes (end Oct) Exhibit 57: SPX skew Oct 22, 30 and Nov 2
Things that could go wrong in 2010

Beyond the deleveraging story which is likely to spread over a number of years, a few, lowprobability macro imbalances could potentially derail financial markets fragile rally. According to
Andrew Garthwaite, a Fed tightening, a government funding crisis or acceleration in Chinese
wage growth could all cause a new leg down. On top of those we see unemployment, risky exit
strategies, and nation solvency risk but the list may be longer. The risk may actually be longer and
depend on clients view and we do not try to be exhaustive.
Unemployment & consumption
If corporate profits are likely to be stronger, this comes at the cost of poor labor market
conditions, especially in developed countries. Continuing unemployment may yield higher
economic distress and volatility for two reasons: first, the 2009 banks stress tests only checked
for consequences of unemployment rates rising to 10.2%. Were there already and any rise in
unemployment could further endanger the US regional banking system. Second, unemployment
may delay the expected rise in consumption which is the important lever for what Jonathan
19
Wilmot calls Phase 2 of the recovery. So far the US solution to jobless recoveries has been
liberal Credit. Now the credit channel has been foreclosed, what other solution if European-style
Welfare State is deemed politically unacceptable?
Exit Strategies and Banks funding crisis (again):
Increases in the refinancing rate remain a matter for H2 2010 or even 2011. However, the ECB
has already announced that it will tighten its conditions for providing funding to European Banks
(in brief, requiring at least two eligible ratings from an accepted external credit assessment
institution for all ABS issued as of 1 March 2010 provided as collateral). This measure is clearly
targeting the practice of securitizing ABS with the primary intent of making the underlying assets
eligible to be financed via the ECB.
According to Credit Suisse Rates strategists, the ECB policy has reached a point of inflection,
and the intent of policy going forward will be to create incentives for banks to rely more heavily on
market funding rather than ECB funding. Highest impact are likely to be felt in Spain, Ireland,
Greece and France which have seen the greatest increases in their banks lending as a
percentage of the total. These increases are even more striking given the huge increase in the
ECBs total lending. Will this forced migration from the ECBs full allotment refunding operations
be smooth? Not sure given the renewed difficulties of the Irish Greek and Spanish banking
systems.
Exhibit 58: Eurozone countries usage of ECB balance sheet
Nation Solvency:
After Ireland, can we see another country fail? Based on Andrew Garthwaites country
vulnerability scorecard, Greece and Spain fare worse than a number of emerging economies.
Exhibit 59: Andrew Garthwaites Country Risk screen
20
Buy-back tail risk with deep OTM puts

Whether long delta, short volatility, short skew or short correlation, most of the strategies
discussed so far in this outlook have this in common that they would suffer large drawbacks in the
event of a new systematic risk that would see Equity volatility jump over 50%.
Our last trade idea for this outlook would be to profit from current good pricing of tail risk, as
shown by the low spread between SPX 6M 20% Delta volatility and the 50% Delta volatility
(below 6% versus 12.5% at the peak of the crisis), to enter tail-risk hedges for cheap.
We suggest going long deep out-of-the-money put options. Buying tail risk could be financed by
selling a little bit more skew through 1x2 or 1x3 put ratios (selling one near-the-money put to
purchase 2 or 3 deep out-of-the-money put options). A backtest of a systematic 70/95% 1x3
put ratio indicates that going long tail risk does not necessarily have to be costly, with the
cumulative loss of the 1x3 over the two years prior to the 2008 crash representing less than 2%
of notional for the SX5E ($2m for $100m notional). The cost of carry of the SPX 1x3 was higher
than SX5E prior to the crisis, but has been lower since the peak of the crisis.
Exhibit 60: SPX 20D vs 50D 6M volatility spread
Exhibit 61: Systematic 6M 70/95 1x3 put ratio P&L
13%
10,000,000
12%
8,000,000
11%
6,000,000
10%
4,000,000
9%
2,000,000
STOXX50E
SPX
8%
0
05/01/07
-2,000,000
7%
6%
06/07/07
04/01/08
04/07/08
-4,000,000
5%
-6,000,000
4%
27/11/07
27/05/08
27/11/08
27/05/09
27/11/09
-8,000,000
21
For a systematic notional of $100m
02/01/09
03/07/09
Credit Suisse Derivatives Strategy
Disclaimer
Europe
Stanislas Bourgois CFA
Raymond Hing
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sveinn.palsson@credit-suisse.com
Credit Suisse Europe Equity Derivatives Sales

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+44 20 7888 4792
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http://www.cboe.com/LearnCenter/pdf/characteristicsandrisks.pdf
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22
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Credit Suisse - 2010 Vol Outlook

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Credit Suisse - 2010 Vol Outlook

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Derivatives Strategy

Stanislas Bourgois, CFA

2010 Equity Derivatives Outlook

Following the strong market performance in

Out of steam heading into 2010

Source: Credit Suisse Derivatives Strategy

Risk appetite fuelled by the weak dollar

Exhibit 3: Global 3M LIBOR rates

Source: Credit Suisse Derivatives Strategy

Risky Assets are no longer cheap

Source: Credit Suisse Derivatives Strategy

Exhibit 5: 5-year cumulative default rate

Exhibit 7: Equity-switch convertibles yield advantage

Source: Credit Suisse Derivatives Strategy

Source: Credit Suisse Prime Services

Source: Credit Suisse Research

The Delta outlook bullish or range-bound?

Exhibit 12: US banks holding of govt debt (%)

Source: Credit Suisse Research

In accordance with his macro scenario, Andrew Garthwaite is 5% overweight on equities,

Exhibit 14: Equities vs High Yield

Source: Credit Suisse Research

Stronger Eurozone and China

Source: Credit Suisse Research

The end of Phase 1 of recovery

Exhibit 19: US Retail Sales

Source: Credit Suisse Research

Will poor Equity risk reward continue in early 2010?

Can volatility tick higher in 2010?

Exhibit 21: SPX 6M Realised vol now vs 2002/2003

Source: Credit Suisse Derivatives Strategy

The end of Market stress as a driver of volatility

Exhibit 22: Ted spread + OIS diff

Source: Credit Suisse Research

Equity vol in 2010: slightly higher than currently?

Exhibit 24: Scenarios for Equity volatility in 2010

Source: Credit Suisse Derivatives Strategy

Implied volatility fairly priced

Source: Credit Suisse Research

Exhibit 26: SPX 6M implied volatility model

Exhibit 27: Scenarios for Equity volatility in 2010

Source: Credit Suisse Derivatives Strategy

Naked short volatility is a dangerous bet

Exhibit 29: Short 2Y Delta Hedged straddles in 2009

29/07/09 09/09/09 21/10/09 02/12/09

Source: Credit Suisse Derivatives Strategy

If anything, sell long term forward-starting variance

Source: Credit Suisse Derivatives Strategy

The Happy Few go Short Skew

Exhibit 32: Delta Hedged risk reversal in 2009

Source: Credit Suisse Derivatives Strategy

Investors are still underinvested or fully hedged

Exhibit 34: SX5E Dec09 put open interest

Source: Credit Suisse Derivatives Strategy

Sell skew to receive cheaper upside exposure

Exhibit 34: Payout of an SX5E

Long 90/105 Risky

Source: Credit Suisse Derivatives Strategy

Exhibit 35: Indicative risk reversal prices

Mar10 90/110 Jun10 90/110 Dec10 90/110

Mar10 90/105 Jun10 90/105 Dec10 90/105

Source: Credit Suisse Derivatives Strategy

Double Knock Out Call

Source: Credit Suisse Derivatives Strategy

Composite forward: payoff in payout currency: FXtIndext FX0Index0