Global Equity Derivatives & Delta One Strategy

07 December 2010

2011 Equity Derivatives Outlook

Global Derivatives Themes
Summary In this review we present our outlook for Global Equity Derivatives Markets. Our outlook includes analyses and forecasts for equity correlation, price and term structure of volatility, skew, and dividends. In 2011 we expect a medium level volatility regime similar to what we saw in 2010. Our base case forecast for S&P 500 realized volatility is 18%, with a most likely range of 15-20%. While asset prices propped by quantitative easing point to the low end of our forecast range, risks related to global monetary and fiscal policy developments point to the upper end of our range. Given the global nature of the derivatives market, we first outline our views on global equity volatility. In the subsequent sections, we present regionally focused analyses of the derivatives and volatility markets in the US, Europe, and Asia, as well as a global outlook for index dividends. In the last section of this report we list several trade ideas that incorporate our market and volatility views. These ideas range from directional to volatility arbitrage ideas and are implemented with equity derivative instruments.

Global Equity Derivatives and Delta One Strategy Marko KolanovicAC (Global Head)
(1-212) 272-1438 mkolanovic@jpmorgan.com

J.P. Morgan Securities LLC

Davide SilvestriniAC (EMEA)

(44-20) 7777-1018 Davide.Silvestrini@jpmorgan.com

J.P. Morgan Securities Ltd.

Tony SK LeeAC (Asia ex Japan)

(852) 2800-8857 tony.sk.lee@jpmorgan.com

J.P. Morgan Securities (Asia Pacific) Limited

Michiro NaitoAC (Japan)

(81-3) 6736-1352 michiro.naito@jpmorgan.com

J.P. Morgan Securities Japan Co., Ltd.

Global Equity Derivatives and Delta One Strategy US

Marko Kolanovic Adam Rudd Amyn Bharwani Kapil Dhingra Min Moon
mkolanovic@jpmorgan.com adam.ch.rudd@jpmorgan.com amyn.x.bharwani@jpmorgan.com kapil.dhingra@jpmorgan.com min.k.moon@jpmorgan.com

EMEA
Davide Silvestrini Bram Kaplan Trista Rose Peng Cheng
davide.silvestrini@jpmorgan.com bram.kaplan@jpmorgan.com trista.j.rose@jpmorgan.com peng.cheng@jpmorgan.com

Asia Ex-Japan
Tony Lee Clara Law Sue Lee
tony.sk.lee@jpmorgan.com clara.cs.law@jpmorgan.com sue.sj.lee@jpmorgan.com

Japan
Michiro Naito Hayato Ono
michiro.naito@jpmorgan.com hayato.ono@jpmorgan.com

See page 68 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. In the United States, this information is available only to persons who have received the proper option risk disclosure documents. Please contact your J.P. Morgan representative or visit http://www.optionsclearing.com/publications/risks/riskstoc.pdf

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Table of Contents
Equity Derivatives Outlook......................................................3
Equity Volatility in 2010 .............................................................................................3 2011 Volatility Outlook ...............................................................................................4 Volatility Targets by Region........................................................................................6

Americas Derivatives Market and Volatility ...........................8

Equity volatility in 2011 and beyond...........................................................................8 Term Structure and Skew...........................................................................................11 Correlation .................................................................................................................14 Performance of Systematic Strategies........................................................................15

European Derivatives Market and Volatility .........................18

2010 European Volatility Review..............................................................................18 Derivatives Market Risk Parameters..........................................................................19 2011 European Volatility Outlook.............................................................................22 Derivatives Strategies Update....................................................................................24 Trends in Derivatives Usage ......................................................................................29 Emerging Market Volatility .......................................................................................31

Asia Equity Market Volatility Outlook ...................................33

Market Outlook and Risk Factors ..............................................................................33 Volatility Regime and Equity Risk Premium.............................................................33 Realized Volatility Base Case Forecast .....................................................................35 Volatility Supply and Demand Dynamics..................................................................36 Skew and Term Structure...........................................................................................40 Correlation .................................................................................................................41

Global Dividends ....................................................................44

Nikkei dividends ........................................................................................................46 European dividends....................................................................................................47 Hang Seng / H-shares Index Dividend Futures..........................................................49

Trade Ideas for 2011...............................................................50

US: Sell (and partially hedge) S&P 500 Dec 2011 Variance.....................................50 US: Long Market through S&P 500 Risk Reversals (Sell Skew) ..............................52 US: Buy Calls on the Energy Sector..........................................................................54 Europe: Sell a knock-in put on the J.P.Morgan EMEA 2011 Top Picks Basket........55 Europe: Improve Call Overwriting with Range-bound Methodology .......................56 Emerging Markets: Turkey and Russia......................................................................58 Europe: Sell SX5E Dec-11 correlation on full index or on enhanced basket.............60 Asia: Short ASX 200 Correlation ..............................................................................62 Asia: Potential Weakening of JPY vs KRW Prefer Nikkei 225 over KOSPI 200 ..63 Asia: Cheap NIFTY Puts to Take Advantage of Cross-Asset Correlation.................64 Asia: Cheap Downside Protection Strategies in Index and Single Stocks .................65 Global: 2011 Year Ahead Thematic Baskets .............................................................66

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Equity Derivatives Outlook

Equity Volatility in 2010
In order to better understand market volatility in 2010, we point to some remarkably similar volatility patterns of the past (Figure 1 and Figure 2). Studying the anatomy of market crises can also help anticipate future patterns of volatility. Spikes in volatility similar to what we saw in 2008 and 2010 are likely to occur in 2011 as well. The cause of many crises is a disconnect between asset prices and their fundamental valuations. While the severity of each crisis is determined by the magnitude of this disconnect, the behavior of equity investors and resulting volatility patterns tend to be similar. A primary cause of the 2008 crisis (Figure 1) was a housing and credit bubble in the US. The first serious showing of the severity of the crisis was the collapse of Bear Stearns. Following the collapse, many market participants failed to recognize the magnitude of the problem or misconstrued a quick fix for a long-term solution. The 2008 crisis fully escalated six months later, resulting in multiple failures and a recession in the US and Europe. During this most acute phase, investors overreacted (i.e., projected a collapse of the global financial system and a great depression), sending asset prices sharply lower. Large US government stimulus and Fed interventions helped set a floor the collapse, while reduced asset prices and the stimulus set the stage for the growth cycle in 2009. As the markets rallied, propped by the removal of systemic risk and a return to growth, volatility plummeted. Several smaller aftershocks (e.g., Dubai, CIT bankruptcy) didnt notably change the declining volatility pattern.
Figure 1: 2008 Market Crisis
90%

Figure 2: 2010 (Smaller) Market Crisis

50%

EU Finances Greece

70%
Global GDP and Earnings

40%

Greece Aid Problem Resolved? Earnings, GDP

Quantitative Easing US Earnings (Q2, Q3) Ireland EU Govs and Banks?

VIX

50%

VIX

US Subprime Bear Stearns Collapse Contained?

Systemic Risk Removed CIT Dubai US Financial System? Global Depression? US ~$1T Stimulus QE, Bailouts

30%

30%

20%

Global Contagion? EU/IMF $1T Bailout Fund

10% Jan 08

Apr 08

Jun 08

Sep 08

Nov 08

Feb 09

Apr 09

Jul 09

Sep 09

Dec 09

10% Dec 09

Jan 10

Mar 10

Apr 10

May 10

Jul 10

Aug 10

Oct 10

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

Among the primary causes of the market crisis in 2010 (Figure 2) were the high debt levels and budget deficits of several European sovereigns. In an almost identical pattern to the 2008 crisis, Greeces issues were not fully acknowledged and only superficially resolved in January. Following the initial spike, volatility declined, propped by strong growth in the US and Asia. Following this brief phase of problem denial, the sovereign credit problem resurfaced, causing multiple shocks in volatility and the overreaction of market participants (i.e., projection of a collapse of the euro and global contagion). The ensuing EU and ECB interventions ($1T bailout fund), further easing by the Fed (QE2), and strong US corporate results set the stage for a market recovery and decline in volatility. The most recent volatility spike due to Irelands credit did not significantly impact S&P 500 volatility and appears only as an aftershock of the 2010 crisis at this junction. The 2008 global crisis was triggered by low-quality US mortgages. In 2008, US GDP dropped faster and bottomed before Europes. Fortunately for the markets, the quality of European sovereign debt was not in question at the peak of the 2008 crisis. During the 2008 crisis, Emerging Asia never entered recession and maintained positive growth through the crisis. The time lag between the US subprime and Europe sovereign crises, as well as positive growth in Emerging Asia, helped the financial system avoid the perfect storm that could have made the crises all the more severe. Currently, relatively strong
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

growth in the US and Asia is helping global markets weather the European sovereign crisis. Less than perfect synchronization between economic cycles, capital markets, and market regulations in different regions in this way helps to protect the global economy from major disasters. For instance, after recent crises in the US and Europe, should risks start emerging in Asia, the global economy may recover just enough to dampen its impact.

2011 Volatility Outlook

In this section we discuss our base case volatility forecast for the S&P 500. We base our forecast on J.P. Morgans 2011 projections for the overall economy, equities, and credit and also taking into account interest rate risk and ongoing concerns in Europe. In addition to the S&P 500 volatility forecast, we will forecast the volatility of major European and Asian indices. Finally, we outline the main risks for our base case. Volatility of the S&P 500 in 2011 will most likely be realized at the same or slightly lower level compared to 2010. Our forecast is that the average realized volatility of the S&P 500 in 2011 will be 18% with a most likely range of ~1520% (please see the end of this section for region-specific forecasts). While projected tightening of credit spreads and the anticipated appreciation of equities point to a lower level of volatility of ~15%, asset prices may have elevated volatility as a result of changes in monetary stimulus and interest rate volatility. Over the course of the year, we expect periods of equity volatility below our target range and volatility spikes above our target range. Volatility spikes are likely to occur due to the European sovereign crisis and potential exit from QE and are less likely due to weak growth or inflation. Economic DataBased Forecast Evidence continues to build that the global economy is regaining momentum. Global economies are expected to grow at a ~2.7% rate in Q3 and Q4. In 2011 the global economy is expected to grow at a rate of 3.3%. This increase in growth rate should benefit equity markets and put downward pressure on market volatility. The highest growth is expected in the Asia ex-Japan region at ~7.6%. The US is expected to grow 3% in 2011 (growth is expected to be 2.6% in 2010), the Euro area 1.6%, and Japan 1.45%. J.P. Morgan economists expect US GDP to grow at an annualized pace of 2%, 3%, 3%, and 4% in each of the consecutive quarters of 2011, respectively. Based on the historical relationship between US GDP and volatility, market volatility has averaged ~15% in a 3% growth environment (the volatility range was 10-20%). Given that we had 18% volatility with 2.6% growth in 2010, the expected increase in GDP should be a positive and would point to an average realized volatility at the end of 2011 of ~17%. The current high unemployment rate is likely a structural problem. Unemployment and a weak consumer segment will be a source of downside risk for equities, and hence an upside risk for volatility. US unemployment is expected to peak in Q1 2011 and decline to 9.5% by the end of 2011. While the slight decline in unemployment should benefit markets, these levels of unemployment were historically associated with higher levels of volatility (~20%). A projected marginal decline in unemployment would not have a meaningful effect. We think that the unchanged unemployment outlook translates into unchanged end of 2011 volatility of ~18%. Equity-Based Forecast The J.P. Morgan outlook for global equities in 2011 is positive. Positive developments in global economies are expected to lift equity indices from the current levels by approximately ~15% in the US, ~15% in Europe, and ~25% in emerging market economies. Our strategists see multiple reasons to remain constructive on equities, ranging from US post-election dynamics, quantitative easing, economic momentum, and M&A activity. A significant part of any volatility forecast is related to the directional view on equities. The historical regression of annual market returns against the subsequent change in realized volatility suggests that a projected ~15% increase in equities would lead to a ~2% drop in volatility. Given the current level of realized volatility of 18%, this would point to an average realized volatility at the end of 2011 of ~16%. Credit-Based Forecast In our equity volatility forecast we also refer to J.P. Morgan Strategy outlooks for HG and HY credit spreads. The CDX Investment Grade (IG) Index began 2010 at ~80bps and is now at ~95bps. The J.P. Morgan High Grade Credit Strategists maintain an overweight recommendation for HG credit, with a 70bp 2011 year-end target for the CDX IG Index. The strategists believe that spreads are likely to continue to tighten due to both the rise in sentiment and equity markets and the
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

reduction in available fixed Income product supply. The midterm elections are also positive for HG credit as the large banking, energy, and healthcare sectors, which have been under significant regulatory scrutiny, could see some relief. In addition, credit fundamentals such as record high cash balances, profit margins, and free cash flow support lower spreads. Based on the historical relationship between HG credit and equity volatility, when the spread was 70bp, volatility averaged ~17%. However, a drop of 27bps in HG spread suggests a significant drop in equity volatility (~5%). Given the current level of 6M realized volatility of 18%, we assess that both level and projected changes of high grade spreads point to S&P 500 realized volatility at the end of 2011 of ~15%. We repeated a similar analysis for HY credit spreads based on J.P. Morgan HY credit 2011 forecasts. The 2011 target for CDX HY index is 390bps, which is 140bps below the current level. Based on the historical relationship of volatility to HY spreads, the projected level of 390bps would point to a ~15% realized volatility level. A 140bps tightening from current spread levels would suggest a drop in equity volatility of ~5% from current levels. We think that such a decline of equity volatility is not realistic and perhaps reflects a dislocation between the current levels of equity volatility and HY spreads. Interest RateBased Forecast Interest rate volatility is highly correlated with equity volatility.1 Currently, the volatility of the 10-year rate appears higher than equity volatility (based on the regression of the past 30 years). The historical relationship between the two would imply S&P 500 volatility of ~20% (versus the current level of 18%). This discrepancy wasnt of much concern for us over the past year as there was no inflationary pressure and quantitative easing kept rates low. However, we think that potential interest rate volatility could put some upward pressure on equity volatility in 2011. There are essentially two scenarios in which interest rate changes can negatively affect equities and thus cause higher volatility. The main risk is the Fed removing monetary stimulus from the system, which would cause intermediate rates to rise. During this Fed exit scenario, equity volatility would be elevated due to the potential reduction of risky asset holdings (e.g., unwind of carry trades) and increased borrow cost for companies and consumers. As the Fed exit is more likely to happen in a growth scenario, we think that it would not cause a very large increase of equity volatility. The other interest raterelated risk is inflation, which could cause an increase of longer rates and introduce uncertainty for companies and increase equity volatility. Non-US Risks Forecasting S&P 500 volatility based solely on US economic, equity, and fixed income projections is incomplete as it overlooks possible volatility shocks outside the US. In particular, we believe that an ongoing European sovereign debt crisis will continue to add to S&P 500 volatility (e.g., Spain, Portugal). The transfer of volatility from Europe to the US is realized via the strong correlation of global equity indices and via perceived risk of a spillover. While we believe that the crisis will stay contained to the periphery of the region, and eventually be resolved by EU policy makers, we estimate its impact to add ~100bps of volatility to the S&P 500 in 2011. We also recognize potential risk from inflation and asset volatility in China, though we perceive this as a smaller risk. Gradual monetary policy tightening in 2011 would not significantly impact the growth in emerging Asia, in our view. Our S&P 500 volatility targeta weighted average of individual forecastsfor 2011 realized volatility is 18%, with a most likely volatility range of 15-20%. Figure 3 shows each of the factors influencing our forecast. While asset prices propped by quantitative easing point to the low end of our forecast range, risks related to global monetary and fiscal policy developments point to the upper end of our range.

For instance, levels of volatility of the 10-year Treasury rate and S&P 500 volatility had a 70% correlation over the past 30 years. Returns of volatility had a 25% correlation to returns of the 10-year rate.
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 3: Forecast of S&P 500 Volatility Asset 2010 2011 S&P Volatility HG Credit 97 70 15% HY Credit 530 390 15% S&P 500 1180 1375 16% GDP 2.6% 3.0% 17% Unemployment 9.6% 9.5% 18% Interest Rates -+1% 19% Non-US Risks +1% +1% +1% S&P Volatility 18%
Source: J.P. Morgan Equity Derivatives Strategy.

Risks to Our Base Case The risks to our base case forecast are skewed to the upside, in our view. These risks are related to economic growth and associated changes in interest rates: Should the economy start growing steadily, a removal of monetary stimulus and related interest rate volatility could lead to medium-sized but short-lived volatility spikes. The risk is that policy changes cause multiple interest rate and asset price shocks and 2011 S&P 500 volatility ends in a 20-25% range. Should growth start weakening and the central banks policies fail to reverse the trend, we may see a period of low growth and higher inflationstagflation. Stagflation would negatively affect equities and would cause a significant increase of equity volatility. Depending on the severity of the condition, S&P 500 volatility would likely end up in a 20-30% range. The most extreme and the least likely risk is a full-blown double-dip recession. The ensuing unemployment, falling housing prices and consumption levels, and disappointing corporate earnings would likely send S&P 500 realized volatility to a 30-40% range. Outside the US, we see the European sovereign debt crisis as a main source of upside volatility risk. Concerns about the solvency of peripheral European sovereigns appeared to be most acute before the bailout of Greece. However, the recent arrangement for Ireland has drawn attention back to the solvency and liquidity of European sovereigns. The markets focus is now set to move to Portugal and Spain. We accounted for some of this risk by increasing our largely US-driven volatility forecast. However, our assumption was that this crisis will stay contained within Europe and perhaps within its periphery. Should the crisis spill over, it could potentially trigger a global crisis sending S&P 500 volatility above our target range. Although hard to predict, escalations of geopolitical risk can put further upward pressure on volatility. A breakdown in global policy coordination, trade restrictions (e.g., terms of trade between US and China), and currency crises (currency manipulations, dollar crisis) can all increase equity volatility. On a more extreme end, there is a risk of conflicts between the two Koreas as well as a Middle East crisis involving Iran and Gulf oil shipments.

Volatility Targets by Region

Global equity derivatives markets largely revolve around the ~$5 trillion listed index option market.2 About 90% of index option markets consist of options on only the six most active indices: S&P 500, Euro STOXX 50, DAX, FTSE 100, Nikkei 225, and KOSPI 200. The S&P 500 listed option market represents ~40%, the European Indices are ~50%, and Asian indices are about 10% of the global index volatility market (Figure 4). Before we proceed to formulate our 2011 volatility view for these indices, it is perhaps instructive to put the current volatility levels in a historical context. Current levels of implied volatility of western indices (US and Europe) are elevated (in ~70th percentile relative to 10 year history). Over the past quarter, short-term realized volatility dropped from high (~70th percentile) to below-average levels (~40th percentile),

2 This does not include delta one derivatives, single stock derivatives, or structured products. For a more comprehensive overview of the listed equity derivatives market see our Global Liquidity Markets Volumes report.

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

which caused volatility carry to widen to 10-year highs (~100th percentile). This high level of volatility premium will be the basis for some of our short volatility recommendations for 2011. The volatility of equity indices in Asia is lower. For instance, the KOSPI 200 realized volatility is at its lowest point in 10 years and slightly lower than the volatility of the S&P 500. While this may be viewed as a historical dislocation, it can also be viewed as a convergence of volatilities due to the increased globalization of risk. Figure 5 shows the level of implied volatility for these six indices over the past 10 years. We note how the difference between the most volatile and the least volatile index dropped from 15 volatility points to only 5 volatility points over the past decade.
Figure 4: Global Listed Index Option Market Figure 5: Implied Volatility of Global Indices Over the Past 10 Years
65%

Notional OI of Listed Options in $Bn US EMEA Asia SPX 242 1,946 SX5E 1,776 NKY RUY 114 DAX 397 KOSPI2 233 NDX 105 UKX 304 HSI 56 MNX 16 SMI 50 HSCEI 23 OEX 9 CAC 37 AS51 23
Source: J.P. Morgan Equity Derivatives Strategy.

55%

45%

Volatility Implied 6M %-tile Rank Realized 3M %-tile Rank Carry 6M-3M %-tile Rank

SPX 22.7% 67% 14% 42% 8.7% 99%

SX5E 27.5% 78% 18% 39% 9.9% 100%

DAX 24.1% 62% 15% 24% 9.4% 100%

UKX 23.4% 75% 14% 44% 9.2% 100%

NKY KOSPI2 22.6% 21.0% 47% 30% 18% 13% 26% 4% 4.5% 7.9% 87% 99%

35%

25%

15%

S&P 500

EuroStoxx FTSE KOSPI2 Jul 09 Aug 10

Implied Volatility
5% Nov 00 Dec 01 Jan 03 Feb 04 Mar 05 Apr 06 May 07

DAX Nikkei Jun 08

Source: J.P. Morgan Equity Derivatives Strategy.

Volatility Targets by Region Our base case volatility forecast was formulated in terms of realized S&P 500 volatility. Regional equity benchmarks can have higher or lower volatility compared to the S&P 500. The volatility of a regional equity index typically depends on the index composition, Emerging/Developed market designation, and region-specific fundamentals. Europe: We expect that the Euro STOXX 50 average realized volatility in 2011 will be in an 18-24% range, with a most likely level of 21.5%. Our base case forecast puts realized volatility for the Euro STOXX 50 3.5 points above our forecast for the S&P 500, a spread slightly higher than the long-term average of 2 volatility points. Our forecast for FTSE 100 average realized volatility is identical to our forecast for the S&P 500, with a 15-20% range and most likely level of 18%. Asia ex-Japan: We expect the volatility in the region to remain similar to or slightly higher than the current level. Our base case realized volatility forecasts for 1H 2011 are 14.9% for the ASX 200 (vs. current level of 15.8%), 17.3% for the Hang Seng (vs. current level of 16.1%), and 16.1% for the KOSPI 200 (vs. current level of 14.4%). While a bullish outlook for equity markets and solid economic growth expectations impose downward pressure on the volatility forecasts, risk of interest rate hikes, the ongoing development of the Eurozone sovereign debt crisis, and the normal relationship of the Asian indices and S&P 500 supports the volatility forecasts. Japan: The correlation between the Nikkei 225 and S&P 500 volatility was ~50% over the last eight years. As such, we believe that the Nikkei 225 volatility in 2011 will likely follow the trend outlined for the S&P 500. Historically, the Nikkei 225 displayed higher volatility than the S&P 500 (e.g., the average 6M Nikkei 225 realized volatility over the last eight years was ~4 points higher than for the S&P 500). We expect the Nikkei 225 volatility to come only ~2 points above that of S&P 500 (this was the case in 2005 when the Nikkei 225 spot outperformed S&P 500). Accordingly, we expect the year-end volatility for the Nikkei 225 to be around 19.5%.

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Americas Derivatives Market and Volatility

2010 Review from the perspective of a short volatility trade A short S&P Dec 10 variance position entered on December 3, 2009, would have initially benefited from the low realized volatility from December to April. The European sovereign and banks credit crisis during May-June pushed Dec 10 implied variance levels back up to around 40. This peak for implied variance (and the trough mark-to-market loss for a short Dec 10 variance position of around 4 vegas) occurred just after the May 8-9 weekend when the EU / IMF $1 trillion loan package was announced. This provides an indication of the challenging experience of holding a short volatility position during 2010. Efforts by the Fed to reinflate the economy through its Quantitative Easing 2 announcement of an additional $600bn of asset purchases through June 2011, made on November 3, led to a rally in equities and commodities and a further decline in implied volatility. Furthermore, realized volatility since December 3 has remained below 20. Consequently, the profit earned through holding a short Dec 10 variance position over the full period would have recovered to exceed its mark-tomarket highs of late April and appears likely to result in a profit of around 8 vegas (Figure 6).

Equity volatility in 2011 and beyond

Short term, bullish. Consensus is looking for around $94 EPS for the S&P 500 in 2011, suggesting 10% earnings growth compared to 2010. This provides a positive backdrop for equities and for equity volatility. Historically, there has been a strong relationship between S&P earnings growth and S&P realized volatility. After the ~30% year-on-year earnings decline suffered at the peak of the credit crisis, earnings have rebounded very strongly this year, growing around 35% year-on-year. The expectation of positive earnings growth leading into 2010 pre-empted the decline in realized volatility that has subsequently occurred. The expectation for continued positive earnings growth of around 10% this year suggests that equity volatility could be expected to fall significantly below recent realized levels (Figure 7). However, this may be in contrast to medium-term prospects for earnings and volatility discussed below.
Figure 6: The performance of a short Dec 10 variance position (daily mark-to-market incorporating changes in Dec 10 implied variance levels and accrued realized volatility)
Dec 10 implied variance / Realised vol since Dec 3 Dec-10 implied v ariance (left) 45% Realised v ol since 03-Dec-09 (left) 40% p/l (right) profit / loss (vegas)

Figure 7: S&P 500 realized volatility has historically shown a strong relationship to S&P 500 earnings growth. Expectations for 10% earnings growth in 2011 point to a decline in realized volatility this year.
S&P 500 12-month realized volatility (inv) year-on-year earnings growth

10% 8% 6% 4% 2% 0% -2% -4% -6%

35% 30% 25% 20% 15% 10% 5% 0% Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Source: J.P. Morgan Equity Derivatives Strategy, 2010.

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Dec-95 Dec-98

12M realised v olatility 12M Earnings Grow th

-40% -30% -20% -10% 0% 10% 20% 30% 40%

Dec-01

Dec-04

Dec-07

Dec-10

Source: J.P. Morgan Equity Derivatives Strategy, Thomson Financials, data to September 2010

Medium term, risks remain. Household (HH) and Non-Financial Corporate (NFC) Debt as a percentage of US GDP have started to decline but nonetheless remain at elevated levels. As we have highlighted previously (see Equity Derivatives 2009 Outlook) US household and company leverage has been steadily increasing for more than 50 years. HH and NFC debt now stand at 93% and 76% of GDP, respectively. Corporate debt levels do not appear to be too extreme compared to historical levels, but household debt increased substantially from 2001 to 2008. At these levels of debt, the ability of the US consumer to drive earnings growth may fail for the first time in recent history (Figure 8).
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Longer term, deleveraging could lead to lower volatility in 2012-2014. Continued deleveraging could lead to a lower level of realized volatility in the future. For instance, the start of deleveraging in 1987 set the stage for low volatility in 1993-1995, and deleveraging in 2000 for low volatility in 2004-2006. Given an approximately 4-year lag from the start of deleveraging, we may expect lower volatility in 2012-2014 (Figure 9).
Figure 8: Household and Non-Financial Corporate Debt as a % of GDP has begun to fall, although they remain at elevated levels
Total debt for Households (HH) and Non-Financial Corporates (NFC) as % of GDP

Figure 9: Historically, falling leverage has been associated with lower subsequent realized S&P 500 volatility
SPX realized volatility 3Y change in non-financial corporate leverage

175% 150% 125% 100% 75% 50% 25% 1980 1985

HH and NFC/GDP HH/GDP NFC/GDP

60% 50% 40% 30% 20% 10% 0%

SPX 6M realised v olatility (left) 3Y Change in lev erage NFC (right)

30% 25% 20% 15% 10% 5% 0% -5% -10%

1990

1995

2000

2005

2010

1980

1986

1992

1998

2004

2010

Source: J.P. Morgan Equity Derivatives Strategy, Thomson Financials, data to September 2010.

Source: J.P. Morgan Equity Derivatives Strategy, Thomson Financials, data to September 2010

The Feds actions are an attempt to smooth the impact of the otherwise inevitable deleveraging that would be taking place. Its objective is to increase incentives to invest and help to build the confidence of companies and individuals. The Fed has introduced unconventional measures to achieve this, but thus far the actions have served to maintain actual inflation as well as inflation expectations in a relatively tight range, with the latest J.P. Morgan Inflation survey suggesting reduced likelihood of either hyperinflation or deflation (see J.P. Morgan Inflation Expectations Survey: November 2010, Jorge Garayo). After the decline in volatility over the last two years, implied levels have fallen back to around the midpoint of their historical range of the last 10 years. Shorter dated realized volatility is now falling below current implied volatility levels for all maturities out to two years, and longer dated implied volatility is still above even the maximum realized volatility for all maturities greater than five years (Figure 10). Realized volatility of different sectors in 2010: Financials and Energy stocks have been key drivers of S&P 500 index volatility throughout the last three years. In Figure 11 we show the relative contribution of key sectors on overall S&P 500 index 1-month realized volatility over the last 10 years by comparing the index volatility assuming current sector weights to what the hypothetical realized volatility would have been if a particular sector had a zero weighting and all other sector weightings were increased proportionately. This provides an indication of which sectors have been most important for driving S&P 500 index realized volatility or those that have had a dampening influence. Consumer Staples and Healthcare stocks have unsurprisingly reduced overall index volatility. A little more surprisingly perhaps, Technology stocks have actually slightly dampened S&P 500 realized volatility over the last three years as the overall sector has exhibited a beta to the S&P 500 of less than one a far cry from the substantial excess volatility that the sector delivered in 2000-2002 (Figure 11).

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 10: S&P 500 ATM implied and realized volatility cones

Figure 11: Financials and Energy stocks have been key drivers of S&P 500 volatility. Consumer Staples, Health Care, and even Technology have reduced index volatility.
Relative contribution of sectors on overall S&P 500 index 1-month realized volatility

S&P 500 ATM implied / realized volatility

80% 70% 60% 50% 40% 30% 20% 10% 0% 0 1 2 3 4 5

Max / Min Realised Recent realised Max / Min Implied Current implied

10% 8% 6% 4% 2% 0% -2% -4% -6%

S5FINL Index S5HLTH Index Tech

S5ENRS Index S5CONS Index Energy

S5INFT Index S5COND Index Financials

10

Consumer Staples

Healthcare

Maturity (years)
Source: J.P. Morgan Equity Derivatives Strategy.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: J.P. Morgan Equity Derivatives Strategy.

Earnings visibility is especially limited for financials stocks due to changing regulations, interest rate volatility, continued household deleveraging, and a housing market that is yet to recover. In this environment, the risks of higher volatility do appear relatively acute for the financials sector. Financials stocks could continue to deliver excess volatility and exhibit a relatively high beta for some time. Longer term we would expect the financials sector volatility to decline to historical implied levels once banks are fully capitalized under a steady regulatory regime. The stabilization of interest rates or a potential housing market recovery could accelerate such a return to a regime of lower excess volatility from financials. The excess volatility contributed by different sectors may help to explain the relatively high current volatility spread between the Russell 2000 (RTY) and the S&P 500 since the RTY has a considerably larger weighting to Financials (~20% compared to the S&P ~14%) and a substantially smaller weighting to Consumer Staples (~4% compared to the S&P ~12%). It may also help to explain the low recent realized volatility spread between the Nasdaq 100 (NDX) and the S&P 500 since the Technology sector (~65% weighting in NDX compared to ~19% in the S&P) has exhibited a beta of less than one to the S&P 500 index over the last 2-3 years and the NDX has no exposure to highly volatile Financials (~14%) or Energy (~12% weighting of the S&P). We would expect the RTY-S&P 500 spread to decline closer to historical average (~5%) levels if the Financials stocks were to become less volatile (Figure 12). Latin America volatility has converged with S&P index volatility (Figure 12). This is likely due to the strong relative performance of Emerging Markets and in particular Latin America the S&P Latin America 40 index has outperformed the S&P 500 by a compound 18% per annum for the last five years. Given the convergence of Latin America / US volatility and our Emerging Markets equity strategists positive view on Latin America in 2011, investors may wish to exploit the current relatively low implied volatility spread by buying calls on the S&P Latin America 40 index, funded by selling calls on the S&P 500. This trade would have historically performed well, and current volatility levels offer an attractive entry-point, in our view (Figure 13).

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 12: The Russell 2000, with a relatively high exposure to Financials, has exhibited higher volatility relative to the S&P 500. By contrast, Latin America volatility has converged toward S&P index volatility.
6-month realized volatility spread to S&P 500

Figure 13: Long 6-month calls on Latin America 40, short 6-month calls on S&P 500 would have historically performed well. The recent convergence of implied volatility levels provides relatively attractive entry point for this trade in our view.
Hypothetical payoff of 6-month call switch, current indicative cost (% of notional)

50% 40% 30% 20% 10% 0% Nov-02 -10% Nov-04 Nov-06 Nov-08 Nov-10
Nasdaq Russell LatAm Canada

70% 60% 50% 40% 30% 20% 10% 0% -10% Dec-02 Apr-04 Aug-05 Jan-07 May-08 Oct-09 Historical payoff Current indicative net cost

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy. Past performance is not indicative of future results.

Term Structure and Skew

In our H2 2010 Outlook we discussed the potential impact of derivatives regulation on long-term volatility and the increased cost of protection resulting from concerns about proprietary trading restrictions, segregation of derivatives trading units, and forcing some OTC derivatives onto exchanges. The uncertainty surrounding the actual implementation caused long-term implied volatility and skew to rise to extreme levels, but some hedge funds and overseas pension funds recognized the opportunity to lock in these elevated levels and have benefited as implied volatility and skew has declined somewhat since May. The term structure has now returned to similar levels to those seen last year although it is slightly steeper at the 1Mto-9M maturities (Figure 14). Indeed, the S&P 500 term structure has been at its all-time steepest in early November, as measured by 12-month minus 3-month implied variance, and remains close to its steepest levels (Figure 15). The current steepness of the term structure is higher than what might generally be expected given the current levels of implied volatility (Figure 16).

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 14: The term structure has returned to similar levels compared to last year after initially falling through mid-April and then inverted in May. However, the term structure has now steepened at the 1-month to 9-month maturities.
S&P 500 ATM implied volatility

Figure 15: The S&P 500 implied volatility term structure remains close to its steepest levels. We look for strategies that exploit the slide down of the steep part of the term structure.
S&P 500 12-month minus 3-month implied variance

40% 35% 30% 25% 20% 15% 10% 0 2 4 6 8 10 12 14 16

1-Dec-10 20-May -10 15-Apr-10 1-Jan-10

10% 5% 0% -5% -10% -15% -20%

18

20 22

24

Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-10

Source: J.P. Morgan Equity Derivatives Strategy.

Maturity (months)
Source: J.P. Morgan Equity Derivatives Strategy.

Consequently, we look for strategies that exploit the slide down the steep part of the term structure by selling outright spot variance for maturities from 1-month to 12-month maturities. Conversely, for investors who have long volatility positions, we recommend avoiding this part of the curve, where practicable. For example, the steepest part of the term structure can be avoided by buying forward-starting variance, such as 6-month variance starting in 12-months time, which would suffer minimal slide given the relatively flat shape of the term structure at these points on the curve. Forward-starting variance has historically provided a relatively low-cost protection that does tend to perform in the case of large, long-lasting spikes in implied volatility that are typically associated with protracted equity market corrections. There remains evidence of enduring risk aversion and continued demand for longer-dated skew and convexity. In volatilityadjusted terms, the premium of implied variance to ATM implied volatility is close to its highest level over the last five years for all maturities greater than 9 months (Figure 17). In our view, this presents an opportunity for short volatility investors. The extreme steepness of the ATM implied volatility term structure from 1-month to 12-month maturities as well as the monotonically increasing richness of variance to ATM implied volatility for these same maturities mean that investors entering a short 1-year variance position should benefit from both the slide down the term structure as well as the declining premium of implied variance to ATM implied volatility as time elapses. Furthermore, the one-year maturity allows investors to express a view on the likely realized volatility over the full year rather than depending heavily on judicious market timing for a shorter dated volatility position. Therefore, the one-year maturity for such a variance position represents the sweet spot" for maximum value in a short volatility position, in our view.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 16: The term structure is steep relative to current level of volatility
S&P 500 12-month minus 3-month implied variance

Figure 17: The premium of implied variance to ATM implied volatility is at extreme levels for all maturities > 9 months
S&P 500 Implied variance, ATM volatility (Var-ATM)/ATM percentile

6% 3% 0% -3% -6% -9% -12% -15% -18% 20% 2008 2009 2010 Current 25% 30%

y = -2.7148x + 1.4236x - 0.1685 R = 0.6297

2

34% 32% 30% 28% 26% 24% 22% 20% 18% Var ATM Vol Spread Percentile 0 6 12 18 24 30 36

100% 90% 80% 70% 60% 50%

35%

40%

45%

50%

55%

S&P 500 12-month implied variance

Source: J.P. Morgan Equity Derivatives Strategy. Source: J.P. Morgan Equity Derivatives Strategy.

Maturity (months)

The S&P 500 fixed strike skew surface is ending the year at similar levels to those seen at the beginning of the year. S&P fixed strike skew has remained relatively steady during 2010, with the exception of the May-June correction. Implied volatility for options with a strike in the 1300-1500 range has fallen slightly compared to the levels at the beginning of the year, while the implied volatility of options in the 800-1100 range has increased slightly. Over the year, fixed strike volatility levels fell gradually through to mid-April before spiking during the May-June correction and then subsided to the current levels (Figure 18). The difference between downside skew and upside skew (i.e., convexity) has compressed across regions. Another sign of risk aversion is the elevated cost of deep out-of-the-money options. The convexity premium of Asian and European indices has compressed relative to the US, and this favors buying the wings in the KOSPI, Nikkei, and Euro STOXX 50 versus selling the S&P wings in our view. As we argue above, the S&P implied variance looks rich relative to ATM implied volatility levels (Figure 19).
Figure 18: S&P 500 fixed strike skew has remained relatively steady during 2010, with the exception of the May-June correction when volatility spiked before subsequently reverting to early 2010 levels
S&P 500 3-month Implied volatility

Figure 19: The premium of downside skew to upside skew in Asia and Europe has compressed relative to that in the US
1-year downside skew minus upside skew

60% 50% 40% 30% 20% 10% 0% 700 900 1100

25-Nov -10 20-May -10 15-Apr-10 1-Jan-10 Historical ATM implied lev els

8% 7% 6% 5% 4% 3% 2% 1% 0%

SX5E DAX NKY KOSPI2 SPX

1300

1500

1700

Nov-07

May-08 Nov-08 May-09 Nov-09 May-10 Nov-10

Fixed strike (S&P 500 index level)

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Correlation
Correlation remains at elevated levels. We recommend exploiting what we view as expensive implied correlation through short index volatility trades and short correlation positions. 1-year implied correlation on the S&P Top 50 is around 60%. Recent 1-year realized correlation is around 50% (~90th percentile compared to the last 10 years of historical data). Furthermore, 1-year realized correlation has only very briefly exceeded the current level of implied correlation (briefly rising above 60% and peaking at 61.7% in January 2009). Recent S&P 6-month realized volatility is 17%, around the ~50th percentile compared to the last 10 years of historical S&P volatility. Our US High Grade Credit Strategists argue that credit fundamentals, including record high cash balances, profit margins, and free cash flow, as well as strong bank capital positions, support lower credit spreads (see High Grade Bond and CDS 2011 Outlook, Eric Beinstein, November 26, 2010). These dynamics are already largely reflected by single stock volatility, which is close to the low end of its historical range with 3-month realized volatility at only 21% (Figure 20). Implied correlation remains at a premium to recent realized correlation. Do concerns about the macro environment justify the elevated implied correlation levels, or are companies going to become less healthy than they currently appear to be, causing an increase in single stock volatility? In our view, index implied volatility is relatively expensive. We expect realized correlation in 2011 to be lower than current 1-year implied correlation of around ~62%. For index volatility to increase from current levels would likely require an increase in single stock realized volatility. Therefore, we recommend buying protection at the single stock level or at the sector level for those sectors where implied correlation is relatively cheap (please see our trade recommendation on page 50, where we identify cheap single stock implied volatility, which could be bought as a hedge for a short index variance position). Figure 20 shows index volatility, correlation, and average stock volatility since 1996, illustrating the relatively high level of correlation and the relatively low levels of stock volatility. Motivated by this observation, we analyzed correlation and stock volatility scenarios and the implications for realized index volatility in 2011. Figure 21 illustrates the historical and potential future changes in realized volatility. On the horizontal axis we show historical percentiles (past 10 years) for correlation and on the vertical axis historical percentiles for average stock volatility. The color coding shows hypothetical changes in the current level of S&P 500 realized volatility (from the current level of 17%) coming from the potential changes in correlation and average stock volatility. The chart shows 1-year index realized volatility for different years, positioned according to the realized correlation and single stock volatility, starting with 2005 (10.5% realized volatility), 2006 (10% realized volatility), 2007 (18%), 2008 (40%), 2009 (28%), 2010 year-to-date (17%), and over the last six months (13.5%). The arrows show the increasing realized volatility from 2005/6 to 2008, the subsequent decline through 2009, 2010, and the last six months. Finally, we show possible outcomes in 2011 if single stock volatility and correlation were to move back toward the historical trendline, volatility would stay in the 1520% range.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 20: Average single stock realized volatility is close to the low end of it historical range, while index realized correlation remains at elevated levels.
S&P 500 Index / Average single stock realized volatility, realised correlation

Figure 21: Scenario Analysis for S&P 500 realized volatility in 2011

Correlation
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
10 0% -10% -8% -8% -7% -7% -7% -6% -5% -5% -3% -2% 10.5 10% -10% -7% -7% -6% -6% -5% -4% -4% -4% -2% 0%

70% 60% 50% 40% 30% 20% 10% 0% 1997 2000

Index Realised Volatility Average Single Stock Volatility Realised Correlation

Last 3M

SS Volatility

20% -9% -7% -6% -6% -6% -5% -4% -4% -3% -2% 0% 13.5 30% -9% -7% -6% -6% -5% -5% -4% -3% -3% -1% 1% 40% -8% -5% -5% -4% -4% -3% -2% -1% -1% 1%

2010 YTD 2003 2006 2009

50% -7% -4% -3% -3% -2% -1% 0% 1% 1% 3% 6% 18 60% -6% -2% -1% -1% 0% 1% 2% 3% 4% 6% 9% 28 70% -4% 0% 1% 2% 2% 3% 5% 6% 7% 10% 13% 80% -2% 3% 4% 5% 5% 6% 9% 10% 10% 13% 17% 90% 1% 7% 9% 9% 10% 11% 14% 15% 16% 20% 25%
40 100% 10% 18% 20% 21% 23% 25% 29% 30% 32% 37% 44%

17

3%

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

Performance of Systematic Strategies

2010 year was a year of opportunities for systematic volatility strategies. Strong returns came at a price of significant volatility during the May to July time period. In our view, 2011 will provide similarly attractive opportunities for short volatility positions. A short S&P Dec 10 variance position would have generated a profit of around 8 vegas over the last year (Figure 6 on page 8). A short Jun 10Dec 10 forward-starting variance position would have performed even better, due to the slightly higher strike sold and the lower realized volatility of about 17% over the last six months. In addition, during the course of 2010, investors could have achieved entry points for short correlation and short skew positions at their highest ever levels. Investors can sell S&P 500 correlation through volatility swap dispersion, through delta hedged options in a volatility dispersion trade, or through unhedged options in a payoff dispersion trade. A package of short Dec 10 S&P index straddle combined with long Dec 10 straddles on each of the Top 50 members of the index would have produced a positive payoff by the end of this year after suffering mark-to-market losses in May-September. Figure 22 shows the mark-to-market profit / loss progression of such a trade where we assume that each straddle is struck ATM on the first trading day of the year and delta hedged at the close every day. We assume correlation weighting, where the total notional of single stock exposure is approximately 60% of the index exposure. For comparison purposes, we also show the performance of a short S&P Dec 10 variance position over the same time frame. The short correlation position would have generated about half the return of the short variance position but suffered a similar drawdown to the short variance in May-June. The reason is the relatively high level of realized correlation versus low realized single stock volatility. Furthermore, implied correlation spiked to levels that had never been observed before, while index implied variance didn't spike as much, again because of relatively low stock volatility. For investors who are able to implement such a strategy and agree with our view that realized correlation is likely to fall further in 2011, we believe that the timing for entering such a position is currently favorable. Alternatively, investors who do not wish to trade correlation directly can still take advantage of the elevated implied correlation levels indirectly by maintaining a general bias to sell index volatility (for example selling index puts to receive premium and potentially achieve a lower effective entry point for a long equity position, or selling index calls as an overlay to existing long equity positions

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Global Equity Derivatives & Delta One Strategy 07 December 2010

to enhance income) and to buy single stock volatility (for example selectively choosing individual stocks on which to buy put protection or on which to gain upside leverage through calls).
Figure 22: A short variance position would have outperformed a short correlation position in 2010 due to high realized correlation occurring at the same time as relatively low stock realized volatility
Profit / loss from short S&P 500 Dec 10 correlation via delta-hedged straddles (vegas), Profit / loss from short S&P 500 Dec 10 variance (vegas)

Figure 23: Covered calls and put spread collars would have outperformed an outright long S&P 500 equity position in 2010
Return in each calendar year

8% 6% 4% 2% 0% -2% -4% -6% -8% -10% Jan-10

Short S&P Dec10 Top 50 correlation (0.6 : 1 notional) Short S&P Dec10 Variance

40% 30% 20% 10% 0% -10% -20% -30% -40%

95 Put 95 / 100 / 105 PS Collar Short 105 Call S&P 500

Mar-10

May-10

Jul-10

Sep-10

Nov-10

2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

A systematic 1-month call overwriting strategy would have slightly outperformed an outright long S&P equity position this year as it has done each of the last five years. Put spread collars would have further improved performance (Figure 19). Below we review the performance of systematic protection strategies in more detail. Option-based protection strategies are most commonly long volatility. As we outlined previously (see Volatility, Correlation, Skew, and Term Structure sections), the current market environment is such that volatility is trading at a premium to fair value, skew is expensive, and the implied volatility term structure is upward sloping. Hence, we prefer strategies that are volatility neutral and short skew. In Figure 24 below we compare the performance of four hedging strategies. In the protective put strategy, an investor buys a 3-month put struck at 95% of the spot level of the index (3M 95% put) on a rolling basis i.e., the puts are rolled every 3 months, at expiry. By doing so, the investor is long index volatility, which usually trades at a premium. This strategy had an information ratio of 0.18 over the past ~14 years. The information ratio of this strategy was slightly less than that of the S&P 500. Hence, buying puts decreased risk by ~5% but also decreased returns in higher proportion. The average cost of the puts over this time period was ~2.4% of the index notional exposure. Currently the cost is at ~2.3%. To reduce the cost of the hedge, an investor can instead buy a 3-month 95%-85% put spread (buying a 95% put and selling an 85% put). In this case, the investor is short typically expensive skew but also long expensive volatility. The information ratio of this strategy was higher than that of the protective put strategy over the same time period by 11% (at 0.29). The cost for this strategy is currently ~1.7% of the notional exposure (compared to an average of 1.5% since 1996). The zero-cost collar strategy involves buying a 3-month 95% put option on a rolling basis while simultaneously selling an out-of-the-money call option (currently a ~102% call) with an equal cost to the put. A zero-cost collar is neutral on volatility (but long relatively expensive skew). This strategy has had an information ratio of 0.38 since 1996. In the zero-cost put-spread collar strategy the investor buys a 3-month 95%-85% put spread and sells a call that makes the structure costless. Currently an investor would need to sell a 3-month 103% strike call to offset the cost of the put spread. Over the past 14 years this strategy had the highest return (~5.5%) and had an information ratio of 0.46.
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 24: S&P 500 Protection Strategies over the Past 14 Years
$300 S&P 500 Protective Put Put Spread Zero-Cost Collar Zero-cost put-spread collar

$250

$200

$150

$100 Feb 96

Aug 97

Feb 99

Aug 00

Feb 02

Aug 03

Feb 05

Aug 06

Feb 08

Aug 09

R isk/R eturn S tats

R eturn (A nn.) R (A isk nn.) Inform ation R atio (IR )

S P & 5.1%
20.2% 0.25

Put Put S pread 2.7% 4.7%

14.8% 0.18 16.4% 0.29

Z C C ollar 3.0%
8.0% 0.38

Z . PS C C ollar 5.5%
12.0% 0.46

Source: J.P. Morgan Equity Derivatives Strategy.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

European Derivatives Market and Volatility

2010 European Volatility Review
Realised volatility in Europe experienced three distinct phases throughout 2010, characterised by different drivers. In the first quarter, improving economic data and corporate earnings led to a continuation of 2009s declining trend for realised volatility, despite a market dip which started mid January. The second quarter saw European volatility spiking, driven by concerns that contagion from the European sovereign debt crisis could lead to a double dip in economic growth. These fears eased in Q3, as Q2 economic data came in strong (e.g. German Q2 GDP grew at a 9.5% annualised rate) and corporate earnings again beat expectations. This led volatility to once again embark on a declining trend. Recently, we have seen a moderate uptick in volatility (though much more subdued than in May), as a sovereign debt crisis was reignited in Ireland and peripheral European CDS spreads reached new record highs. The annualised Euro STOXX 50 realised volatility was 50% in May, but averaged 20% during the rest of the year-to-date. Euro STOXX 50 equity realised and implied volatilities were more affected by the European sovereign debt crisis in May than S&P 500 volatilities, as Europe was the center of the crisis, and it was at first widely considered a local problem with limited consequences for other regions. This led to a widening of the spread between European and US equity realised and implied volatility during Q2 (Figure 25). The spread between the VSTOXX and VIX indices surged in April and remained elevated until the end of May. The spread displayed a high correlation to Greek CDS spreads early this year, indicating that sovereign debt concerns were likely a main driver of the increase in the Europe/US volatility premium (Figure 26). The relationship broke down in June, as the average CDS spread for countries directly involved in the crisis remained high while the Europe/US implied volatility spread reverted to Q1 levels, but they have begun moving up again in tandem since mid October.
Figure 25: The first half of the year saw a marked divergence between Figure 26: The spread of European and US implied volatilities was well US and European realised volatility correlated to sovereign debt issues in H1, and started moving up in 3M volatility tandem again since mid October
45% 40% 35% 30% 25% 20% 15% 10% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: J.P. Morgan Equity Derivatives Strategy.

SX5E 3M implied SX5E 3M realised

SPX 3M implied SPX 3M realised

Volatility points

Avg CDS Spread*

14 12 10 8 6 4 2 0

VSTOXX less VIX spread Av g Periferal CDS

600 500 400 300 200 100 0

Aug-10

Sep-10

Feb-10

Jun-10

Apr-10

Source: J.P. Morgan Equity Derivatives Strategy. *Average 5Y SNR CDS spread for Greece, Spain, Portugal, Italy and Ireland

Financials continue to be a key driver of overall index volatility in 2010, but recently Basic Resources have been contributing more. Similar to 2009, the performance of Banks and Basic Resources sectors have had the greatest impact on overall index volatility. By contrast, the relatively defensive Healthcare sector has again dampened delivered index volatility during the course of the year due to the relatively low volatility of its members and their relatively low correlation to the broader market. We show the difference between the realised volatility of the STOXX 600 and the hypothetical realised volatility that would have been delivered by the STOXX 600 index if the relevant sector were excluded from the index for a given one-month period. This can be thought of as the incremental contribution to index volatility from each

18

May-10

Nov-10

Dec-10

Jul-10

Mar-10

Oct-10

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

sector (Figure 27). Recently, the Basic Resources sector has been the primary driver of index volatility, as several metals such as gold, copper, silver, tin and palladium have recently reached multi-year or all-time highs.
Figure 27: Banks and Basic Resources stocks have driven overall index volatility in 2010, while Healthcare continues to have a dampening effect on volatility
Relative contribution of sectors to overall STOXX 600 1M realised volatility

8% 6% 4% 2% 0% -2% -4% 2007 Tech

SX7P Index SXIP Index SX8P Index

SXDP Index SXEP Index SXPP Index

Basic Res. Financials

Insurance

Energy 2008 2009

Healthcare 2010

Source: J.P. Morgan Equity Derivatives Strategy, Datastream.

Even though volatility never reached extreme levels in 2010, we saw dislocations in the term structure, skew, and correlation at different points during the year, as each neared record highs during 2010. We discuss each of these parameters in the next section.

Derivatives Market Risk Parameters

Term Structure All European index term structures are currently upward-sloping, as short-dated implied volatility has been pulled to the lower levels of realised volatility in H2, while options markets remained invariably concerned about medium-term risks surrounding European sovereign debt and the global economic recovery (Figure 28). In October the Euro STOXX 50 term structure neared the steepest upward slope in our records, but has since nearly flattened, as the shorter end of the term structure moved up on higher volatility in November due to the Irish debt crisis (Figure 29). The term structure still appears steep relative to history on the FTSE 100 and DAX, and longer-dated volatilities appear rich relative to our base case volatility expectations (see 2011 Volatility Outlook below). Indeed, the FTSE 100 6M-1M term structure is still in the 81st percentile relative to the last 10 years. Accordingly, we are biased toward selling longer dated (e.g. Dec 11) volatility on the FTSE and DAX due to their rich volatility levels and steep term structure.

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 28: European index term structures are upward-sloping, Figure 29: Term structures neared record steepness in October before reflecting the pull to realised in the front end while longer term worries flattening on higher short-dated volatility due to the Irish debt crisis linger
ATM implied volatility Euro STOXX 50 6M-1M implied volatility spread

28% 24% 20% 16% 12% 0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48

Maturity (Months)
Source: J.P. Morgan Equity Derivatives Strategy.

5% 0% -5% -10% -15%

SX5E SMI DAX UKX CAC
6M-1M Term Structure

-20% -25%

Jan-07

Jan-08

Jan-09

Jan-10

Jul-07

Jul-08

Jul-09

Source: J.P. Morgan Equity Derivatives Strategy.

Skew In the aftermath of the European sovereign debt crisis, skew widened near record highs at all maturities even as implied volatility remained well below Q4 2008 levels across most developed market indices. As we pointed out in our H2 2010 Outlook, skew remained at extremely distressed levels throughout the summer, then fell significantly at the front end (6M and shorter) in August/September, and finally at the longer end in October (Figure 30). Skew has picked up somewhat over the last few weeks on increased hedging demand and higher perceived tail risks during the Irish debt crisis. Despite its sharp fall from the record highs, skew remains rich by historical standards, particularly at 1-year and longer maturities (Figure 31) as markets continue to price in an elevated probability of tail events.
Figure 30: Skew has retraced significantly from the record levels recorded in May . . .
3-Month Euro STOXX 50 implied volatility skew 1-Year skew

Figure 31: . . . but skew remains elevated compared to history, particularly at longer maturities
Euro STOXX 50 90-110% implied volatility skew 10Y percentile

14% 12% 10% 8% 6% 4% 2%

3M 90-110 skew 1Y 90-110 skew (RHS)

7% 6% 5% 4% 3%

25% 20% 15% 10% 5%

Jul-10
100% 80% 60% 40% 20% 0% 2Y

Current Level 10Y Range 10Y Percentile (right axis)

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

0% 1M 3M 6M 1Y

Source: J.P. Morgan Equity Derivatives Strategy. Source: J.P. Morgan Equity Derivatives Strategy.

Maturity

As economic growth accelerates into H2 next year and increasing clarity is gained on the end-game for peripheral European sovereign issues, demand for protection may subside throughout next year, allowing skew to decline. With the continued elevated skew levels, we maintain a short skew bias and continue to favour short skew strategies such as selling levered risk reversals and buying put ladders or 1x2 put ratios.
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Global Equity Derivatives & Delta One Strategy 07 December 2010

Skew convexity also remains elevated (Figure 32), which is keeping variance swap strikes and their spread to at-the-money forward implied volatility high (Figure 33). Another reason for the continued richness of variance swaps is the limited interest in selling variance from investors, which reflects a diminished risk budget allocated to these strategies, in our view. Accordingly, we continue to recommend that investors who are looking to sell volatility do so through variance swaps rather than delta-hedged straddles. As discussed in the Short Volatility Strategies section below, selling variance was a profitable strategy overall in 2010, despite the losses incurred in May and November during the European sovereign debt crises.
Figure 32: Skew convexity surged in May and retraced significantly since, but remains elevated, close to what seems to be the 'new normal' level post Q4-08
Euro STOXX 50 3M skew convexity

Figure 33: The high skew and skew convexity kept the premium of variance swap strikes to ATMF high
Euro STOXX 50

8% 7% 6% 5% 4% 3% 2% 1% 0%

25-50-75 delta conv ex ity 10-50-90 delta conv ex ity

80% 60% 40% 20% 0%

Spread (right ax is) 3M v ariance sw ap 3M ATMF implied

25% 20% 15% 10% 5% 0%

Jan-08

Jan-09

Jan-10

Jan-08

Jan-09

Jan-10

Apr-08

Apr-09

Apr-10

Apr-08

Apr-09

Apr-10

Jul-08

Oct-08

Jul-09

Oct-09

Jul-10

Oct-10

Jul-08

Oct-08

Jul-09

Oct-09

Jul-10

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

Last year upside skew trended downwards throughout the year while downside skew remained well supported, which opened a large gap between the two measures. However, the gap between downside and upside skew has narrowed this year, and is now close to historical averages. Correlation The year has been characterized by rising levels of implied and realised correlation (Figure 34). The level of correlation recorded in the market became excessive, in our view, towards the end of the year, when we recommended shorting longdated implied correlation (see Why we have a correlation bubble, 5 Oct 10). Since then, implied correlation levels have come off for most European indices. We continue to like the idea of selling correlation, reiterate our short correlation bias and recommend selling Euro STOXX 50 correlation3 (see the Trade Idea section for implementation), as this correlation has declined less then others (Figure 35) and has a more attractive carry in our view.

See the Trade Ideas section for implementation.

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 34: The recent decline in realised correlation has pushed the implied to realised correlation spread higher
Euro STOXX 50 volatility/correlation

Figure 35: Long-dated correlation levels recently declined across major European indices, with the notable exception of the Euro STOXX 50
1Y implied correlation

90% 75% 60% 45% 30% 15% 0% -15% 2007

6M Realised Volatility 1Y Implied correlation

6M Realised Correlation 1Y implied - 6M realised

0.90 0.80 0.70 0.60 0.50 0.40

DAX FTSE Euro STOXX 50

SPX SMI

Sep-10

Jan-10

Mar-10

Jul-10

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

2011 European Volatility Outlook

One cannot begin a forecast of European equity volatility without acknowledging the potential tail risk for the region due to looming sovereign debt issues. Since Europe was the focal point in the sovereign debt crisis in May, we saw a strong divergence between volatility in the Eurozone and the rest of the world in Q2 of this year. After largely moving to the back burner through Q3, these sovereign debt issues are again coming to the forefront, stoked by an intensified crisis in Ireland, and Eurostats upward revision to Greek deficit and debt figures. This has led to peripheral sovereign CDS spreads rising to record levels over the last few weeks (Figure 26). J.P. Morgan European Credit Strategists note that the market reaction to the latest round of Euro-area sovereign stress has been very different to May they note it appears that risk markets current interpretation seems to be that Ireland, Portugal, and Greece's collective issues represent an idiosyncratic risk, rather than posing a systemic threat4. J.P. Morgan Fixed Income Strategist Pavan Wadhwa notes that his central case remains that Spain and Italy will not need to be bailed out by the EFSF due to disciplined policymaking, better overall fiscal health and the improving macro picture5. He sees peripheral spreads widening further, but peaking in Q1 next year before retracing somewhat (to levels similar to early November) by the end of next year. Accordingly, while our base case forecast for volatility next year assumes that Spain and Italy stay largely insulated from the worst of the sovereign debt crisis, we acknowledge there is a low-probability tail event risk where volatility rises sharply if the sovereign debt crisis contagion spreads to Spain/Italy and beyond. The Euro area economy is expected to continue to be one of the global laggards on growth among major economies, as peripheral sovereign debt problems persist and fiscal tightening restrains economic expansion. J.P. Morgan Economists are currently forecasting 2011 real GDP growth in the Eurozone at a 1.6% annualised rate, compared to 2.6% growth forecast for the US, an average of 2.1% across developed markets, and 3.1% for global GDP. Meanwhile, Euro area unemployment is expected to remain elevated throughout next year, only falling from 10.0% to 9.7% by year-end. For these and other reasons detailed below, our base case forecast for realised volatility of the Euro STOXX 50 in 2011 is higher than our forecast for the S&P 500. J.P. Morgan Equity Strategists see 15% upside potential for European Equities through year-end 2011. Our strategists highlight 5 key supports for European equities: 1) Global economic activity is picking up after the summer slowdown, with our economists calling for an acceleration to above-trend growth in the second half of next year; 2) they

4 5

See European Credit Outlook & Strategy 2011, 11 Nov 2010 See Global Fixed Income Markets 2011 Outlook, 26 Nov 2010 for more details

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May-10

Nov-10

2008

2009

2010

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Global Equity Derivatives & Delta One Strategy 07 December 2010

find 2011 earnings forecasts of 15% year-on-year growth in Europe to be realistic; 3) equity valuations, at 11x forward earnings, are not priced for perfection; 4) the credit backdrop remains supportive; and 5) developed market monetary policy will remain accommodative throughout 2011. Our Equity Strategists recommend staying OW cyclicals and holding selected exposure to EM through the cheaper exposed names. Our Strategists base case is not for peripheral sovereign concerns to dominate next year, but believe they are likely to flare up from time to time, so prefer to be OW the core European countries vs. the periphery. Realised volatility on the Euro STOXX 50 is 24% year-to-date. An accelerating macro economy and positive outlook for European equities should support a lower volatility environment in 2011 compared to 2010, in our view. However, ongoing noise around peripheral sovereign debt, policy risks around the implementation of fiscal tightening, and risks of overheating in developing Asian economies will prevent a return to the low volatility environment of 2004-2006, in our view. Our forecast is that the average realised volatility of the Euro STOXX 50 in 2011 will stay in a ~18-24% range, with a most likely level of 21.5% (or 3.5% above the S&P 500). Below we discuss the drivers of our view and the premium compared to the US. Index Composition As we noted in the 2010 volatility review above, Financials continued to be the primary driver of European index volatility this year. The Euro STOXX Banks index (SX7E) has realised 38% YTD, or ~16 vol points more than the broad Euro STOXX (SXXE) index. Financials currently comprise 27% of the Euro STOXX 50 index, compared to just 11% of the S&P 500. Lawmakers and regulators globally continue to debate the shape of financial regulation, capital requirements and taxation in the aftermath of the credit crunch, while Banks face risks associated with their holdings of peripheral European sovereign bonds. Accordingly, Financials will likely continue to exhibit elevated volatility and continue to drive European index volatility higher, in our view. On this basis, we believe the Euro STOXX 50 will continue to realise higher volatility than the S&P 500 in 2011, due to the formers relative overweight in Financials. In large part due to the relative sector weights and the greater concentration of the Euro STOXX 50 versus the S&P 500 (as the latter contains 10 times more securities), the Euro STOXX 50 has historically exhibited higher realised volatility. As a long-run estimate of the spread between the two, we note that since Jan 1987, the Euro STOXX 50 has on average realised 2.0 points higher volatility than the S&P 500 (or 3.5% higher since 2000). From the 9 Mar 09 market lows until the end of April 2010, this spread contracted to just 1.5 points; however, during the sovereign credit crisis in May, the Euro STOXX 50 S&P 500 realised volatility spread blew out (averaging 16.4% in May). In the second half of this year, the spread again contracted, to 2.9%. We expect this spread to remain well below the levels in Q2 as the acute fears of sovereign-debt-fuelled contagion should once again subside early next year, but to remain above the long-run average in 2011 as these issues continue to be worked out. Credit-Based Forecast The sovereign debt crisis has caused a dramatic widening of sovereign credit spreads for Greece, Portugal, Spain, Ireland, and Italy (Figure 26). Since European banks are major holders of these bonds, this led to a significant widening of financials credit spreads in the region. J.P. Morgan European Credit Strategists forecast a moderate tightening in both Investment Grade and HY spreads in 2011, placing year-end targets of 79bps for the iTraxx Europe (Investment Grade) and 400bps for the iTraxx Xover (High Yield). Underlying these forecasts is the view that we will see some fading in sovereign stress from current levels. Our credit strategists forecasts for these iTraxx indices have historically pointed to an average level of equity volatility of 22% (and a typical range of 20-24%). We also looked at a historical regression of the spread between Euro STOXX 50 and S&P 500 volatility against the spread between European and US Investment Grade and High Yield credit. J.P. Morgan US Credit Strategists are forecasting a year-end target for the CDX Investment Grade and CDX High Yield indices of 70bps and 390bps, respectively. The difference in forecast credit spreads for Europe vs. the US is consistent with approximately a 4 vol point spread between the Euro STOXX 50 and S&P 500 realised volatility.

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Implied VolatilityBased Forecast The markets best estimate of the spread in future realised volatility can be observed by the spread in current implied volatility. Currently, the market is pricing in a 3.3% spread between Euro STOXX 50 and S&P 500 1-year volatility, but it has tended to underprice this spread historically, due to the option markets inability to foresee events like Mays sovereign debt crisis which can cause this spread to widen sharply. We ran a regression model of the spread between Euro STOXX 50 and S&P 500 subsequent realised volatility and the spread between the indices 1-year implied volatility at the start of the period. The current spread between the Euro STOXX 50 and S&P 500 1Y ATM implied volatility of 3.3 vol points leads to an estimated spread between Euro STOXX 50 and S&P 500 realised volatility of 5% based on this simple regression model. Equity-Based Forecast J.P. Morgan European Equity Strategists believe the risk-reward for European equities in 2011 remains favourable and target approximately 15% upside through year-end. Based on a regression of historical market returns and the related changes in realised volatility, a 15% increase in European equities led on average to a ~3% drop in realised volatility. The current level of 6-month realised volatility is 20.3%, pointing to an average realised volatility for 2011 of 17.4%. UK Volatility Forecast Our forecast for FTSE 100 average realised volatility in 2011 is identical to the S&P 500, in a ~15-20% range with a most likely level of 18%. Volatility on the UK benchmark index has historically been below that of the Euro STOXX 50 as the FTSE is more diversified across sectors, with twice the number of constituents and 21% weight in financials vs. 27% on the Euro STOXX 50. J.P. Morgan Economists expect GDP growth in the UK at 2.2% next year (vs. 1.6% in the Eurozone), despite strong fiscal consolidation expected to take place in order to bring the countrys budget deficit under control. We expect FTSE volatility to remain well below the Euro STOXX 50 next year, due to the FTSE's lack of direct exposure to peripheral European countries, and stronger economic growth expected in the UK compared to the Eurozone. FTSE 100 realised volatility has displayed a strong historical correlation to the S&P 500, with a regression R2 of 0.88. Based on the regression equation between FTSE and S&P volatility and our forecast for S&P volatility in the first section of the report, we arrive at a 17.5% target with a 15-19% range. Meanwhile, the relationship between credit (iTraxx Europe and Xover) and FTSE volatility suggests a target volatility level of 19.5%, with a likely range of 17.5-21%. Finally, J.P. Morgan Equity Strategy forecasts a 15% return for UK equities in 2011. Looking at the econometric relationship between equity returns and volatility in the UK, a 15% gain is consistent with a 3% decrease in volatility. This would point to a volatility level of ~14% based on the current 17% 6-month volatility on the index. Combining the measures above, we conclude that FTSE volatility will be in line with our expectations for the S&P 500. 1-year implied volatility on the FTSE 100 is currently 0.3 vol points below the S&P 500, which is consistent with our forecast. Upside risks to our UK volatility forecast exist as there is a small chance that the government's fiscal austerity drive may cause a double dip in the economy or inflation could prove unwieldy, and banks remain under pressure due to regulatory risks and exposure to peripheral European economies.

Derivatives Strategies Update

Short Volatility Strategies The performance of systematic short equity volatility strategies was overall positive over the year, but was dented by the spike in volatility in May (Figure 39). The banks-heavy Euro STOXX 50 was particularly affected by the May crash. Figure 36 shows the P&L for shorting 1M variance swaps on the main European indices and illustrates how the losses incurred on a short Euro STOXX 50 short-dated variance position were much larger than those experienced on the DAX and FTSE. As we highlighted above (Figure 27), the Banks sector was the main driver of realised volatility for European equities throughout the year. This is consistent with the observation that short variance strategies on European indices with a higher weight in the Banks sector experienced higher losses than indices with lower weights, as illustrated in Figure 37.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 36: During the May correction Euro STOXX 50 short variance underperformed significantly similar positions on DAX and FTSE
Returns for selling 1M variance swap (vega)

Figure 37: The worst single month losses on 1M short variance YTD were recorded for the indices with the largest weights in Banks
Worst 1M performance year-to-date for 1M short variance strategy (vega)

20% 0% -20% -40% -60% Aug-10 Sep-10 Feb-10 Jan-10 Jun-10 Apr-10 May-10 Nov-10 Dec-10 Jul-10 Mar-10 Oct-10
Euro STOXX 50 DAX FTSE

0% -10% -20% -30% -40% -50% -60% -70% -80% -90% 0% 5% 10% 15% 20% 25% 30% 35%

DAX

FTSE

OMX

CAC SX5E

R = 0.6574

IBEX

Source: J.P. Morgan Equity Derivatives Strategy. Source: J.P. Morgan Equity Derivatives Strategy.

% weight in Banks sector

In September we recommended shorting Euro STOXX 50 volatility while hedging Banks volatility risk by going long Euro STOXX Banks index (SX7E) volatility on a fifth of the notional shorted in the Euro STOXX 50 (see Reduced tail-risk short variance strategy, 7 Sep 10). This position performed well, but recently the P/L started to flatten as renewed concerns on European sovereign risk increased realised volatility levels (Figure 38).
Figure 38: The Euro STOXX 50 ex banks short variance carried well
Theoretical mark-to-market (vega)

Figure 39: Systematic 1M short Euro STOXX 50 variance was overall positive over the year, despite suffering heavy losses in May
Systematic strategy performance

7% 6% 5% 4% 3% 2% 1% 0% -1% 03-Sep 10-Sep 17-Sep

Short Dec-10 Euro STOXX 50 ex Banks volatility

140 130 120 110 100 90 80

24-Sep 01-Oct 08-Oct 15-Oct 22-Oct 29-Oct 05-Nov 12-Nov 19-Nov 26-Nov 03-Dec

Short Euro STOXX 50 1M v ariance sw ap

70 Aug-10 Feb-10 Dec-09 Jun-10 Apr-10 Dec-10

25

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

Protection Strategies We review the performance of typical systematic protection strategies during 2010. With markets choppy but relatively range-bound this year and performance finishing nearly flat on the year, an outright long equity index position would have outperformed most systematic option protection strategies, despite the sell-off in May (Figure 40). However, the rangebound nature of markets this year and relatively wide implied-to-realised volatility spread has benefited overwriting strategies, which have outperformed the market in 2010. The substantial decline in the cost of protection over the last two years (Figure 41) has increased the attraction of option-based protection strategies (Figure 42) which is reflected in increased put/call open interest ratios and increased levels of downside skew which reached extreme levels earlier this year.

Oct-10

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 40: With markets flat to slightly up in 2010, protection overlay Figure 41: The cost of protection has fallen, potentially prompting a strategies would have underperformed an outright long equity position return to more traditional systematic protection strategies
Relative performance of overlay protection strategies in 2010 Euro STOXX 50 3M ATM put option price (% of notional)

110 105 100 95 90 85 80 Dec-09

Euro STOXX 50 95 / 100 Put Spread 95 / 100 / 105 PS Collar Short 105 Call 95 Put ATM Put

14% 12% 10% 8% 6% 4% 2% 0% 2000 2002

Put Premium (% of notional)

Mar-10

Jun-10

Sep-10

2004

2006

2008

2010

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

Some systematic protection strategies have outperformed both cash and equity holdings over the long term. In particular, a short 105 call overlay has historically improved the returns of a long equity position, and put spreads have delivered better returns than outright long puts (Figure 43). As discussed previously, the reason for this outperformance was the richness of index implied volatility and downside skew.
Figure 42: Long put overlay strategies have performed poorly over the Figure 43: Put spreads and put spread collars have delivered better last 10 years, despite weak equity market returns returns than long put overlay strategies
Relative performance of overlay strategies since January 2000 Annualised return since January 2000

180 160 140 120 100 80 60 40 20 2000

Euro STOXX 50 95 / 100 Put Spread 95 / 100 / 105 PS Collar

Short 105 Call 95 Put ATM Put

4% 2% 0% -2% -4% -6% -8% -10% 95 / 100 Put Spread 95 Put 0% 5% 10%

Short 105 Call 95 / 100 / 105 PS Collar Euro STOXX 50

2002

2004

2006

2008

2010

15%

20%

Source: J.P. Morgan Equity Derivatives Strategy.

Downside Volatility
Source: J.P. Morgan Equity Derivatives Strategy.Data since January 2000.

Enhanced Protection Strategy We have previously recommend a strategy that involves buying a portfolio of overlapping 12-month ATM puts and selling 105% 1-month calls. This strategy sells expensive short-term index options that decay quickly, and buys longer dated options that decay more slowly. While 1-year volatility is typically more expensive than 1-month volatility, 1-month options are sold 12 times a year and most of the time expire worthless (as index volatility usually trades above realized volatility). In addition, the strategy captures the market tendency to mean revert over short time horizons, and trend over mid- to longterm time horizons. Holding a long index position and protecting it using the enhanced protection strategy would have provided superior returns to any of the following over the last 10 years: 1) an outright long index position, 2) a long index position combined with 1month 105% index call overwriting strategy, and 3) a long index position combined with the 12 overlapping 12-month puts
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Global Equity Derivatives & Delta One Strategy 07 December 2010

on their own. During the 2008/9 market downturn, the maximum drawdown suffered by the portfolio would have been reduced from 61% for a long equity position in the Euro STOXX 50 to only 13.4% for the enhanced protection overlay on the index. The enhanced protection strategy underperformed a long equity holding by 5% in 2010, since the market is nearly flat on the year, but continues to be an attractive long-term portfolio overlay for those seeking protection, in our view.
Figure 44: The enhanced protection strategy overlay would have outperformed a long equity and a long equity plus 12M puts strategy
Performance of enhanced protection strategy, compared to Euro STOXX 50

Table 1: Historical performance of enhanced protection strategy on the Euro STOXX 50

SX5E Return Volatility Information Ratio Underlying Index Return Enhanced Protection Strategy Outperformance 2.8% 7.2% 0.38 -5.9% 8.6% Strategy Returns by Year 2010 2009 2008 2007 2006 2005 2004 2003 2002 -6.5% 12.7% -6.9% -0.3% 9.5% 12.6% 0.6% 5.4% -0.7% -0.2%

160 140 120 100 80 60 40 2000

Euro Stox x 50 Index plus enhanced protection strategy Index plus 12-month put strategy only

2002

2004

2006

2008

2010

2001

Source: J.P. Morgan Equity Derivatives Strategy. Data since August 2000.

Source: J.P. Morgan Equity Derivatives Strategy. All figures annualised, except 2010 return. * Through 15-Nov-10.

Best-of puts can cheapen the cost of protection for a co-ordinated downturn in equities. A best-of put has the same payoff as a standard vanilla put option, but the underlying instrument is the best performing index within the selected basket. By conditioning the payoff on the best performer out of a basket of three indices, investors can cheapen the cost of the put significantly, particularly by optimizing the choice of basket by selecting indices with low implied volatility and correlation. These instruments benefit from an increase in correlation and volatility during the life of the option, which both typically occur during a market correction. For further details on best-of puts, please see European Equity Derivatives Weekly Outlook, 23 August 2010. Call Overwriting6 We believe that call overwriting will be an attractive strategy to enhance portfolio returns in 2011. As implied volatility remains rich, and equity is expected to deliver positive though not extraordinary returns, equity investors can monetize the richness in implied vol without sacrificing much upside using call overwriting. While the strategy improves a portfolios risk/return profile in a flat or bear market, as we show below call overwriting can still be effective in a rising market. J.P. Morgan European Equity strategists Matejka and Cau forecast a probability weighted return of 16% for European equities in 2011 based on three possible scenarios: a base case scenario of 15% return where earnings deliver and sovereign concerns remain contained, a bubble scenario of 40% return where excess liquidity spills over into equities, and a double-dip scenario of -30% return where growth falters and sovereign concerns spread. Figure 45 shows the historical returns of buy-write strategies on the S&P 500 and Euro STOXX 50 plotted against their underlying equity returns for all available years, as well as the 45 degree line and the best fit line. As can be seen in the chart, in our strategists' downside and base case scenario, the call overwriting strategy is able to deliver returns similar to or better than the underlying index. Specifically, in years where equities returned 10-20% (i.e. in line with our strategists forecasted average return for 2011), such as 1993, 2004 and 2006 for the S&P 500, and 2003 and 2006 for the Euro STOXX
6

For a complete overview of the call overwriting strategy, see Calling all Overwriters, Aug 2002.
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Global Equity Derivatives & Delta One Strategy 07 December 2010

50, index call overwriting has performed well relative to the underlying index, with invariably higher information ratios (see Table 2). The main risk to the strategy lies in the case where the equity index rallies strongly, as in our strategists bubble scenario, causing investors to underperform due to the capped upside. However, as long as the strong performance plays out evenly over the year, investors will have the opportunity to reassess the overwriting strategy as the market progresses.
Figure 45: Buy-write strategy tends to outperform index when return Table 2: Buy-write strategy outperforms in terms of risk-reward in years is modest or negative, but underperform in strong rallies where equity returns are between 10% and 20%
buy-write strategy return

45 degree line Linear Regression Line

40 30 20 10 0 -10 0 -20 -30 -40

Equity index return

Year 1993 2003 2004

Index SPX SX5E SPX SPX SX5E

Return 10.1 18.4 10.9 15.8 18.1

Vol 8.6 26.8 11.1 10.0 14.9

IR 1.17 0.69 0.98 1.58 1.21

Index BWM SX5E BW BWM BWM SX5E BW

Return 14.1 36.8 8.3 13.3 17.5

Vol 5.8 23.7 7.3 6.2 13.5

IR 2.43 1.55 1.14 2.15 1.30

-40

-20

20

40

2006 2006

Source: J.P. Morgan Equity Derivatives Strategy. IR = Information Ratio, Vol = Volatility

Source: J.P. Morgan Equity Derivatives Strategy.

In addition, we show the price return of an equally weighted portfolio of the current SX5E members, in comparison with the same portfolio with single name 1M ATM call overwriting, rolling over at the end of every month. Table 3 shows that the single name overwriting strategy has delivered lower returns in years where the underlying equity return are between 10 and 20%. However, from a risk-reward perspective, the call overwriting strategy performance still appears favourable (see Table 4). The reason for the difference in performance relative to index call overwriting is that short index calls are also short correlation, and would tend to outperform overwriting using single stock calls unless dispersion for stock returns is low.
Table 3: Yearly returns of hypothetical equally weighted SX5E basket and corresponding single stock buy-write strategy
Single Stock YTD 2009 2008 2007 2006 2005 2004 2003 2002 2001 -7.4 28.8 -39.7 12.1 19.1 14.4 6.8 15.9 -24.2 -8.8 Single Stock Buy Write -0.9 23.3 -20.8 10.5 11.8 6.4 8.4 15.4 -15.4 0.4

Table 4: Single stock buy-write strategy also favourable compared to underlying basket in terms of IR
Year 2003 2005 2006 2007 Index Outright Outright Outright Outright Return 15.9 14.4 19.1 12.1 Vol 20.7 11.8 10.3 8.5 IR 0.77 1.22 1.85 1.42 Index Covered Call Covered Call Covered Call Covered Call Return 15.4 6.4 11.8 10.5 Vol 8.7 5.3 5.4 4.2 IR 1.77 1.21 2.19 2.50

Source: J.P. Morgan Equity Derivatives Strategy. IR = Information Ratio, Vol = Volatility

Source: J.P. Morgan Equity Derivatives Strategy.

From the exercise above, we note that call overwriting can still provide investors with attractive risk-adjusted return in the coming year. At the same time, we believe that when overwriting a fixed portfolio of shares, overwriting with index calls is preferable to selling calls on all the constituents, due to the systematic premium of implied to realised correlation. Nonetheless, because of the higher implied volatility on single stocks, selling covered calls on the constituents of a basket

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Global Equity Derivatives & Delta One Strategy 07 December 2010

has the potential to outperform index overlays through judicious choice of overwrite candidates. In the Trade Ideas section (Page 56) we discuss the use of our range-bound methodology for selecting attractive call overwriting candidates.

Trends in Derivatives Usage

Structured Products Although structured product volumes and open interest remain relatively subdued compared to the peak of the market in 2007, European structured product volumes have grown considerably over last year, as issuance through mid-November 2010 has already surpassed 2009s full-year total. We analyse the trends in structured product flows in 2010, and investigate the potential impact that they may have on the volatility market in 2011. Italy has had the highest structured product issuance this year, but the vast majority of its products were fixed income linked. Switzerland structured product issuance exceeded Germany's year-to-date (both in total volumes and equity-linked product volumes), for the first time in our records, while Germany is running second among equity structured product markets. Italy, Switzerland and France have all experienced strong issuance growth this year, while Germany and the UK have both recorded double-digit percentage losses vs. 2009 (Figure 46). A notable shift in the structured products market has been the decline in the share of products linked to the equity asset class and increase in rates and credit-linked products from 2007 to 2009 (Figure 47). However, in 2010 the trend has partially reversed, as equities have increased their share, primarily at the expense of rates and credit-linked products.
Figure 46: The Italian, German and Swiss structured products markets Figure 47: European structured product issuance by asset class dominated within Europe this year, but most Italian products are fixed income linked
Structured product monthly sales by country ($Bn) Structured product volume by asset class (%)

$14 $12 $10 $8 $6 $4 $2 $0

Germany Sw itzerland France UK Italy

100% 80% 60% 40% 20% 0% 2004 2005 2006 2007 2008 2009 2010
Equities Rates / Credit FX / Commodities Funds / Alternativ es

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Source: J.P. Morgan Equity Derivatives Strategy, Structured Retail Products Magazine.

Source: J.P. Morgan Equity Derivatives Strategy, Structured Retail Products Magazine.

In general, the flows from retail structured products in 2010 appear more balanced than last year in their exposure to volatility and skew, but with a marginal short skew bias. Typical structures this year included capped and uncapped calls which are both long volatility (while the capped calls are long upside skew), reverse convertibles which are short volatility and skew, and (retail investors selling) worst-of put options which gave investors short volatility and short skew exposure. Structured products have continued last years migration towards simpler payoffs (e.g., linked to a single index underlier instead of an index basket), generally with lower leverage and more principal protection. For example, investors seemed more willing this year to accept a lower coupon on reverse convertibles in exchange for lowering the knock-in put barrier. Against this trend, however, worst-of reverse convertibles (which allow for higher coupons than similarly structured single name reverse converts) have gained in popularity this year.

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Maturities of structured products have become longer this year, reversing the trend towards shorter-dated products over the prior few years. Capped calls have emerged as the single most popular product this year as the embedded optionality is cheaper than for uncapped calls the low interest rate environment has led to a small discount to par for zero-coupon bonds, which means that the premium available for acquiring upside exposure (or downside protection) is limited. Exchange Traded The collapse in equity markets in Q4 2008 brought deterioration in the liquidity of several over-the-counter derivatives products such as exotics structures and single-stock variance swaps. In contrast, exchange business fared relatively well by comparison. Meanwhile, the macro-driven environment that has emerged since 2008 has broadly led volumes in equity index instruments to be more resilient than stock-level instruments. Below we present an analysis of trends in liquidity of both index and single-stock exchange traded options. Two years on, notional turnover on single-stock and index options remains below pre-credit crisis levels due to the lower equity prices. The value of index and single stock options traded plunged alongside equity markets in Q4-08, and have only partially recovered. Notional turnover on index and single stock options remains ~45% below the same period in 2007, though the majority of this drop can be explained by the decrease in equity prices, as the STOXX 600 has fallen ~30% over the period (Figure 48). Meanwhile, index option turnover is ~15% above the same period in 2006, while single stock option turnover is down by 25%, compared to a 25% drop in equity values. This suggests the number of single stock options contracts traded is roughly unchanged compared to 4 years ago, while volumes have increased on index options.
Figure 48: Index option turnover remains well below 2008 peaks, but is Figure 49: Futures continue to dominate cash equity flows, while more resilient than stock options relative to 2006-7 levels index options remain more prevalent than stock options relative to 2007, but well below Q4-08 peaks
Daily index option turnover bn Single-stock turnover Bn

100 80 60 40 20 0 2006 2007 2008 2009 2010

Total index Total Single Stock (RHS)

10 8 6 4 2 0

Major index futures/ MSCI Europe cash turnover

Index/single stock option turnover

4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 2007 2008 2009 2010

20

15

10
Futures/Cash Ratio Index /SS Options Ratio (RHS)

Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg. 3M average. Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg. 3M average.

The Euro STOXX 50 remains the most liquid index option underlier by a significant margin, with roughly 28bn of average daily turnover over the last three months. The second most liquid index, the DAX, attracted less than half of the Euro STOXX 50 turnover at around 8bn. Financials continue to dominate the single-stock option flow, attracting ~25% of all European single stock option flows throughout 2010. Meanwhile, Materials, Industrials, Health Care and Consumer Discretionary stocks all attracted roughly half the options volumes in Financials, or 1/8 of total stock option volumes each. However, the concentration of turnover in the Financial and Telecom sectors has declined over the last year, owing to gains in Health Care and Industrials (Figure 50).

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 50: Financials continue to attract the highest turnover in European single-stock options but the concentration has decreased from the same time last year
Notional turnover by sector

Figure 51: Euro STOXX 50 dividend futures continue to gain in popularity

SX5E dividend future 1M avg daily turnover Mn Total open interest Mn

3,000 2,500 2,000 1,500 1,000 500 0 2006 2007 2008

C. Disc. Energy Health Care Techno lo gy Teleco ms

C. Staples Financials Industrials M aterials Utilities

300 250 200 150 100 50 0

Turnov er Open Interest (RHS)

8000 7000 6000 5000 4000 3000 2000 1000 0

2009

2010

Jan-09

Jul-09

Jan-10

Jul-10

Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg. 3M average.

Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg. 3M average.

Euro STOXX 50 dividend futures usage has continued to gain, with total open interest now surpassing 7Bn and daily turnover averaging 150Mn over the last month.

Emerging Market Volatility

Strong returns were recorded across the board for EM equities in 2010 (MSCI EM +15.9%, ISE30 +27.7%, RDXUSD +12.6%, CECEEUR +17.3%, TOP40 +14.4%, as of 3-Dec-2010). Looking into 2011, J.P. Morgan EM strategists Adrian Mowat and team remain bullish on EM equities and see a year-end target of 1500 for the MSCI EM index. They believe that EM equity valuation will be buoyed by accelerating investment and consumption growth, expanding growth premium, and the relative cheapness to EM bonds. Within EMEA, Mowat maintains an OW rating on Turkey, where the resilient domestic demand and a low interest rate environment remain supportive of economic growth, and is Neutral on Russia, South Africa, Czech Republic, Hungary and Poland. On the volatility front, despite the spike in May and the recent uptick due to European sovereign stress, implied volatilities on EM indices overall have declined over the course of the year. Currently, the implied volatilities are at low levels by historical standards, thanks to strong equity returns and low realised volatility. The pull to realised effect is especially pronounced at the short end, while the longer end vol has not declined as dramatically, resulting in steep term structures. In particular, the 1M realised vol on the RDX index is now at the 14th percentile in our historical data since Oct 2006, whereas the term structure, defined as the difference between 1M and 6M ATM vol, is at the 93rd percentile over the same period. Another notable observation is the skews on some of the EM indices have crept up since September. Observing the 3M 90110% skew, we see that the current CECEEUR skew is at the 90th percentile, and the ISE30 skew at the 83rd percentile since Sep 2006. In the Trade Ideas section (Page 56) we present several ways to incorporate the directional and volatility views to capitalize on the observations above.

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 52: Current term structure of EM Indices

ATM Implied Volatility

Figure 53: Implied vol generally trended downward

1-Month ATM Implied Volatility

35%

30%

RDXUSD ISE30 CECEEUR TOP40 RDX

55% 45% 35%

RDXUSD ISE30 CECEEUR TOP40 RDX

25%

25% 15% Aug-10 Feb-10 Dec-09 Jun-10 Apr-10 1M 2M 3M 6M 9M 12M Oct-10

20%

Maturity (Months)
Source: J.P. Morgan Equity Derivatives Strategy

Source: J.P. Morgan Equity Derivatives Strategy

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Asia Equity Market Volatility Outlook

Market Outlook and Risk Factors
The outlook on Asian equities remains bullish for 2011 as the lack of DM growth combined with low discount rates supports a high growth premium. Our EM equity strategist Adrian Mowat has a 2011 year-end target of 570 for the MSCI Asia Pacific ex-Japan Index, representing over 20% upside from current levels. The main market drivers for the region include expanding growth premium, equities being cheap relative to sovereign and corporate bonds, accelerating investment and consumption growth, and lower relative risk profile of EM vs. DM. The hunt for carry, growth, and momentum by investors should continue, providing strong support for Asian equities. For Japan, our equity strategist, Hajime Kitano is also bullish on Japanese equities for 2011. He believes that the global economy will likely emerge from the lull seen since May 2010 and go into a cyclical upturn, and Japan will benefit as a result, given the current relative low valuation of TOPIX against S&P 500.
Figure 54: Asia equity volatility vs. credit
Implied Volatility
100% 700

Figure 55: Japan equity volatility vs. credit

Credit Spreads (bps) Implied Volatility
90%

Credit Spreads (bps)

600

80%

Hang Seng 3M Implied Vol KOSPI 200 3M Implied Vol iTraxx Asia ex Jap IG

600
70%

Nikkei 225 3M Implied Vol iTraxx Japan IG

500

500 60% 400

50%

400

300

40%

300
200

200 20% 100 0% Sep-07 0 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10

30% 100

10% Sep-07

0 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10

Source: J.P. Morgan.

Source: J.P. Morgan.

Throughout 2010, the volatility across the Asia Pacific markets continued to moderate, implying declining equity risk premium and lower cost of equity. However, the rally was not entirely smooth, due to recurring systemic shocks, such as the sovereign debt crisis in the Eurozone and anti-inflation policies. Compared to the spikes during the financial crisis in 2008, the volatility outcome of systemic shocks has been surprisingly benign. The evolution of equity volatility is mirrored in the credit markets (see Figure 54 and Figure 55), where spreads generally remained at tight levels similar to last year, largely reflecting the improved corporate performance, continued de-leveraging, low default levels, and search for yield by investors. Despite our bullish outlook for the region, we are cognizant of the potential risk factors or event risks that can lead to volatility spikes and even derail our thesis. In terms of economic risks, the unintended consequences of QE2 such as sharp inflation and public sector debt stress in DM economies, in particular the worsening Eurozone sovereign debt crisis, are the main factors. Capital controls, anti-asset inflation policies and trade wars, which are by-products of QE2, as well as the ongoing North Korea saga are the main policy and political risks.

Volatility Regime and Equity Risk Premium

As far as years go, 2010 was not one lacking in macro surprises, but these shocks did not result in a volatility regime change. Volatility regime changes usually occur as a result of a series of spikes rather than a general trend upwards. The regime transition occurs in this way because a shock, which at first is considered an isolated problem, turns out to have more serious and wider macroeconomic repercussions. In addition, shocks can translate into meaningful increases in
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Global Equity Derivatives & Delta One Strategy 07 December 2010

volatility only in the presence of excessive leverage. Hence, while the risk-on/risk-off behavior of investors was still extreme in 2010, neither a series of shocks nor excessive leverage were in place to ignite a volatility regime transition.
Figure 56: Asian index implied to realized volatility premium
3M Implied to Realized Volatility Spread

16% 12% 8% 4% 0% -4%

Hang Seng

KOSPI200

ASX200

Nikkei225
North Korea Saga

April/May market sell-off amid Eurozone sovereign debt crisis

China tightening

Risk premium remains fairly high in Asia equity volatility overall due to various macro/geopolitical uncertainties

-8% Nov-09
Source: J.P. Morgan.

Feb-10

May-10

Aug-10

Nov-10

Implied volatility has seen one relatively large spike and a number of smaller spikes in 2010. After surging to levels unseen since early 2009 during the Eurozone sovereign debt crisis, the implied to realized volatility spread, an indicator of equity risk premium, has quickly normalized across Asia as the risk of contagion failed to materialize (see Figure 56). However, the pace of retracement in realized volatility is even quicker, and realized volatility has continued to reset back toward the lows of the range after the volatility spikes have occurred. The lower than expected realized volatility exerted downward pressure on the elevated implied volatility with market participants engaging in profit-taking of existing long volatility positions as well as volatility selling through vanilla options. However, despite realized volatility remaining subdued, implied volatility has actually moved higher in 4Q10, initially driven by the strong demand for upside exposure amid the QE2 rally and then later by a plethora of event risks related to the Eurozone sovereign debt crisis and Chinas inflation as well as the North Korea saga, which weighed on the markets and created an overall bearish risk-off tone. Consequently, the level of carry has widened, reflecting the increased risk premium of volatility spikes and increased cost of capital of holding risky positions. Going into the year-end, Asian implied volatility seems to be fairly rich relative to realized volatility now, with the risk premium for the ASX 200, Hang Seng, and KOSPI 200 being quite elevated while that for the Nikkei 225 is relatively cheap. The two conflicting forces currently driving the markets, namely the positive outlook on the equity market and the aforementioned macro risk factors, present an interesting scenario for pricing implied volatility risk premium. The gradual fading of these uncertainties would be supportive of the decline in realized volatility as well as risk premium, which bodes well for volatility sellers. However, the Eurozone sovereign debt crisis is unlikely to fade soon while tightening concerns in China will lead to an overhang on the market, keeping a structural risk premium in place and preventing the collapse of risk premium below the historical average in 1H 2011, in our view. In the long term, on the back of our 2011 bullish outlook, we would expect the equity risk premium for Asia to decline to reflect the regions sound fundamentals, just as the region survived the extreme external demand shocks during the credit crisis in 2008 and recovered well ahead of DM economies. Barring significant market shocks or tail events, we also believe a change of volatility regime is unlikely.
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Realized Volatility Base Case Forecast

To quantity the aforementioned risk factors into our expectation of future realized volatility, we set a base case volatility target level for the major Asia ex-Japan indices, namely the ASX 200, Hang Seng and KOSPI 200, based on a similar statistical analysis we use for our S&P 500 2011 volatility forecast. This analysis incorporates the latest regional J.P. Morgan fundamental views and outlooks as well as factoring in the relationship of volatilities across regions. We use GDP growth and interest rate forecasts from our economists and equity index price targets from our strategists for this statistical analysis. We also incorporate the relationship between the volatility spread of the respective Asian index versus the S&P 500 and derive a volatility estimate using our base case volatility forecast for the S&P 500. Finally, given the wide variability in the R-squares across the different regression forecasts, the volatility estimates from each analysis are weighted by their respective R-squares to arrive at the realized volatility base case forecast for 2011. The inputs and results of our volatility forecast analysis are summarized in the table below. Our base case scenario is for volatility to remain similar or slightly higher than the current level. Based on the statistical analysis above, our base case realized volatility forecasts for 1H 2011 are 14.9% for the ASX 200 (vs. current level of 15.8%), 17.3% for the Hang Seng (vs. current level of 16.1%), and 16.1% for the KOSPI 200 (vs. current level of 14.4%). While our bullish outlook for the equity market and solid economic growth expectation can impose downward pressure on volatility, the risk of interest rate hikes, ongoing development of the Eurozone sovereign debt crisis, and the normal relationship of Asian indices and S&P 500 Index supports our volatility forecasts.
Table 5: 2011 realized volatility forecast derived from statistical analysis (weighted average based on R-squares of different risk factors)
2011E GDP GDP Growth Volatility Estimate R-square 2011E Target Return 1Y Equity Return Volatility Estimate R-square 4Q10E Rate Target Volatility Estimate Interest Rate R-square Target S&P500 Vol Spread vs Volatility Estimate S&P500 6M RV R-square Target 6M Realized Vol Likely Range Current 6M Realized Vol Hang Seng 6.8% 14.8% 0.03 19.3% 13.5% 0.26 5.56%(China) & 0.25%(US) 20.0% 0.36 18.0% 21.9% 0.02 17.3% 13.5% - 21.9% 16.1% KOSPI 200 4.0% 13.4% 0.14 17.6% 11.4% 0.36 2.5% 18.0% 0.37 18.0% 18.6% 0.53 16.1% 11.4% - 18.6% 14.4% ASX 200 3.6% 14.8% 0.04 6.5% 14.8% 0.43 4.8% 13.8% 0.14 18.0% 15.2% 0.70 14.9% 13.8% - 15.2% 15.8%

Source: J.P. Morgan Equity Derivatives & Delta One Strategy *For the Hang Seng, we use the historical data and JPM estimates of Hong Kong and China GDP growth, weighted by the proportion of the Hong Kong and China stocks in the index. Similarly, we use the historical data and JPM estimates of US and China interest rates, weighted by the proportion of the Hong Kong and China stocks in the index. * Interest rate and realized volatility shows correlation with some time lag. A 6M lag is used for the KOSPI 200 and ASX 200 while for the Hang Seng, 6M (China rates) and 1Y (US rates) are used.

For Japan, based on the aforementioned bullish scenario, the following three charts will perhaps help us forecast appropriate volatility levels in Japan. The first chart plots the Nikkei 225 6-month historic volatility against the Nikkei 225. We see a common phenomenon of generally falling volatility in a rising market and vice versa. The implication is that we expect the volatility to fall from the current 19.3%, given the bullish outlook.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 57: Nikkei 6M realized volatility and Nikkei 225 (left) and USDJPY (right)
30030 25030 20030 N K Y 2 25 15030 10030 5030 30 40% 35% 30% V o latility
U S D JP Y 160 150 140 130 120 110 100 90 80 70
1 1 / 91 /24 / 5/ 9 2 24 1 1 / 94 /24 / 5/ 9 5 24 1 1 / 97 /24 / 5/ 9 8 24 1 1 / 00 /24 / 5/ 0 1 24 1 1 / 03 /24 / 5/ 0 4 24 1 1 / 06 /24 / 5/ 0 7 24 1 1 / 09 /24 /1 0 24

40% 35% 30% V o latility 25% 20% 15% 10% 5% 0%

25% 20% 15% 10% 5% 0%

11 / 91 /24 / 5/ 9 2 24 11 / 94 /24 / 5/ 9 5 24 11 / 97 /24 / 5/ 9 8 24 11 / 00 /24 / 5/ 0 1 24 11 / 03 /24 / 5/ 0 4 24 11 / 06 /24 / 5/ 0 7 24 11 / 09 /24 /1 0

5/

24

3M HV

NKY225

Average

5/

3M HV

USDJPY

Average

Source: J.P. Morgan, Bloomberg

The correlation between the volatility and currency is less clear-cut (see the second chart in Figure 57) as the correlation between the spot and currency has not always been strong. If we focus on the last few years, however, we see that the stronger JPY tends to generate higher volatility and vice versa. The bull scenario implies that the U.S. will likely enter into a monetary tightening cycle, which will likely result in the stronger USD against JPY. Here again, we will likely see the volatility fall from the current levels.
Figure 58: Nikkei 6M realized volatility and ISMPMI
65 60 55 ISMPMI 50 45 40 35 30
5/ 24 11 /91 /24 / 5/ 92 24 11 /94 /24 / 5/ 95 24 11 /97 /24 / 5/ 98 24 11 /00 /24 / 5/ 01 24 11 /03 /24 / 5/ 04 24 11 /06 /24 / 5/ 07 24 11 /09 /24 /1 0

40% 35% 30% Volatility 25% 20% 15% 10% 5% 0%

6M HV

US ISMPMI

Av erage

Source: J.P. Morgan, Bloomberg

Figure 58 ties the cyclical argument (represented by the US ISMPMI) to the Nikkei volatility. The common interpretation of the ISMPMI is that when this is above 50, the market is in a bull cycle, otherwise a bear cycle. Over the last 20 years, when the market is in a bull cycle, the Nikkei 225 average 6-month realized volatility has been around 19.6%, while in a bear cycle around 24.0%. Again, based on this analysis as well, the volatility will likely fall from the current levels. We note that over the last 10 years, the Nikkei 6-month volatility has been approximately 4 volatility points higher than that of the S&P 500 on average. Thus, although we forecast a declining Nikkei 225 volatility in 2011, the downside will likely be supported by the levels of the S&P 500 volatility.

Volatility Supply and Demand Dynamics

The price of risk, implied volatility, is determined by two factors 1) the expectation of future realized volatility, which has been discussed in detail in the previous section; and 2) the supply and demand from various market participants, which are usually the result of directional and hedging flows, the issuance of retail structured products, and the overreaction of market participants to short-term moves. While the implied volatility for an asset should reflect the markets expectation for future
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Global Equity Derivatives & Delta One Strategy 07 December 2010

realized volatility, supply and demand are important factors that drive implied volatility away from its fair value, and their imbalance can persist for extended periods of time, creating opportunities for option investors and volatility arbitrageurs. Hence, having the complete volatility landscape of supply and demand dynamics as well as a good understanding of realized volatility drivers is important for determining implied volatility. Over the past few years of bull and bear market cycles, the supply and demand volatility drivers were largely unchanged. The vast majority of volatility supply for this region is still provided by retail investors through their investments into structured products, which are predominantly volatility and skew selling in nature (see Figure 59). These products, namely autocallables, accumulators, and equity-linked notes (also known as reverse convertibles) tend to be very homogenous, with a limited range of structures constituting the vast majority of volume. In addition to structured products, there is also some supply of volatility coming from overwriting activities, in particular for Australia where selling call options to generate yield has been a common practice among the income generation funds. On the other hand, the demand for volatility is coming from the option buying interests of institutional investors through the OTC markets as well as retail investors through the exchange-listed covered warrants. Depending on whether there is an oversupply/undersupply of volatility, the banks, who are the counterparties for the retail and institutional investors, can sometimes suppress/increase market volatility with their collective hedging activities as they manage their trading positions.
Figure 59: Volatility supply and demand dynamics
Retail Investors Warrant Buyers Sell Vol Buy Vol Retail Investors Structured Product Buyers Buy Vol Sell Vol

Figure 60: Impact on term structure from retail investment products

Implied Volatility
40% Long Dated Structured Products such as Autocallables

35%

Investment Banks Product Issuers Sell Vol Buy Vol Buy Vol Sell Vol

Short Dated Structured Products such as ELN & Accumulators

30%

25%

Covered Warrants

Institutional Investors Option Sellers (Overwriting)

Source: J.P. Morgan.

Institutional Investors Option Buyers (Directional/Hedging)

20% 1M 2M 3M 6M 9M 1Y 2Y

Source: J.P. Morgan.

In 2010, there was an urgency to put investment capital to work as bank deposits were providing close to zero return. We observe that retail investment activities, rather than institutional, have more pronounced impact on volatility, both on the supply and demand side of the food chain, particularly in the Hong Kong market. Amid the recent market rally and recovery of risk appetite, we have seen Hong Kong retail investors becoming more active in the structured products and warrants markets to participate in the upside through these products. The impact of the heavy issuance of structured products and warrants is focused on the front end of the curve as most of these products have an effective maturity of three to six months (see Figure 60). Those products collectively tend to flatten the skew as warrant issuance (investors buying OTM calls) supports upside volatility while structured product issuance (investors selling OTM puts) suppresses downside volatility (see Figure 61). While the warrants market can be used as a channel for investment banks to hedge their long volatility exposure from structured product issuance, the volatility demand from the warrants issuance has been occasionally outweighing the supply from the structured product issuance in 2010, having a net impact of pushing up implied volatility. As a result, we often observe an abnormality in the moves of implied volatility and skew for the Hang Seng where its implied volatility resets higher but skew trends lower. The rise was more pronounced on the upside driven by warrants issuance as well as strong demand for upside calls from institutional investors. Such implied volatility moves have also resulted in the large implied over realized volatility premium for the Hang Seng during the 2-month market rally after the end of August. A similar trend can be found in the single stocks, which are popular in the warrants and structured product markets, and these stocks often

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

have very flat or even negative skews (see Figure 62). The cheapness in skew often presents attractive opportunities for risk reversal and call ratio trades in the Hong Kong indices as well as single stocks.
Figure 61: Impact on skew from retail investment products
Implied Volatility
40% 35% 30% 25% 20% 85
Source: J.P. Morgan.
Covered warrant activities support upside skew
0% high warrant demand causing flattening or inverting of single stock skew -3% Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Figure 62: Impact on skew from retail investment products

3M 90-110 skew
9% China Mobile (941 HK) HKEx (339 HK) China Life (2628 HK)

Structured products such as ELN & Accumulators suppress downside skew

6%

3%

90

95

100

105

110

115

Strike

Source: J.P. Morgan.

In Japan, since the equity market weakened significantly in 2H 2010, the flow of structured products dwindled as a result. Still, we have seen the total flow of 1.2 trillion notional in Japanese equity-linked structured products in Japan (up to Q3). Of these, 940 billion are in Nikkei-linked products (tenors varying from 1 to 5 years with concentration in 3 years), or approximately 72% of the total, 275 billion or 21% in single-stocks (tenors varying from 0.5 to 3 years), and 83 billion or 6% in worst-of-put notes (tenors varying from 1 to 2 years). Compared to the rest of Asia, structured products tend to have much longer tenors in Japan. Figure 63 compares the implied to realized volatility spreads among the Nikkei 225, TOPIX, and TOPIX Core 30. The presumption is that since the structured products are only linked to the Nikkei 225, we may be able to see the cheapening of the Nikkei 225 implied volatility versus TOPIX or TOPIX Core 30 volatility.
Figure 63: Implied to realized volatility spreads among Nikkei 225, TOPIX, and TOPIX Core 30
20 15 Spread (%) 10 5 0 -5 NKY 3M TPX 3M
Spread (%)

12 10 8 6 4 2 0 -2 -4 -6 -8
11 /24 /2 12 00 /24 9 /2 00 1/ 24 9 /2 01 2/ 24 0 /2 01 3/ 24 0 /2 01 4/ 24 0 /2 01 5/ 24 0 /2 01 6/ 24 0 /2 01 7/ 24 0 /2 01 8/ 24 0 /2 01 9/ 24 0 /2 10 010 /24 /2 11 010 /24 /2 01 0

NKY 1Yr TPX1Yr TPX 1Yr C30

TPX C30 3M

Source: J.P. Morgan, Bloomberg

At first glance, the flow of structured products may indeed be affecting implied volatility of the Nikkei 225, as opposed to the other indices, as seen in the 3-month volatility spread. The 1-year volatility spread, however, makes it less convincing. We may indeed attribute the cheap Nikkei 225 3-month implied volatility relative to realized to the popularity and liquidity of the Nikkei 225 options. As most index options traded in Japan are the Nikkei 225 options, it may be that dealers and investors are paying closer attention to Nikkei 225 volatility than the others, and consequently, the implied volatility is trading closer to the realized. The suspicion may very well stand to reason as the impact is seen in the short-dated volatility only, and trades are largely concentrated in relatively short-dated options.
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11 /24 /2 12 009 /24 /2 00 1/ 24 9 /2 01 2/ 24 0 /2 3/ 010 24 /2 01 4/ 24 0 /2 01 5/ 24 0 /2 01 6/ 24 0 /2 01 7/ 24 0 /2 01 8/ 0 24 /2 01 9/ 24 0 /2 10 010 /24 /2 11 010 /24 /2 01 0

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Considering high turnover in the index futures and options, we may not be surprised to see no clear impact of structured products on index volatility. The story, however, will not be repeated on single stocks as single stock options are primarily traded OTC in Japan and thus often have limited liquidity. One of the companies whose structured products have been traded on a consistent basis in 2010 is JFE Holdings. Nippon Steel, a comparable steel company in Japan, on the other hand, had no structured products this year. Hitachi is another such company, with six issues of structured products in 2010, while Mitsubishi Electric only had one. Figure 64 compares the implied to realized volatility spreads of these companies.
Figure 64: Implied to realized volatility spreads between JFE and Nippon Steel (left) and Hitachi and Mitsubishi Electric (right)
20 15 10 Sp re a d (% ) 5 0 -5 -10 -15 -20
/2 0 /2 09 3/ 20 0 1/ 23 9 /2 01 2/ 23 0 /2 3/ 010 23 /2 01 4/ 23 0 /2 5/ 010 23 /2 01 6/ 23 0 /2 7/ 010 23 /2 01 8/ 23 0 /2 01 9/ 23 0 /2 01 10 /23 0 /2 11 01 0 /2 3/ 20 10
Sp re a d (% ) 15 10 5 0 -5 -10 -15 -20
20 /23 09 /2 00 1/ 23 9 /2 01 2/ 23 0 /2 3/ 010 23 /2 01 4/ 23 0 /2 01 5/ 23 0 /2 01 6/ 23 0 /2 01 7/ 23 0 /2 01 8/ 23 0 /2 01 9/ 23 0 /2 01 10 0 /2 3/ 20 11 10 /2 3/ 20 10

11

12

JFE 3M

Nippon Steel 3M

JFE 1Y

Nippon Steel 1Y

11

Hitachi 3M

12

/2 3/

/23

Mitsubishi Elec 3M

Hitachi 1Y

Mitsubishi Elec 1Y

Source: J.P. Morgan, Bloomberg

The impact of the structured product on the single stock implied volatility is unmistakable, in our view. Just to add more fuel to the argument, we show two more examples in Figure 65. Nissan has had four structured products, while Honda has had none. Similarly, Mitsui & Co has had eight structured products, while Sumitomo Corp has had none. The lesson to be learned here is that the flow of structured products may offer us a hint as to which single-stock volatility may remain relatively cheap throughout the year.
Figure 65: Implied to realized volatility spreads between Nissan and Honda (left) and Mitsui & Co and Sumitomo Corp (right)
25 20 15 10 5 0 -5 -10 -15 -20 -25
20 15 10 Spread (%) 5 0 -5 -10 -15 -20

Spread (%)

11 /2 3/ 12 200 9 /2 3/ 20 09 1/ 23 /2 01 2/ 23 0 /2 3/ 010 23 /2 01 4/ 23 0 /2 01 5/ 23 0 /2 01 6/ 23 0 /2 01 7/ 23 0 /2 01 8/ 23 0 /2 01 9/ 23 0 /2 10 01 /23 0 /2 11 010 /23 /2 01 0

Nissan 3M

Honda 3M

Nissan 1Y

Honda 1Y

Source: J.P. Morgan, Bloomberg

For 2011, we believe that the flow of retail structured products likely will remain robust as the outlook on Asian equities remains bullish. Should investors recover their appetite for long-dated risk and the demand for equity exposure pick up, the demand for longer dated structured products (1-3 years) would also increase as well. Overall, the structural volatility imbalance should remain in place, with supply outweighing demand. Vibrant warrant activities in markets like Hong Kong can remove a good portion of the volatility supply from structured product issuance. However, the concentration of warrant
39

11 /23 / 12 200 /23 9 /2 00 1/ 23 9 /2 01 2/ 23 0 /2 3/ 010 23 /2 01 4/ 23 0 /2 01 5/ 23 0 /2 01 6/ 23 0 /2 01 7/ 23 0 /2 01 8/ 23 0 /2 01 9/ 23 0 /2 10 01 /23 0 /2 11 010 /2 3/ 20 10

Mitsui & Co 3M Sumitomo Corp 3M Mitsui & Co 1Y Sumitomo Corp 1Y

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

risks and barrier positions from the increased product issuance can potentially present upside risks to market volatility due to the impacts from derivatives hedging. Simple and transparent structures should remain popular as the risks of exotic products linger in the minds of both investors and regulators. We would expect the usage of exotic products to pick up slightly as risk appetite increases, but this change in product mix should only have a minor influence on the dynamics of Asian volatility.

Skew and Term Structure

Index skew began the year by moderating across the board before widening sharply as a result of the April/May sell-offs. As the risk of contagion failed to materialize, index skew softened to levels near the lows of the year but widened again recently on the back of the series of event risks that weighed on the markets and created an overall bearish risk-off tone (see Figure 66 and Figure 67). Despite the volatile movements, index skew was largely unchanged across the region from the levels at the start of the year. Over the course of the year, in terms of 3M 90-110 skew, the Hang Seng, KOSPI 200, and Nikkei 225 exhibited similar behavior, while the ASX 200, which usually tends to be higher than the rest of the region, remained somewhat elevated after the volatility spike in May. Clearly, supply and demand and investor preference should be an important driver of skew. Structured product flows tend to suppress downside volatility for the Asia ex-Australia markets. In Hong Kong, the warrants market activities have raised the demand for upside volatility, leading to further flattening of index skew. On the other hand, investors in Australia tend to call overwrite single stocks to generate yield while buying index puts for portfolio hedging, which keeps the index skew elevated.
Figure 66: 3M 90-110 skew for Asian indices
3M 90-110 Skew
14% 12% 10% 8% 6% 4% Hang Seng KOSPI 200 ASX 200 Nikkei 225

Figure 67: Skew remains low with smaller down moves

3M 90-110 skew
12% KOSPI 200 3M 90-110 Implied Vol Spread Max Sell-off 10% -20%

Max Sell-Off
-25%

8%

-15%

6%

-10%

4%
2% 0% Jan-07

-5%

Jan-08

Jan-09

Jan-10

2% 2005

0% 2006 2007 2008 2009 2010

Source: J.P. Morgan.

Source: J.P. Morgan.

The outlook for index skew in 2011 remains finely balanced. In 2010, index skew was driven both by market direction and risk appetite as well as supply and demand. With the outlook for underlying markets in the coming year remaining bullish amid accommodative credit conditions, barring significant market shocks or tail events, the argument for lower index skew in 2011 remains supportive, even though index skew has largely normalized from the peak levels after the May sell-offs. Indeed, as the supply and demand imbalance of volatility can persist for an extended period of time, with flows which have suppressed skew in 2010 likely to continue into the coming year, the tailwinds for a lower skew will likely remain. Throughout 2010, Asian index term structures were mostly upward sloping except the period shortly after the market correction in May due to heightened sovereign risk concerns. Since then, the inverted term structures have quickly normalized and mostly stayed upward sloping for the rest of the year. The normalization at the time was partly driven by very low realized volatility, leading to long gamma positions becoming very expensive to carry. Volatility traders were then forced to sell out of long volatility positions, eventually pulling down the short end of the curve. In addition, as explained in the previous section, we can also see the evidence of volatility supply and demand across the Asian term structures. Call
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

overwriting activities in Australia and the issuance of accumulator products and other bullish equity-linked notes in the rest of Asia have the initial overall impact of lowering volatility. Because most of these products have been concentrated on the short maturities this year and their effective maturity could be shorter than their contractual maturity, they put more downward pressure on short-term volatility, resulting in more upward-sloping term structure. Despite the recent flattening, except for a slight inversion in the front months for the KOSPI 200, all Asian term structures are upward sloping (see Figure 68). In general, the current term structures still look steeper (or more upward-sloping) relative to their implied volatility levels. Figure 69 highlights this trend using the Hang Seng as an example. Based on data since 2004, the current 3-month vs. 12-month term structure spread is standing at the lower end of the band relative to its 3-month implied volatility level.
Figure 68: Current Asian index term structures
Implied Volatility
36% 33% 30% 27% 24% 21% 18% 15% 0 6 12 18 24 30 36 42 48 54 60

Figure 69: Hang Seng 3M-12M term structure vs 3M implied volatility

3M-12M Term Structure
ASX 200 Nikkei 225
25% y = 0.4633x - 0.0663x - 0.0116 20% 15% 10% 5% 0% -5% -10% 10% 20% 30% 40% 50% 60% 70% 80% Current Point R = 0.8074
2 2

Hang Seng

H-shares

KOSPI 200

Source: J.P. Morgan.

Maturity (Months)

Source: J.P. Morgan.

3M Implied Volatility

On the back of the bullish outlook on Asian equities for 2011, the overall term structures should remain sensitive to market directions. With implied volatility trending lower across the curve, short-term implied volatility should largely remain suppressed due to low realized volatility, keeping the upward slope intact. However, we note that the long end of the volatility curve is also particularly driven by supply and demand for structured products. Yield enhancement products will often involve selling longer-dated volatility to generate premium. As investors become more bullish on Asian equities and recover their appetite for long-dated risk, we expect that the demand for longer-dated structured products can potentially pick up, putting downward pressure on the back end of the volatility curve. In addition, further increase in warrants activities would alleviate some of the supply-demand imbalance in short-term implied volatility. Also, there still exists a possibility of volatility spikes as we have seen in the Eurozone sovereign debt crisis in May, but they are likely to be only temporary, keeping the general trend of upward-sloping term structure intact in 2011.

Correlation
Alongside the overall decline in index implied volatility after the sell-offs in May, implied correlation has also softened from its highs. The structural imbalance of supply and demand of volatility in Asia also has a major influence on implied correlation. Across the region, the issuance of structured products as well as call overwriting activities (particularly in Australia) tend to suppress single stock implied volatility, leading to relatively elevated levels of index implied volatility and correlation. Due to this structural imbalance, implied correlation tends to be very sticky and remain stubbornly elevated on both historical and relative basis. In terms of ranking, among the indices with liquid index and single stock options markets, the implied correlation for the Hang Seng is the highest, ASX200 ranks second, and the TOPIX is the lowest (see Figure 70, Figure 72, and Figure 74). We also note that while correlation and volatility usually move together, the current level of realized correlation appears high in comparison to the relatively moderate levels of component stocks volatilities, especially for the ASX 200 and TOPIX (see Figure 71, Figure 73, and Figure 75). As market conditions normalized after the May sell-offs, the Hang Seng realized correlation dropped to levels below 45%. On the other hand, realized correlations for the TOPIX and ASX 200 continue to rise further and are similar or even higher than the levels observed back in late 2008 and early 2009. While implied correlation remains elevated, the spread between
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

implied and realized correlation for the Hang Seng has become quite wide, making index dispersion trades quite attractive. While the Hang Seng currently has the widest implied to realized spread, the implied to realized correlation spread for the ASX 200 has been the most stable. On both absolute and relative bases, index dispersion is the most attractive for the Hang Seng and ASX 200, in our view.
Figure 70: Hang Seng 6M implied and realized correlation*
Correlation
100% 80% 60% 40% 20% 0% -20% Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Implied to Realized Spread 6M ATM Implied Correlation 6M Realized Correlation

Figure 71: 6M realized correlation vs. avg stock realized volatility*

Correlation
80%

70%

60%

50% 40%

30%

Current 2010 2009 2008 2007 2006

20% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Source: J.P. Morgan. *Based on top15 components and weightings of Hang Seng as of 1-Dec-10

Source: J.P. Morgan Avg Stock Realized Volatility *Based on top15 components and weightings of Hang Seng as of 1-Dec-10

Figure 72: ASX 200 6M implied and realized correlation*

Correlation
100% 80% 60% Implied to Realized Spread 6M ATM Implied Correlation 6M Realized Correlation

Figure 73: 6M realized correlation vs. avg stock realized volatility*

Correlation
60%

50%

40%
40%

30%
20% 0% -20% Jul-06

20%

Current 2010 2009 2008 2007 2006 20% 30% 40% 50% 60% 70%

10%
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

10%

Source: J.P. Morgan. *Based on top15 components and weightings of ASX 200 as of 1-Dec-10

Source: J.P. Morgan Avg Stock Realized Volatility *Based on top15 components and weightings of ASX 200 as of 1-Dec-10

42

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 74: TOPIX 6M implied and realized correlation*

Correlation
100% 80% 60% 40% 20% Implied to Realized Spread 6M ATM Implied Correlation 6M Realized Correlation

Figure 75: 6M realized correlation vs. avg stock realized volatility*

Correlation
70%

60%

50% Current 2010 2009 2008 2007 2006 30% 40% 50% 60% 70% 80%

40%
0% -20% Jul-06

30%
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

20%

Source: J.P. Morgan. *Based on the components and weightings of TOPIX Core 30 as of 1-Dec-10

Source: J.P. Morgan Avg Stock Realized Volatility *Based on the components and weightings of TOPIX Core 30 as of 1-Dec-10

In general, realized correlation tends to move in the opposite direction of the equity market and fundamental growth. During periods of falling markets where macro uncertainty tends to dominate, stocks become more volatile and more highly correlated at the same time. On the other hand, an environment of low correlation and low stock volatility tends to coincide with steadily rising markets where underlying fundamentals become the main driver and macro risk factors are lacking. While the markets will still be largely affected by investors risk-on and risk-off sentiment as well as the aforementioned macro drivers, single stocks should start moving more on company fundamentals and be less driven by macro factors, leading to lower realized correlation. Upon potential upside earnings revision and the bullish outlook across the Asia Pacific equity markets, barring significant market shocks or tail events, we therefore should likely see realized correlation come down next year, in our view. Given that the imbalance of supply and demand of volatility tends to be structural and structured product issuance tends to pick up during bull markets, we also believe implied correlation will remain elevated above realized correlation. Summary While the bullish outlook for Asian equities should generally lead to the decline of Asian volatility and equity risk premium, the aforementioned macro risk factors are unlikely to fade soon, preventing the collapse of risk premium, in our view. We would be mindful of the risks of an increase of volatility related to unintended consequences of QE2 such as sharp inflation and public sector debt stress in DM economies, which could cause some short-lived volatility spikes. Hence, our core view for 2011 is that realized volatility for the region will remain relatively similar or slightly higher than the current level. Nonetheless, we do not think the macro headwinds will be strong enough to decisively shift the volatility regime to a higher level. Barring significant market shocks or tail events, the argument for lower index skew and upward sloping term structure in 2011 remains supportive. The macro beta trades that dominated during the bear market and the subsequent recovery phase will become less important as bottom-up fundamental strategies and earnings estimate revision should be a key driver of stock prices in 2011, leading to a drop in correlation, which can drive down volatility. The structural imbalance of supply and demand for volatility in Asia as a result of the pickup in retail structured product flows has contributed to the downward volatility trend this year and will likely continue in 2011, providing the tailwinds for lowering volatility. However, we note that the concentration of risks and barrier positions from the increased product issuance can potentially present upside risks to market volatility due to the impacts from derivatives hedging.

43

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Global Dividends
Dividend performance was strong into year-end 2009 but has been mixed during 2010. Nikkei dividend futures have performed particularly well, led by the shorter dated 2010 and 2011 dividend futures, which are up 27% over the last year. The Euro STOXX 2011 dividend futures were the best performing dividend contracts in Europe, up 12%, but the longerdated dividend futures have still not fully recovered from the correction suffered during May-July (Table 6 and Figure 76).
Table 6: Current implied dividends for the Nikkei 225, S&P 500, Euro STOXX 50, and FTSE 100 as well as dividend returns over the last year
Nikkei Current 24-Nov-09 Nov09-Nov10 Year-to-date Current 24-Nov-09 Nov09-Nov10 Year-to-date Current 24-Nov-09 Nov09-Nov10 Year-to-date Current 24-Nov-09 Nov09-Nov10 Year-to-date 2010 174.1 137.5 26.6% 17.0% 22.80 22.36 1.9% -3.4% 112.8 106.4 6.0% 0.7% 177.4 182.0 -2.5% -4.1% 2011 175.0 138.0 26.8% 18.8% 24.85 22.84 8.8% 0.5% 116.1 103.7 12.0% 3.4% 191.8 183.4 4.6% 4.0% 2012 166.1 135.8 22.3% 13.4% 26.60 23.18 14.7% 2.7% 109.0 103.9 4.9% -2.7% 198.4 185.8 6.8% 7.2% 2013 160.6 135.8 18.3% 10.4% 27.68 24.07 15.0% 3.4% 104.1 104.3 -0.2% -8.5% 198.6 185.8 6.9% 6.8% 2014 157.5 136.3 15.6% 8.2% 28.85 24.96 15.6% 4.2% 101.1 105.2 -3.9% -11.5% 198.8 186.0 6.9% 0.1% 2015 154.6 142.0 8.9% 5.5% 29.95 25.72 16.4% 4.2% 101.1 106.4 -5.0% -12.2% 200.4 187.0 7.2% 0.7% 2016 152.0 2017 150.6 2018 149.3 2019 147.9 Index 10,030 9,402 6.7% -4.9% 1,198 1,106 8.3% 6.3% 2,758 2,878 -4.2% -7.0% 5,657 5,324 6.3% 4.8% 2011 yield 1.7% 1.5%

S&P

Euro Stoxx

FTSE

31.08 26.83 15.8% 4.6% 101.6 108.1 -6.0% -13.5% 201.4

32.25 27.30 18.1% 5.3% 103.2 110.0 -6.2% -13.1%

33.25 28.31 17.5% 5.2% 104.8 111.7 -6.2% -13.9%

34.25

2.1% 2.1%

106.5

4.2% 3.6%

-12.1%

3.4% 3.4%

0.9%

Source: J.P. Morgan Equity Derivatives Strategy.

The dividend term structure is now inverted for both the Euro Stoxx and Nikkei, having been almost flat one year ago. By contrast, the S&P dividend swap term structure now prices in consistent high dividend growth, having steepened further over the last year. Based on our estimates, S&P dividend swaps incorporate a 12.7% compound annual dividend growth rate through 2019 compared to 5.8% for the Euro Stoxx and 5.4% for the Nikkei (Figure 77).
Figure 76: Nikkei dividends have outperformed during 2010. All dividend contracts suffered substantial losses during the correction in May-June this year.
Dividend future / dividend swap performance year-to-date

Figure 77: S&P dividend swaps price in consistent dividend growth through 2019, while the Euro Stoxx and Nikkei dividend term structure remains inverted
Implied dividend term structure (relative to current 2010 level which is set = 100)

130 125 120 115 110 105 100 95 90 85 23-Nov

Euro Stox x 2011 FTSE 2011 Nikkei 2011 S&P 2011

150 140 130 120 110 100 90 80 70

S&P FTSE Euro Stox x Nikkei

23-Feb

23-May

23-Aug

23-Nov

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Dividend Maturity
Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

44

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

We continue to recommend long Nikkei and Euro STOXX 50 2012 dividends. The outperformance of the one-year forward dividend future in Europe and Japan vindicates the view that we advocated in our 2010 outlook that investors should focus their exposure on shorter-dated dividend futures due to their relatively defensive characteristics. We argued that the benefits of holding short-dated dividends outweighed the benefits of holding the longer-dated dividend positions, even though the latter offered greater upside potential to bottom-up estimates. Longer-dated dividends expose an investor to higher volatility, higher beta to the equity market and greater uncertainty about the timeframe over which the return will be generated. We continue to recommend owning Nikkei and Euro STOXX dividends through a rolling one-year forward dividend position because the contracts offer sufficient upside potential in our view (Figure 78), and our analysis of structured product issuance on the underlying indices leads us to conclude that the supply of longer dated dividends will increase meaningfully prior to the expiry of these contracts (Figure 79). This may cause the discount to fair value to persist until the longer dated contracts get closer to expiry. See our publication Global Derivatives Themes Opportunities in Global Dividends, August 16, 2010, for further details of our views on the risks and opportunities for dividend investors presented by the global structured product market.
Figure 78: Nikkei and Euro Stoxx dividends offer the greatest upside potential to bottom-up fair value estimates. We recommend buying the 2012 dividend futures.
Upside or downside potential to bottom-up fair value estimate for each maturity

Figure 79: We expect the continued issuance of structured products on the Euro Stoxx, Nikkei, and FTSE to meaningfully increase the supply of longer dated dividends
Euro Stoxx dividend supply from structured products/ dividend futures open interest

50% 40% 30% 20% 10% 0% 2011

Source: J.P. Morgan Equity Derivatives Strategy.

100
Euro Stox x Nikkei FTSE S&P

80 60 40 20 0 2012 2013

Actual Div idend Futures Open Interest Estimated Already Oustanding Estimated Oustanding plus Estimated Future Issuance

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Source: J.P. Morgan Equity Derivatives Strategy. *We estimate the dividend supply from structured products (see Global Derivatives Themes, 16 August 2010) while the Actual Dividend Futures Open Interest is based on exchange data.

Maturity (Calendar Year)

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Nikkei dividends
As we conclude 2010 and roll over to the next year, many Japanese companies have already provided dividend guidance for 2011 and sometimes even beyond. Hence, the dividend outlook for 2011 has greater transparency, and it is essentially priced in, with only 3.5% upside with Toyo Keizai estimates and 10.1% upside with our estimates.*
Figure 80: Potential upside of Nikkei dividends remain high, with the upside being greater as we move further down the maturity
Potential upside of Nikkei dividends as compared to bottom-up estimates
220
Potential Upside w/ JPM Estimates*

30.0%
Potential Upside w/ Consensus Potential Upside w/ Toyo Keizai

210 200 190 Dividends (Index Points)

24.1%24.1%

25.0% 20.0% 15.0% Potential Upside (%)

180 170 160 150 2010 2.2% 2.1%

10.1%10.0%

10.0% 3.5% 5.0% 0.0%

0.8% 2011 2012

Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg, Toyo Keizai. *Currently, 111 out of 225 Nikkei constituents are covered by our analysts.

Nikkei dividends continue to be heavily downward sloping, which makes longer dated dividends a potentially attractive buy compared to our bottom-up estimates; for example, we currently see over 30% upside for 2013 dividends. However, longer dated dividends are also highly correlated with the Nikkei spot, and this may expose dividend investors to potentially greater downside risk. Since there is little upside in 2011 dividends, and longer dated dividends beyond 2013 offer little transparency to dividend estimates and also pose greater downside risk with respect to the underlying, we believe 2012 dividends represent the sweet spot.
Figure 81: Nikkei dividends remain highly downward sloping, potentially offering investors greater upside on longer dated dividends as compared to bottom-up estimates . . .
Term Structure of Nikkei Dividends

Figure 82: But the correlation of longer dated dividends with the Nikkei spot are also greater, potentially exposing investors to greater downside risk as well
Correlation of Nikkei dividends with the Nikkei spot
Nikkei 2010 Nikkei >0.8 0.0~0.8 <0.0 2010 -0.20 2011 0.38 2012 0.52 2013 0.64 2014 0.75 0.03 -0.06 -0.07 -0.16 0.74 0.79 0.71 0.82 0.75 0.95 -0.20 2011 0.38 0.03 2012 0.52 -0.06 0.74 2013 0.64 -0.07 0.79 0.82 2014 0.75 -0.16 0.71 0.75 0.95

175 Dividends (Index Points) 170 165 160 155 150 145 2010 2011 2012 2013 2014 2015 2016 2017 2018
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg.

Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg.

46

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

European dividends
We assess the relative attractiveness of implied dividends to equities. In order to look at this we use a simple dividend discount model; the model calculates the fair value for the equity index as the sum of the discounted implied dividends and a terminal value beyond the last traded dividend instrument, which depends on a terminal growth rate.7 Using the observed dividend futures levels and equity index level we calculate the implied dividend growth rate the rate at which dividends need to grow from the longest dated point in the dividend curve to perpetuity in order for equity to be fairly priced at the current level. Figure 83 illustrates the historical evolution of the implied growth rate, calculated assuming an equity risk premium of 6.5%. Despite a pickup in the last few months, the implied growth rate has been declining since H2-09, indicating that the relative attractiveness of implied dividends across the entire term structure vs. equities has been declining.
Figure 83: The implied growth rate for Euro STOXX 50 dividends has been declining, pointing to dividends becoming less attractive to equities in relative terms
Implied terminal growth rate for Euro STOXX 50 dividends

Figure 84: Long-dated (2015) Euro STOXX 50 dividend yield is a sell, despite having declined from the first half highs; increase short dividend yield position if the implied yield goes above 4%
Dividend Yield

9% 8% 7% 6% 5% 4% Aug-08

Implied grow th rate (risk av ersion 6.5%)

4.5% 4.0% 3.5% 3.0% 2.5%

2015 implied div idend y ield

Aug-09

Aug-10

Sep-09

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

This observation on the relative value between equities and dividends applies to the dividend curve in its entirety and does not imply that all long dividend trades are unattractive. We continue to believe that buying dividends on the short end of the curve to play the 'pull to realised effect is an attractive proposition. The upside to bottom-up fundamental estimates remains attractive for Euro STOXX 50 2012 dividends (28.8% as of 03 Dec 2010, based on J.P. Morgan analysts estimates). The 2012 dividends should benefit from the pull to realised effect over the next 12 months, similar to what happened to the 2011 dividends this year. Other advantages of buying 2012 dividends instead of longer dated dividends are the higher visibility on earnings and payout ratios in the short term and their higher liquidity. We find buying longer dated dividends relatively less attractive, despite their higher discounts to fundamental estimates. It will be necessary to carry these positions longer in order to benefit from a convergence to realised, and the equity-like behavior of these positions makes them more risky from a mark-to-market perspective. In addition to this, longer dated dividend futures can suffer more than the shorter dated ones on days of low liquidity. We believe that longer dated dividends are a good sell vs. equity and therefore recommend selling the 2015 dividend yield. We recommend initiating the trade at the current level on half the notional size and increase the position to the full notional size should the implied dividend yield increase above 4% in the future (Figure 84). The dividend yield can be sold either by selling dividend futures and buying equity futures/forwards or by trading a dividend yield swap. A dividend yield swap is a contract to exchange a set implied divided yield (strike) with the future
7

The implied dividend levels are discounted at the risk-free rate as the implied dividends are traded instruments and therefore incorporate a market risk premium. The terminal value estimate is an expectation and is therefore discounted using a risky rate which includes an estimate of the risk premium, which we assume is the same as that for equities (currently 6.5% for European equities).
47

Sep-10

Jun-09

Dec-07

Dec-08

Dec-09

Dec-08

Dec-09

Mar-09

Mar-10

Jun-10

Apr-08

Apr-09

Apr-10

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

realised dividend yield at trade expiry, calculated as the regular dividends paid over the calendar year of concern in index points divided by the average level for the index calculated over four quarterly observation dates in the said calendar year. The implied dividend yield strike in a dividend swap is higher than the 'vanilla' implied dividend yield8 (i.e., ratio of the implied dividend futures level and index forward level). The typical convexity pickup for a 2015 dividend yield swap over vanilla forward yield (i.e., dividend futures level to Euro STOXX 50 forward ratio) is 20-30bps. The main risks for long European dividends are linked to fiscal tightening in Europe, in our view. European governments could increase taxation or intervene on the tariff system for some regulated industries (e.g., Utilities and Telecoms), therefore limiting the ability of these companies to pay out cash dividends. Further to this risk, European financials might have to cut dividend payouts to improve their balance sheets should this be necessary due to a worsening of the credit markets in Europe or pressure from regulators. Finally, idiosyncratic company dividend risk needs to be factored in as it can have a significant effect on index dividend levels, such as in the case of BP for FTSE dividends (dividend cancellation) or Total for the Euro STOXX 50 (transfer of part of the dividend from the 2011 to the 2012 contract). One of the characteristics of dividend futures that should be taken into account is their higher negative returns skewness compared to equity index returns. In other words, implied dividends can have a high downside beta to equity returns on days of large negative market returns. This behavior is caused by the fact that liquidity in dividend futures can become extremely choppy in strong down days, when there are no marginal buyers of dividends and sellers unwind their longs at distressed prices. Figure 85 illustrates how dividends underperformed in the May correction and over last few weeks.
Figure 85: Dividend futures underperformed the equity index both recently and during the May correction
Euro STOXX 50 index/dividend level (rebased)

Figure 86: A signal based on dividend realised returns skewness worked well for timing the latest period of dividend underperformance
Euro STOXX 50 dividend futures level Realised skewness measure

110 100 90 80 70

Euro STOXX 50 index Euro STOXX 50 2012 div idends Euro STOXX 50 2015 div idends

115 110 105 100 95 01-Sep 15-Sep 29-Sep

2012 div futures - left ax is Realised skew - right ax is

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 13-Oct 27-Oct 10-Nov 24-Nov

Aug-10

Sep-10

Jun-10

Source: J.P. Morgan Equity Derivatives Strategy.

May-10

Nov-10

Dec-10

Apr-10

Oct-10

Jul-10

Source: J.P. Morgan Equity Derivatives Strategy.

A measure of the skewness of the dividend futures return distribution can help identify when the short-term underperformance risk is particularly high. Figure 86 shows a chart of a signal based on the skewness of dividend futures vs. the performance of dividends and illustrates how this signal has been effective for timing this underperformance. The J.P. Morgan Structuring Team has created a dividend tracker that replicates investments in dividend futures, controlling the volatility and changing the exposure to dividends based on a returns skewness signal.9 The performance of the index can be tracked on Bloomberg via the ticker DVJP15EU Index.

8 9

The pickup is due to the convexity of the payoff of the dividend yield swap and the non-perfect correlation of dividends and equities. The product holds the nearest five dividend futures and rolls them systematically to maintain the exposure. The risk control mechanism consists of adjusting the exposure to the base tracker in such a way that the realised volatility of the product matches a target level of 15%. The exposure to dividends is reduced from the level determined by the volatility control mechanism when the returns skewness is negative and increased it when the return skewness is positive.
48

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Hang Seng / H-shares Index Dividend Futures

The Hang Seng (HSI) Dividend Point Index Futures and H-shares (HSCEI) Dividend Point Index Futures were listed on the Hong Kong Exchange on November 1, 2010. These futures are based on the HSI/HSCEI Dividend Point Indices, which measure the annual accumulated gross cash dividends10 of the constituent stocks of HSI and HSCEI respectively, in terms of index points, and are reset to zero on the second to the last trading day of each year. See Table 7 for the summary of the contract specifications.
Table 7: HSI/HSCEI Dividend Point Index Futures Contract Specifications
Underlying Index Bloomberg Ticker Contract Multiplier Minumum Fluctuation Flucuation Contract Month Trading Hours Settlement Price Last Trading Day
Source: Hong Kong Exchange.

HSI Dividend Futures HSCEI Dividend Futures HSI Dividend Point Index (HSIDPI Index) HSCEI Dividend Point Index (HSCEIDPI Index) DHSA Index DHCA Index HK$50 per Index point 0.01pts three nearest December contract months 9:45-12:30, 14:30-16:15 The quotation of the underlying dividend point index in two decimal places taken on the business day following the last trading day the second business day after the last trading Day

As dividend swaps are very illiquid in Asia (except for Japan), exchange-traded dividend futures may meet the market demand for hedging dividend exposure or implementing a view on dividends with the benefits of centralized clearing, transparent pricing, and standardized product specifications. However, HSI/HSCEI dividend futures still need some time to raise awareness and popularity among the market participants. The total open interest for HSI/HSCEI dividend futures are merely 971 and 2,481 contracts, equivalent to the notional of USD 4.2Mn and 4.8Mn, respectively (as of Dec 3, 2010), with many days of zero trading volume. Investors should be aware of this liquidity issue, which can be translated into a discount of futures prices. The bottom-up analysis based on the average of sell-side analysts' estimates suggests strong upside potential for the next two years (HSI: +7% in 2011 and 24% in 2012, HSCEI: 17% in 2011 and +38% for 2012) driven by solid economic growth in Hong Kong and China. However, the biggest risk is the limited liquidity of the index dividend futures, which can lead to a wide bid-ask spread and significant mark-to-market loss, especially in times of market correction. Also, irregular dividend policy in many of the Chinese companies and potential economic slowdown due to the aforementioned risk factors poses a downside risk to the realization of dividends in the coming years.
Figure 87: Hang Seng (HSI) Index Dividend
900 Historical Dividend Futures Bloomberg est. Consensus est.

Figure 88: H-shares (HSCEI) Index Dividend

500 Historical Dividend Futures Bloomberg est. Consensus est.

800

400
700

300
600

200
500

400 2008 2009 2010 2011 2012

100 2008 2009 2010 2011 2012

* Consensus est. is the average of estimates from sell-side analysts, gathered by Bloomberg. Source: J.P. Morgan, Bloomberg.

* Consensus est. is the average of estimates from sell-side analysts, gathered by Bloomberg. Source: J.P. Morgan, Bloomberg.

10

Besides normal and special cash dividends, cash dividends with scrip option and scrip dividends with cash option are also included.
49

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Trade Ideas for 2011

US: Sell (and partially hedge) S&P 500 Dec 2011 Variance
As described in the Global and US Equity Market Volatility Outlook, we anticipate S&P realized volatility of around 18% in 2011. In this context S&P Dec 11 variance looks expensive. The S&P ATM implied volatility term structure is near its steepest levels as measured by the difference between 3-month and 12-month maturities (see Figure 15 on page 12). If the term structure maintains this shape, a short S&P one-year volatility position would benefit from the slide down the term structure as time elapses. Beyond a one-year maturity, the term structure remains upward sloping but is relatively flat. Therefore, one year is as far as one needs to stretch the maturity of a short volatility position in order to exploit the steepest part of the term structure, in our view. The premium of S&P variance to ATM implied volatility is currently close to its highs (greater than 90th percentile) for all maturities of 9-months and longer but is close to its median level for shorter-dated (1-month to 3-month) maturities (see Figure 17 on page 13). If this relationship persists, then a short S&P Dec 11 variance position would benefit from the declining premium of variance to ATM volatility as time elapses. The combination of these two factors suggests that Dec 11 variance is the sweet spot for a short S&P volatility position, in our view. In Figure 89 we show the hypothetical P&L progression that would be generated by such a position, assuming that the term structure for both ATM implied volatility and implied variance remains as it is, and assuming realized volatility of 18% throughout. If our S&P realized volatility forecast turns out to be accurate, investors would generate a profit of around 7 vegas.
Figure 89: Hypothetical profit / loss progression from a short Dec 11 S&P variance position, assuming the current implied variance term structure remains the same and S&P realized volatility averages 18%
Hypothetical S&P implied variance, Estimated S&P realised volatility Hypothetical profit / loss (vegas)

Figure 90: The implied minus realized volatility carry for the S&P index currently exceeds that for the basket of 10 cheap volatility stocks that we suggest owning volatility on
Implied minus EWMA realized volatility

30% 28% 26% 24% 22% 20% 18% 16%

Hy pothetical Dec-11 implied v ariance (left) Estimated realised v olatility Hy pothetical profit/loss (right)

8% 7% 6% 5% 4% 3% 2% 1% 0% -1%

10% 5% 0% -5% -10% -15% -20% Dec-08 Jun-09 Dec-09 Jun-10 Dec-10
S&P carry Av erage Stock Carry

Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

A short S&P Dec 11 variance position could suffer substantial mark-to-market losses in the event of a spike in either implied or realised volatility (see the actual performance of a short Dec 10 variance position in Figure 6 on page 8 for an illustration of the impact of the spike in volatility that occurred in May/ June of this year). As a consequence, an outright short Dec 11 variance position may not be appropriate for all investors. Below we suggest a strategy that could be implemented to help alleviate these risks.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Buy volatility on 10 large-cap US stocks as a hedge for a short S&P volatility position. We have screened the US stocks with the greatest options liquidity for cheap implied volatility. Table 8 shows the 10 stocks that rank the cheapest according to the following metrics: Low 3-month ATM implied volatility. Volatility z-score of the spread between the current 3-month ATM implied volatility and the ExponentiallyWeighted Moving Average realized volatility (using two years of data and a decay factor of 0.97). Rangebound score: The ratio of the current high-low range implied by 3-month option prices to the stocks recent 3-month high-low range. Mean-reversion score: The slope of the regression between holding period volatility for long-dated versus shortdated returns: a low or negative score suggests mean-reversion. Volatility z-score versus S&P: The current number of standard deviations rich or cheap compared to the historical regression between the stock's 3-month ATM implied volatility and that of the S&P 500 index. Finally, we excluded all stocks whose 3-month ATM implied volatility was higher than the median ATM implied volatility (26.8%) of the 200 largest S&P members.

Figure 90 above shows the historical implied minus realized volatility carry for the S&P index compared to the average for this particular basket of 10 stocks. We recommend buying volatility on these stocks as a potential hedge for a short S&P Dec11 variance position.
Table 8: 10 stocks with cheap volatility. We recommend buying volatility on these stocks as a potential hedge for short S&P Dec11 variance.
Ticker WAG UN HD UN WIN UW DD UN XOM UN QCOM UW UNP UN DIS UN CVS UN RTN UN Name Walgreen Home Depot Windstream Du Pont Exxon Mobil Qualcomm Union Pacific Walt Disney CVS Caremark Raytheon Sector Retail Retail Telecom Chemicals Oil & Gas Technology Industrials Media Retail Industrials 3M ATM implied 26.6% 24.3% 17.9% 24.3% 19.0% 25.8% 26.3% 22.8% 25.5% 22.1% EWMA realised 26.6% 26.4% 18.7% 21.9% 17.0% 22.7% 22.7% 22.0% 22.7% 21.2% Volatility z-score -0.33 -0.56 -0.42 -0.06 -0.11 0.02 0.07 -0.23 -0.02 -0.22 Rangebound 105% 63% 85% 74% 102% 83% 80% 69% 59% 46% Mean-reversion 0.76% 1.15% -0.24% 0.70% 0.22% 0.57% 0.35% -0.29% 0.26% 0.65% Vol z-score vs. S&P 0.19 -0.74 -1.18 -1.85 0.75 -1.37 -2.72 -1.17 -1.85 0.01

Source: J.P. Morgan Equity Derivatives Strategy.

The high current implied correlation of the S&P 500 index favors selling index volatility and buying single stock volatility (see Figure 21 on page 15 for our view on correlation in 2011). Judicious selection of cheap single stock volatility can enhance the performance of a short correlation trade.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

US: Long Market Through S&P 500 Risk Reversals (Sell Skew)
We mentioned earlier that the S&P fixed strike skew has remained relatively steady during 2010, with the exception of the May-June correction. The S&P 12M 90-100 skew is currently ~3.1% and in its 89th percentile (Figure 91). Although the skew is not as steep as its June levels of ~3.6% we believe that the current level of ~3.1% is still expensive. J.P. Morgan Equity Strategist Tom Lee has a YE price target of $1375 (~16% upside from the current levels). Some of the favorable conditions that support risky assets in 2011 are cyclical lift boosting corporate profits, easy monetary policy, centrist Washington, and attractive relative value. Investors looking to take advantage of our view on equities and skew may want to consider selling puts and buying calls on the S&P 500. Specifically, buying the Dec 2011 $1225 (~0.3% OTM) strike calls for $96.60 and selling the Dec 2011 $1100 (~10% OTM) puts for $71. This trade can be entered into for a net cost of $25.6 (~2.1% of notional). Figure 92 below shows the profit-loss of this trade compared to holding the S&P outright.
Figure 91: S&P 500 12M 90-100 Skew over Past 5 Years
3.8% 3.6% 10% 3.4% 3.2% 3.0% 2.8% 2.6% 2.4% 2.2% -15% 2.0% 1.8% Dec 05 Jun 06 Nov 06 May 07 Nov 07 May 08 Nov 08 May 09 Nov 09 May 10 Nov 10 -20% S&P 500 at Expiry 5%

Figure 92: Profit-Loss of Risk-Reversal and S&P 500

15% Risk-Reversal S&P 500

0% $1,000 -5%

$1,040

$1,080

$1,120

$1,160

$1,200

$1,240

$1,280

$1,320

$1,360

-10%

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

There are multiple benefits of being long risk-reversals when compared to being long the S&P outright. Some of these benefits can be seen in Figure 92 above. For a large drop in the S&P by expiry (greater than ~10%) the risk-reversal would outperform the S&P position by ~7.9% as the short put is 10% OTM. For a move to the upside in the S&P, the risk-reversal would underperform by only ~2.4%. Another benefit that the risk-reversal provides, as with any option position, is leverage as by shifting the strikes you can change the structure that we proposed such that for selling one put you can buy multiple calls. S&P equity performance in 2011 what the options market is telling us. Using the prices for options on the S&P 500 with different strikes, we can calculate what the index implied distribution is for each maturity (Figure 93). Currently, option prices imply around a 10% chance of the index being above 1500 and around a 10% chance of the index being below 800 in December 2011. Considering more probable scenarios, the options market implies a probability of around 27% that the S&P 500 will be at or above 1375 in one years time. Investors that perceive the probability of such an outcome to be higher than this implied probability may find outright call options to be attractively priced at current levels.11 Alternatively, investors may consider the implied probability of potential negative outcomes to be too high. For example, option prices currently imply around a 33% chance of a decline below 1100 by the end of 2011. A short put position could be initiated to hedge against such an outcome. Our view that implied volatility and skew are rich would support this idea. Indeed, we

11 See Hedging Tail Risk On the Upside, Marko Kolanovic, November 1, 2010, for a further discussion of the most effective derivatives strategies for hedging upside tail risk

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

recommend expressing a bullish view on equities by owning risk reversals (short put combined with long call) that benefit from the elevated implied volatility skew.
Figure 93: The S&P distribution implied by option prices suggests around a 10% chance of the index being above 1500 and around a 10% chance of the index being below 800 in December 2011
S&P price history / forward price Percentile implied by options prices

1500 1400 1300 1200 1100 1000 900 800 Dec09 Jun10 Dec10 Jun11 S&P forward price

10% 30% 50% 70%

90% Dec11

Source: J.P. Morgan Equity Derivatives Strategy, Thomson Financials, data to September

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

US: Buy Calls on the Energy Sector

We recommend implementing a bullish Energy sector view through June 11 ATM calls. J.P. Morgan Equity Strategists recently upgraded Energy to Overweight from Neutral for four reasons: 1) J.P. Morgan Commodity analysts raised their oil price target to an average of $90 ($5 above consensus) for 2011 with the drivers being better demand as well as a weaker dollar and QE2. J.P. Morgan Energy Research Analysts estimate that Energy stocks currently discount a $72 oil price. If $90 were discounted in the stocks, this would suggest about 23% to 30% upside potential from current share price levels. 2) Our strategists see upside potential to estimates, particularly if US economic momentum is sustained. The J.P. Morgan Integrated Analyst raised her earnings forecasts by 14% recently to reflect higher oil, and the Street could follow. 3) The recent shift toward centrist in Washington reduces risk of regulatory creep and other actions punitive to Energy companies. The current issue relates to using the EPA to regulate carbon emissions after climate-change legislation failed to pass. Currently, states like Texas are challenging these rules, but we believe changes in Washington recently favor a moderation of these risks. Other issues include recent easing of offshore drilling. 4) Energy tends to be a good coincident economic sector, thus, to the extent GDP growth sustains an upward bias, we see upside to Energy relative performance. The six-month implied volatility on the energy sector is ~25%. The five-year average has been ~31% and went as high as 67% following the Lehman crisis. The current implied volatility is close to its five-year low and in its ~19th percentile (Figure 94). Given the fundamental view on the Energy sector and low implied volatility we recommend investors buy the June 2011 expiry $66 strike calls (~ATM) for $4.20. The breakeven for the trade is $70.20 (Figure 95).
Figure 94: Energy Sector 6M ATM Implied Volatility
70% 65% 60% $7 55% 50% 45% 40% 35% -$1 $50 30% 25% 20% Dec 05 -$3 -$5 Jun 06 Jan 07 Jul 07 Feb 08 Aug 08 Mar 09 Oct 09 Apr 10 Nov 10 Index at Expiry $52 $54 $56 $58 $60 $62 $64 $66 $68 $70 $72 $74 $76 $78 $8 $5 $3 $1

Figure 95: Profit-Loss of June-2011 expiry $66 strike calls

$11 $9

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Europe: Sell a knock-in put on the J.P. Morgan EMEA 2011 Top Picks Basket
Sell a 1-year knock-in put on the J.P. Morgan EMEA 2011 Top Picks Basket (JPDEUT11 <Index>). J.P. Morgan European Equity Research sector heads have identified their top stock picks for 2011, based on their earnings models and our economists and strategists key investment themes and forecasts.12 We recommend monetising our analysts recommendations and the baskets rich volatility by selling a knock-in put on the basket. The payoff of this instrument is similar to a reverse convertible structure, but without the certificate wrapper. Selling a 1-year KI put on the basket indicatively pays a coupon of 7.5%, for a put that knocks in below 85% (where the basket is quantod to EUR and excludes 4 names with no listed options outstanding13). If the basket falls by more than 15% at maturity, the investor is short an ATM put and so will lose the negative performance of the basket net of the coupon. The structure, based on a continuously monitored barrier, pays a higher indicative coupon of 8.2% as long as the basket never drops by more than 20% from the initial level on any daily close. If the basket falls by more than 20% at any point, the investor is short an ATM put but keeps the up-front coupon. Accordingly, the investor may still get to keep the entire coupon without offsetting losses on the put even on a barrier breach, if the basket were to rally back above the initial level by maturity.
Figure 96: Payoff of short ATM put KI at 85% (initial basket value = 100)
Payoff (% of notional)

10 5 0 -5 -10 -15 -20 -25 70 75 80 85 90 95 100 105 110 115 120

KI put pay off

Terminal value of basket

Source: J.P. Morgan. Payoff shown for barrier monitored at maturity only.

12 13

See Europe Year Ahead 2011, Mislav Matejka, dated 29 Nov 2010 Excludes BNR GY, AKE FP, COLOB DC and PFC LN as they have no listed options outstanding, and equally weights the remaining 24 basket constituents. See JPM EMEA 2011 Year Ahead Baskets, 29 Nov 2010 for the full list of constituents and the backtested performance of the original basket.
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Europe: Improve Call Overwriting with Range-Bound Methodology

As discussed in the Market overview section (Page 27), selective single name call overwriting strategy may present profitable opportunities in the coming year. In this section we review the use of our range-bound methodology to identify good option selling candidates. The methodology aims to identify which stocks, relative to their volatility, are likely to trend in the near future and which stocks are likely to remain in a relatively tight trading range. The range-bound methodology contains two separate measures: the range-bound score compares realised stock high-low range to that implied by the options market, while the Mean Reversion score identifies stocks whose long-term moves tend to be lower relative to daily shifts. A daily update of the rankings can be found here (see Movers and Shakers, Jan 2003, for details of the methodology). Using the 1M Range-bound ranking on the current constituents of the Euro STOXX 50, we initiate an ATM covered call portfolio with one-month maturity of the five highest ranked stocks at the beginning of the month. The return is calculated upon maturity of the options at the end of the month as the equally weighted average return of the five covered call positions. At the beginning of next month a new portfolio of the five highest ranked stocks is initiated. The same procedure is repeated for 1M Mean Reversion the combined rankings. Our available data spans from Jan 2001 to present. The transaction cost is assumed to be 1 vol point. In comparison to the blanket call overwriting on all constituents, our range-bound methodology has performed well over the last 9 years. Overwriting based on the Range-Bound and Mean Reversion scores outperformed the blanket overwriting strategy in terms of return and Sharpe ratio (see Table 9). The same backtest is applied with a 3M horizon. The results are similar for systematic overwriting of 3M calls, with both the Range-Bound and Mean Reversion scores outperforming blanket overwriting. However, in this case the combined score underperforms. These results confirm that the Range-Bound methodology is effective and is best applied to the short-term (i.e. 1M) options.
Table 9: Our Range-Bound methodology appears superior to blanket overwriting strategy
1M Return (Annualized) Standard Deviation Information Ratio 3M Return (Annualised) Standard Deviation Information Ratio Blanket 4.3% 11.9% 0.36 3.1% 12.3% 0.25 Range Bound 8.5% 9.9% 0.86 3.0% 11.7% 0.26 Mean Reversion 6.2% 11.5% 0.54 3.2% 11.0% 0.29 Combined 7.9% 10.5% 0.76 1.7% 11.5% 0.15

Source: J.P. Morgan Equity Derivatives Strategy. Past performance is not indicative of future results.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 97: 1M Range Bound strategy strongly outperforms blanket overwriting strategy . . .
250% 200% 150% 100% 50% Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10
Blanket RangeBound MeanRev Combined

Figure 98: . . . while 3M Range Bound outperformance is less pronounced

350% 300% 250% 200% 150% 100% 50% 0% Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10
Avg Rank 1 2 3 4 5 6 6 8 9 9
57

Blanket RangeBound MeanRev Combined

Source: J.P. Morgan Equity Derivatives Strategy. Past performance is not indicative of future results.

Source: J.P. Morgan Equity Derivatives Strategy. Past performance is not indicative of future results.

The table below shows the highest ranked names currently in the Euro STOXX 50 index using 1M Range-Bound measures in our Range-Bound report as of 2 Dec 2010. Equity holders may consider selling 1M covered calls on them.
Table 10: Current top ranked SX5E constituents in the Range-Bound report
Ticker ABI BB OR FP UNA NA PHIA NA BAYN GY MC FP SGO FP EOAN GY ENI IM MT NA RB Score 59.40% 57.70% 65.20% 71.90% 58.20% 45.80% 56.80% 40.00% 83.80% 60.60% RB Rank 8 6 13 17 7 3 5 1 23 9 MR Score -1.83% -0.84% -1.45% -1.78% -0.68% -0.43% -0.56% -0.10% -0.92% -0.22% MR Rank 1 9 3 2 14 19 17 28 7 21 1M Hight 44.9 87.33 22.66 23.11 57.78 122.2 37.4 22.9 16.64 26.23 1M Low 41.93 81.93 21.31 20.79 54.04 114.7 34.2 22.11 15.35 23.7 Close 43.52 84.78 22.39 22.23 57.1 122.2 36.41 22.52 15.79 25.72 Imp Vol 24.90% 23.90% 20.00% 31.40% 24.40% 29.00% 33.50% 19.10% 21.10% 35.20% Hist Vol 23.10% 22.10% 25.00% 32.40% 25.50% 25.40% 34.40% 17.30% 18.50% 34.70%

Source: J.P. Morgan Equity Derivatives Strategy

We are launching the new European Covered Call Writer Screen to aid investors in implementing call overwriting strategies on European underliers (available here and on Morgan Markets on the Equity Derivatives page under Screens EMEA). By using our proprietary Range-Bound and Relative Values scores included in the screen, users can evaluate the attractiveness of call overwriting candidates. In addition, the screen filters listed call options for liquidity, strikes, and expiries to help users locate the appropriate option contracts. A sample image from the screen is shown below.

Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 99: Sample Covered Call Writer Screen

Underlying Stock
Stock Price ($//) 2999.5 2999.5 2999.5 2999.5 2999.5 2999.5 2999.5 2999.5 2999.5 2999.5 2999.5 2999.5 2999.5 19.96 19.96 Option Daily Volume (Contracts) 1 5 5 5 5 0 5 0 135 0 10 1 2 0 83 Call Option Option Option Strike Expiration ($//) 22/01/2011 2900 22/01/2011 3000 22/01/2011 3100 22/01/2011 3200 22/01/2011 3400 19/02/2011 2900 19/02/2011 3000 19/02/2011 3100 19/02/2011 3200 19/02/2011 3400 19/03/2011 3000 19/03/2011 3200 19/03/2011 3600 22/01/2011 19 22/01/2011 19.5

Covered Call Position

Option Bid Price ($//) 204 144.5 101 67 24.5 250 190 149 112.5 55.5 220 139 45 1.32 0.98 Call Write Capped Income Return Return (%) PerAnn (%) PerAnn 7.3% 52.2% 3.7% 26.8% 5.1% 36.2% 5.1% 36.3% 3.5% 24.9% 7.0% 49.8% 2.3% 16.4% 9.1% 65.3% 0.8% 5.9% 14.3% 102.2% 9.1% 42.0% 5.5% 25.3% 6.8% 31.2% 6.8% 31.3% 5.2% 24.2% 8.8% 40.4% 3.9% 18.0% 10.8% 50.1% 1.9% 8.7% 15.5% 71.6% 7.9% 27.0% 7.9% 27.1% 4.9% 16.6% 11.9% 40.5% 1.5% 5.2% 21.8% 74.5% 7.1% 50.7% 1.9% 13.8% 5.2% 37.0% 2.7% 19.6%

Stock Ticker AAL LN AAL LN AAL LN AAL LN AAL LN AAL LN AAL LN AAL LN AAL LN AAL LN AAL LN AAL LN AAL LN ABBN VX ABBN VX

Company Name ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ANGLO AMERICAN ABB AG ABB AG

Country GB GB GB GB GB GB GB GB GB GB GB GB GB SZ SZ

Industry Sector Materials Materials Materials Materials Materials Materials Materials Materials Materials Materials Materials Materials Materials Industrials Industrials

Source: J.P. Morgan Equity Derivatives Strategy.

Emerging Markets: Turkey and Russia

Buy Turkey Jun 11 calls/risk reversals: As noted in the Emerging Markets outlook, our Emerging Markets Equity Strategists recommend an overweight position in Turkey due to structurally lower interest rates and resilient domestic demand. On the back of the 28% YTD return, our strategists expect the strong performance of the Turkish equity market to continue into next year: in the blue sky scenario, assuming a 15% EPS growth and a P/E re-rating from 11 to 15, the market would return 50% by 2011YE. The 6M ATM implied volatility of the ISE 30 is at 32%, in the 38th percentile since Oct 2006. Investors wishing to participate in the upside can take advantage of the relatively low volatility and purchase a Jun 11 105% call outright, indicated at 7.7% (ref 83,966.8). On the other hand, the 95-105% skew is elevated at the 92nd percentile relative to history. Therefore, bullish investors can capitalize on the steep skew and high expected returns through a Jun 11 95-105% risk reversal (selling 95% put and buying 105% call) for a cost of 0.58%. Despite the high skew, investors have to pay for the risk-reversal due to the impact of high interest rates in Turkey on the forward price (85,067 vs. spot 83,966.8). The maximum loss of an outright call is limited to the upfront premium, whereas the risk reversal will lead to a 1-to-1 participation on both the upside and downside outside of the strikes. Our strategists identify the key risks to Turkey as inflation; fiscal reputation of the Turkish government; and potential contagion from the Euro sovereign stress. Long RDXUSD volatility: Medium term implied volatility on the Russian index has declined to low levels thanks to strong returns and low realised volatility. We believe this is a good entry point to be long Russia vol. Our strategists see political uncertainty as the key risk as Russia is nearing the dual 2011-2012 elections. In our strategists view, the government may have to (1) raise taxes, (2) sell assets, and (3) tighten regulated tariff adjustments in order to contain spending and inflation. In particular, energy and utilities are exposed to changes to the tax regime and tariff regulation, with likely downside to consensus earnings. With 70% of the RDXUSD weights in these two sectors, the potential political risk should provide a floor to the volatility, in our view. In addition, Russia is the largest consensus overweight in EM, and therefore could be more sensitive to a further rise in market volatility compared to those markets where positions are less elevated. The current RDXUSD 6-month implied volatility of 31% is at the 13th percentile YTD (see Figure 100). In comparison to the 6M realised vol, it is at the 10th percentile YTD, making the current entry point attractive, in our view.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Figure 100: The decline in RDXUSD implied vol makes the current level an attractive entry point, in our view
Volatility

55% 50% 45% 40% 35% 30% 25% 20%

6M Realised Current 6M Implied 6M Implied

Aug-10

Feb-10

Dec-09

Jun-10

Apr-10

Source: J.P. Morgan Equity Derivatives Strategy

Oct-10

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Europe: Sell SX5E Dec 11 correlation on full index or on enhanced basket

As we highlighted in our recent report (Why we have a correlation bubble, 5 Oct 10), implied correlation has traded at extremely high levels recently. Since the aforementioned report was published, implied correlation has fallen substantially on many indices (see Figure 35), but it remains elevated on the Euro STOXX 50. Euro STOXX 50 1Y implied correlation is currently trading close to the highest level in our records, which was recorded during the May market correction, and is in the 90th percentile relative to the last 5 years of historical data. Meanwhile, Euro STOXX 50 realised correlation has recently been depressed, leading to very high positive carry for short correlation positions. Figure 101 illustrates how realised correlation is well below current implied correlation levels. The J.P. Morgan Equity Strategy team forecasts an upside of ~15% for equities through 2011 year-end, which should be supportive of the short correlation position, leading to a likely return to an environment where company fundamentals become a greater driver of differentiation between stock returns. The main risk for the short Euro STOXX 50 correlation trade is a return to a risk-on/risk-off mentality between investors due to an escalation of the sovereign concerns in Europe. Indeed, the fact that the implied correlation level of the Euro STOXX 50 index remains elevated is partly linked to the direct exposure of this index to contagion in the sovereign debt situation in Europe. This said, we believe that the trade continues to look attractive due to the attractive entry point for selling implied correlation, despite the fact that short-dated realised correlation has increased from the depressed levels recorded during the latest earnings season. Based on this view and consideration of the risks, we recommend selling Euro STOXX 50 implied correlation on a Dec 11 tenor.
Figure 101: Euro STOXX 50 1Y ATM implied correlation is near historic Figure 102: The current indicative Euro STOXX 50 enhanced basket highs and well above recent realised correlation volatility swap correlation bid of 68.3% has been above 6M realised correlation levels all the time since 2006, with the exception of the sixCorrelation month period following May this year 0.90 1Y implied correlation Correlation
0.80 0.70 0.60 0.50 0.40 0.30 Sep-09 Nov-09 Sep-10 Jan-09 Jan-10 Jul-09 Mar-09 Mar-10 Jul-10 May-09 May-10 Nov-10 0.20 0.00 2006 2007 2008 2009 2010
Euro STOXX 50 enhanced basket Dec-11 Vol Sw ap Correl Bid Euro STOXX enhanced basket 6M Realised Correlation 6M realised correlation 1M realised correlation

0.80 0.60 0.40

Source: J.P. Morgan Equity Derivatives Strategy. Implied correlation based on mid-level ATM implied volatilities

Source: J.P. Morgan Equity Derivatives Strategy.

Investors can monetise the richness of Euro STOXX 50 implied correlation by selling Dec 11 volatility swaps on the Euro STOXX 50 and buying Dec 11 volatility swaps on the constituents on the index. Please see our Volatility Swap Product Note for a detailed discussion on Volatility Swaps. We suggest two implementations of the trade, suitable for investors with different risk profiles: 1) Traditional vol swap dispersion: Sell Dec 11 Euro STOXX 50 index volatility swaps and buy Dec 11 vol swaps on the 48 constituents of the index, using a weighting for the notional of the index and single stock components to make the trade gamma neutral overall. This implementation is suitable for investors who are not willing to take tracking error risk on the trade in order to maximize the expected carry. The traditional Dec 11 volatility swap dispersion trade can be initiated at an average single stock to index volatility spread of 7.6%, equivalent to a correlation bid of 60.5%. 2) Enhanced dispersion cheap volatility single stock basket: Sell Dec 11 Euro STOXX 50 index volatility swaps and buy Dec 11 vol swaps on an enhanced dispersion basket of 33 Euro STOXX 50 constituents selected to have the cheapest
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

volatilities based on our RV score methodology (see Why we have a correlation bubble for a detailed discussion of the Enhanced Dispersion Methodology and construction of the enhanced baskets). The enhanced dispersion methodology allows investors to buy cheaper single stock volatility while maintaining a controlled tracking error to the index, therefore potentially monetising a larger carry during the life of the trade while controlling the variability of the P/L caused by imperfect tracking. Figure 102 illustrates the benefit of using the enhanced methodology.14 Our preferred basket has a tracking error of 2.9% to the Euro STOXX 50 index. The Dec 11 volatility swap dispersion trade on this basket can be initiated at an average single stock to index volatility spread of 5.6%, equivalent to a correlation bid of 68.3%. This methodology improves the correlation bid by 7.8 points compared to the traditional dispersion basket above. A more conservative approach would be to sell Dec 11 Euro STOXX 50 index volatility and buy Dec 11 vol swaps on a basket of 30 names selected to potentially exhibit the highest volatility increase in the event of contagion in the European debt crisis. We constructed a basket using the same technique as the enhanced cheap volatility basket, with a selection that favours names which experienced the largest volatility spikes in May. As the dispersion trade is long single stock volatilities and short index volatility, using this basket in the trade would have led to a less adverse outcome in May. This basket has a tracking error to the Euro STOXX index of 2.6% but requires the investor to give up 5.8 correlation points on the initial correlation bid (54.7%). The average single stock volatility of this basket spiked by 20.5 vol points during the May crisis compared to a spike of 16.2 points on the traditional basket.

14

Please contact us for the details on the composition of the enhanced baskets.
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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Asia: Short ASX 200 Correlation

Barring significant market shocks or tail events, the bullish outlook for Asian equities should generally lead to the decline of Asian volatility and equity risk premium. The macro beta trades that dominated during the bear market and the subsequent recovery phase will become less important as bottom-up fundamental strategies and earnings estimate revision should be a key driver of stock prices in 2011, leading to a drop in correlation. Hence, dispersion would still be a key thematic trade for 2011, in our view. For dispersion trades, the absolute level of implied correlation is generally a useful signal for profitability, with higher implied correlation leading to higher expected profit. The importance of the absolute level of implied correlation is partly explained by the fact that correlation has a mean-reverting tendency. Clearly, for any mean-reverting asset, selling when high and buying when low is likely to be profitable. Hence, selling correlation when implied correlation is above a set threshold would be a sensible strategy. Although the equity markets already had a decent rally since the beginning of September and implied correlation levels have come off from their peak levels, some indices still show attractive correlation levels for implementing a dispersion view, and the ASX 200 seems to be a good candidate in the Asia Pacific region. The ASX 200 6M implied correlation currently stands at 64.3% (based on ATM implied volatility mid levels), which is at the 89th percentile level in the historical data since 2005 (Figure 103). One way to implement the correlation view is using volatility swaps. For example, investors can sell an ASX 200 Jun 11 volatility swap and buy Jun 11 volatility swaps on the top 15 single stocks (index weighted) at an implied correlation of 56.5% (indicative bid). This level is about 11 correlation points higher than the current 6M realized correlation and has been rarely realized over the past 10 years as shown in Figure 104. In addition, we believe the current level of realized correlation is not sustainable as single-stock movements should be more driven by company-specific factors in 2011. In summary, we believe the current high implied correlation coupled with the potential lowering of realized correlation presents a good opportunity for the ASX 200 dispersion trade.
Figure 103: ASX 200 implied correlation remains highly elevated
6M Implied Volatility and Correlation
100%

Figure 104: Realized and implied correlation of ASX 200 top 15 basket
6M Correlation
70% 60%

Avg SS Vol - Index Vol Avg SS Implied Vol

ASX 200 6M Implied Correlation ASX 200 Index Vol

Realized correl - Top 15 Basket

Implied correl (bid) - Top 15 Basket

80%

50%
60%

40% 30% 20%

40%

20%

10% 0% 2001

0% Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: J.P. Morgan.

Source: J.P. Morgan.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Asia: Potential Weakening of JPY vs. KRW Prefer Nikkei 225 over KOSPI 200
Potential weakness in JPY versus KRW: Our strategist Hajime Kitano believes if the FED begins to raise rates in the near future, this will add fuel to the weakening JPY. Japanese corporates need weaker JPY against non-USD currencies, especially Asian currencies. It was reported last month that Japans major electric and auto makers complained about JPY appreciation against KRW. In particular, KRW has become more important for Japanese exporters in recent years in terms of the competitiveness of their products. Meanwhile, Bank of Korea (BoK) raised the policy rate by 25bp to 2.50% in November. The decision was "unanimous" with the BoK guiding its comments slightly more hawkish than before. Our economist believes the BoK will stick to a gradual pace of policy rate normalization, which could lead to the weakening of JPY vs. KRW. Although the recent geopolitical risk may bring more volatility, the gradual appreciation of KRW should remain intact. Stronger KRW versus JPY fuel the potential outperformance of Nikkei 225 over KOSPI 200: As Korea rate hikes continue in a gradual manner and JPY weakens against KRW, we could see it as a positive to the Nikkei 225, which is positively correlated to the KRWJPY cross rate (Figure 105). Also, the Nikkei 225 has underperformed KOSPI 200 in 2010 (Figure 106) and the currency movements could potentially cause the Nikkei 225 to catch up with the KOSPI 200. For 2011, our strategists have an UW on Korea while remaining bullish on Japan. Strategy 1: Buy 6M outperformance option of Nikkei 225 over KOSPI 200 with a knock-out barrier on KRW Investors who share our view on the Nikkei 225s potential ourperformance over the KOSPI 200 could buy 6M outperformance options on Nikkei 225 over KOSPI 200. To cheapen the cost, a knock-out barrier could be added where the option will be knocked out if KRWUSD stays below 105% at maturity (i.e., KRW appreciates by less than 5% versus the USD). See the table below for the indicative prices. Strategy 2: 6M call switch strategy of Nikkei 225 and KOSPI 200 Alternatively, investors can consider a call switch strategy by going long Nikkei 225 calls while going short KOSPI 200 calls, with positions unhedged to expiry. This type of option spread trade may entail less outright market-directional risk compared to a single index option strategy as a spread trade. See the table below for the indicative prices.
Table 11: Indicative pricing for Nikkei 225 over KOSPI 200 outperformance option* and call switch strategy (price as of Dec 3, 2010)
No Barrier With KO at maturity if KRW appreciates less than 5% vs USD 6.45% 3.55% 4.05% 2.50% Cost Savings -45% 6M ATM call switch -38% 6M 105% call switch Net Cost 0.50% 0.47% NKY Implied Vol (Offer) 21.7% 20.5% KOSPI2 Implied Vol (Bid) 18.9% 17.9%

6M ATM outperf option 6M 105% outperf option

*Note the observation for the knock-out is only at maturity. Source: J.P. Morgan Equity Derivatives Strategy

Figure 105: Performance of KRWJPY vs Nikkei 225 (re-based to 100)

130 120 110 KRWJPY Nikkei 225

Figure 106: Relative performance of Nikkei 225 vs KOSPI 200

120 Nikkei 225 Index KOSPI Index

110 100 90 80 70 60 50 40 Dec-05 80 Jan-10 90 100

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Apr-10

Jul-10

Oct-10

Source: J.P. Morgan. Bloomberg.

Source: J.P. Morgan, Bloomberg.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Asia: Cheap NIFTY Puts to Take Advantage of Cross-Asset Correlation

In our previous global publication Why we have a correlation Bubble, by Marko Kolanovic, published on October 5, 2010, we highlighted that correlations between stocks are currently at the highest level in recent history as a result of the macro-driven environment, record use of index derivatives such as futures and ETFs, and high-frequency trading. We are observing a similar trend across asset classes as correlation between different assets remains abnormally elevated, although volatility has come down to pre-crisis levels. This is largely because investors have pulled money out of certain assets on the concerns of an economic double dip and piled back into them as sentiment improves, creating a so-called risk-on/riskoff" phenomenon. Here we highlight an example of options strategies that take advantage of current high cross-asset correlation to cheapen the cost of Asian index upside participation or downside protection. Hedging inflation concerns in India: Correlation between Indian equities and oil remains elevated (Figure 107 and Figure 108) as a result of global risk-on/off trades. As oil accounts for over 25% of India's total imports and inflation remains a key concern for investors, a further rally in the oil price would likely hurt the economy and equity market, in our view. Indeed, the sticky issue of inflation has concerned policy makers. The RBI has hiked benchmark rates by over 125 bps in the current cycle, and we believe there could be more to go. J.P. Morgan economists expect rates to be hiked by at least another 100bps by December 2011. Rising interest rates can potentially constrain further re-rating of the Indian stock market. NIFTY puts contingent on crude oil: Investors who are concerned with the risk of inflation and rising crude oil price on the Indian stock market can consider buying vanilla NIFTY put options for portfolio protection. However, the outright downside puts are not cheap, in our view, due to the discounted forwards, rich implied volatility, and relatively steep skew for the index. To lower the price of protection, investors can consider buying a NIFTY put option with a knock-in barrier at expiry contingent on the price of crude oil. The put is activated if crude oil closes above the pre-defined barrier level at expiry; otherwise the put will not be activated and the option contract will expire worthless. The indicative premium for a 6M NIFTY 95% put contingent on crude oil > USD 100/bbl at expiry is 1.03%. Compared to a vanilla 6M NIFTY 95% put that costs 4.0%, the NIFTY put contingent on crude oil can provide approximately 74% cost savings.
Table 12: Indicative pricing for NIFTY put contingent on crude oil (price as of Dec 3, 2010)

6M 95% vanilla put 6M 95% Put contingent on crude oil Cost Saving
*Note the observation for the knock-in is only at maturity.

Oil >100/bbl 4.0% 1.03% -74%

Crude Oil Barrier Oil > 95/bbl 4.0% 1.34% -67%

Oil > 90/bbl 4.0% 1.72% -57%

Source: J.P. Morgan Equity Derivatives Strategy

Figure 107: Performance of NIFTY and crude oil

NIFTY
7200 6200 5200 4200 80 3200 60 2200 1200 160 140

Figure 108: Realized correlation between NIFTY and crude oil

Crude Oil Correlation
0.80 6M Weekly Correlation between NIFTY and Crude Oil

0.60
120 100

0.40

0.20

0.00
40 NIFTY INDEX (LHS) Crude Oil (RHS) 20 0

-0.20

200 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10

-0.40 Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Source: J.P. Morgan. Bloomberg.

Source: J.P. Morgan, Bloomberg.

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Asia: Cheap Downside Protection Strategies in Index and Single Stocks

The recent rise in volatility has reduced the relative attractiveness of many Asian index volatilities as a hedge against macro tail risk events. However, low volatility outliers still exist among Asian indices that offer investors with the inherent value in holding low volatility puts to hedge against a crash scenario, where correlation and volatility can spike together. Based on the regression analysis of 3M implied volatility on 1-year beta against the MSCI AC World, we observe that in 2H10 Asian implied volatility lost its relative cheapness versus other developed market index implied volatilities, with many of Asian indices staying above the regression line. However, the ASX 200 3M implied volatility looks the cheapest, being 2.6 vol points lower than what its 1-year beta suggests, followed by the TWSE 3M implied volatility, which is below the line by 2.3 vol points.
Figure 109: Global equities sold off together with implied volatility spike during the Apr/May sell-off (European sovereign debt crisis)
3M Implied Volatility
50% 40% -10% 30% 20% -20% 10%

Figure 110: 3M implied volatility versus 1Y beta against MSCI AC World for major global indices
27% 25% 23% HSI 21% 19% 17% NIFTY KOSPI2 NKY UKX SPX y = 0.1517x + 0.0748 R = 0.5262
2

Spot Performance 3M Implied Volatility

Implied Vol before Apr/May Sell-off Implied Vol after Apr/May Sell-off Spot Performance
0%

HSCEI SX5E

0%
H SI H SC EI KO SP I2 TW SE N IF TY SX 5E AS 51 N KY SP X U KX

-30%

TWSE 0.5 0.6 0.7 0.8

AS51 0.9 1 1.1 1.2

15%

Source: J.P. Morgan, Bloomberg. Source: J.P. Morgan. Bloomberg.

1Y Beta against MSCI AC World

Table 13: Indicative pricing for Asian index downside protection strategies (data as of Dec 3, 2010)
Index ASX 200 TWSE NIFTY KOSPI 200 HSI Nikkei 225 HSCEI
Source: J.P. Morgan.

3M ATM Implied Volatility 17.3% 17.1% 18.7% 25.7% 18.7% 18.8% 17.3%

3M Implied - Realized Vol Spread 4.3% 4.6% 4.9% 4.1% 4.9% 1.1% 4.3%

3M 90-110 Skew Spread 6.4% 3.7% 6.2% 4.1% 6.2% 6.5% 6.4%

3M ATM Put 3.4% 3.8% 3.4% 3.9% 4.3% 4.2% 5.2%

3M 95% Put 1.8% 1.8% 1.9% 2.1% 2.4% 2.4% 3.2%

In Hong Kong, high warrants activities have caused a significant flattening or inverting of skews in several single stock names (see the Asia - Volatility Demand and Supply Dynamics section for details). As a result, investors can gain protection by buying risk reversals on those popular warrants names and get upfront premium. Please see the table below for the attractive candidates for protection via 3M 90-110 risk reversals and their indicative option pricing.
Table 14: Indicative pricing of risk reversals for Hong Kong stocks with negative skew (data as of Nov 29, 2010)
Ticker 388 HK 1398 HK 2628 HK 941 HK 939 HK Name HONG KONG EXCHNG IND & COMM BK-H CHINA LIFE INS-H CHINA MOBILE CHINA CONST BA-H 3M 90-110 Risk Reversal Premium* -0.76% -0.47% -0.45% -0.41% -0.40% 3M 90-110 IV Spread -0.87% -0.84% -0.44% -2.13% -0.44%
Source: J.P. Morgan.

* Negative premium means investors getting paid by entering the trade.

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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

Global: 2011 Year-Ahead Thematic Baskets

To capture the investment themes highlighted in the 2011 Year-Ahead reports, we have created tradable baskets designed to provide investors with an easy and convenient channel to implement their thematic investment views. The following is a quick summary of the thematic baskets for each region: Asia Pacific 1. ASEAN Top Picks (JPHAX1TP <Index>): Top Picks from the Year-Ahead report that benefit from accelerating growth in ASEAN 2. Asia Pacific ex-Japan Domestic Consumption (JPHAX1DC <Index>): Top Picks from the Year-Ahead report that benefit from domestic consumption in Asia 3. Asia Pacific ex-Japan Domestic Investment Cycle (JPHAX1DI <Index>): Top Picks from the Year-Ahead report that benefit from accelerating fixed investment in Asia 4. Asia Pacific ex-Japan Growth (JPHAX1GW <Index>): Top Picks from the Year-Ahead report with the best growth track record 5. New Singapore (JPHSPNEW <Index>): Singapore is more than just banks and telcos. New Singapore stocks are plays on higher growth industries: commodities, gaming, regional property, etc 6. Japan 2011 Analyst's Top-pick Basket (JPHJTTOP <Index>): Top Picks from the Year-Ahead report Investors can track the performance of these J.P. Morgan Asia Pacific Thematic Baskets (JPTH <GO>) on Bloomberg using the tickers in brackets above. Investors can gain exposure to our thematic baskets through delta-one products such as P-Notes/LEPOs/equity swaps. Depending on liquidity, we can also provide various option structures on the baskets. Europe 1. EMEA Top Picks (JPDEUT11 <Index>): Top Picks from developed Europe for 2011 as selected by European Equity Research sector heads. 2. EMEA Stocks to Avoid (JPDEUA11 <Index>): a shortable basket of European Equity Researchs least favored stocks for next year. 3. UK Top Picks (JPDUKT11 <Index>): Top Picks in the UK for 2011 as selected by European Equity Research sector heads. 4. UK Stocks to Avoid (JPDUKA11 <Index>): a shortable basket of Equity Researchs least favored stocks in the UK. 5. CEEMEA Top Picks (JPDEUCEE <Index>): most favored liquid stocks in the CEEMEA region as chosen by EM Strategy and Equity Research country and sector heads. 6. Global EM Top Picks (JPDEUGEM <Index>): the most liquid names among J.P. Morgan Researchs Top Picks from global emerging markets, weighted according to our EM Equity Strategists target country allocation. Investors can track the performance of these J.P. Morgan European Thematic Baskets on Bloomberg using the tickers in brackets above and can view a list of all current European Thematic Baskets on Bloomberg at JPEU8 <Go>. Investors can gain exposure to our thematic baskets through delta-one products such as equity swaps. Depending on liquidity, we can also provide various option structures on the baskets such as calls, outperformance options on the Top Picks vs. the Stocks to Avoid, and reverse convertibles.

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Risks of Common Option Strategies Risks to Strategies: Not all option strategies are suitable for investors; certain strategies may expose investors to significant potential losses. We have summarized the risks of selected derivative strategies. For additional risk information, please call your sales representative for a copy of Characteristics and Risks of Standardized Options. We advise investors to consult their tax advisors and legal counsel about the tax implications of these strategies. Please also refer to option risk disclosure documents. Put Sale. Investors who sell put options will own the underlying stock if the stock price falls below the strike price of the put option. Investors, therefore, will be exposed to any decline in the stock price below the strike potentially to zero, and they will not participate in any stock appreciation if the option expires unexercised. Call Sale. Investors who sell uncovered call options have exposure on the upside that is theoretically unlimited. Call Overwrite or Buywrite. Investors who sell call options against a long position in the underlying stock give up any appreciation in the stock price above the strike price of the call option, and they remain exposed to the downside of the underlying stock in the return for the receipt of the option premium. Booster. In a sell-off, the maximum realised downside potential of a double-up booster is the net premium paid. In a rally, option losses are potentially unlimited as the investor is net short a call. When overlaid onto a long stock position, upside losses are capped (as for a covered call), but downside losses are not. Collar. Locks in the amount that can be realized at maturity to a range defined by the put and call strike. If the collar is not costless, investors risk losing 100% of the premium paid. Since investors are selling a call option, they give up any stock appreciation above the strike price of the call option. Call Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the stock is below the strike price of the call option. Put Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the stock is above the strike price of the put option. Straddle or Strangle. The seller of a straddle or strangle is exposed to stock increases above the call strike and stock price declines below the put strike. Since exposure on the upside is theoretically unlimited, investors who also own the stock would have limited losses should the stock rally. Covered writers are exposed to declines in the long stock position as well as any additional shares put to them should the stock decline below the strike price of the put option. Having sold a covered call option, the investor gives up all appreciation in the stock above the strike price of the call option. Put Spread. The buyer of a put spread risks losing 100% of the premium paid. The buyer of higher ratio put spread has unlimited downside below the lower strike (down to zero), dependent on the number of lower struck puts sold. The maximum gain is limited to the spread between the two put strikes, when the underlying is at the lower strike. Investors who own the underlying stock will have downside protection between the higher strike put and the lower strike put. However, should the stock price fall below the strike price of the lower strike put, investors regain exposure to the underlying stock, and this exposure is multiplied by the number of puts sold. Call Spread. The buyer risks losing 100% of the premium paid. The gain is limited to the spread between the two strike prices. The seller of a call spread risks losing an amount equal to the spread between the two call strikes less the net premium received. By selling a covered call spread, the investor remains exposed to the downside of the stock and gives up the spread between the two call strikes should the stock rally. Butterfly Spread. A butterfly spread consists of two spreads established simultaneously, one a bull spread and the other a bear spread. The resulting position is neutral, that is, the investor will profit if the underlying is stable. Butterfly spreads are established at a net debit. The maximum profit will occur at the middle strike price, the maximum loss is the net debit. Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate of current market levels and are not indicative trading levels.

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Global Equity Derivatives & Delta One Strategy 07 December 2010

Disclosures
This report is a product of the research department's Global Equity Derivatives and Delta One Strategy group. Views expressed may differ from the views of the research analysts covering stocks or sectors mentioned in this report. Structured securities, options, futures and other derivatives are complex instruments, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated option transactions. Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Important Disclosures
MSCI: The MSCI sourced information is the exclusive property of Morgan Stanley Capital International Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced, redisseminated or used to create any financial products, including any indices. This information is provided on an 'as is' basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind. MSCI, Morgan Stanley Capital International and the MSCI indexes are services marks of MSCI and its affiliates.

Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] The analyst or analysts teams coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe.
J.P. Morgan Equity Research Ratings Distribution, as of September 30, 2010 Overweight (buy) 46% 49% 43% 69% Neutral (hold) 43% 45% 48% 60% Underweight (sell) 12% 33% 8% 50%

J.P. Morgan Global Equity Research Coverage IB clients* JPMS Equity Research Coverage IB clients*

*Percentage of investment banking clients in each rating category. For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

Valuation and Risks: Please see the most recent company-specific research report for an analysis of valuation methodology and risks on any securities recommended herein. Research is available at http://www.morganmarkets.com , or you can contact the analyst named on the front of this note or your J.P. Morgan representative. Analysts Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking. Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US affiliates of JPMS, are not registered/qualified as research analysts under FINRA/NYSE rules, may not be associated persons of JPMS,
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Global Equity Derivatives & Delta One Strategy 07 December 2010

and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.

Other Disclosures
J.P. Morgan ("JPM") is the global brand name for J.P. Morgan Securities LLC ("JPMS") and its affiliates worldwide. J.P. Morgan Cazenove is a marketing name for the U.K. investment banking businesses and EMEA cash equities and equity research businesses of JPMorgan Chase & Co. and its subsidiaries. Options related research: If the information contained herein regards options related research, such information is available only to persons who have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporations Characteristics and Risks of Standardized Options, please contact your J.P. Morgan Representative or visit the OCCs website at http://www.optionsclearing.com/publications/risks/riskstoc.pdf. Legal Entities Disclosures U.S.: JPMS is a member of NYSE, FINRA and SIPC. J.P. Morgan Futures Inc. is a member of the NFA. JPMorgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. 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Marko Kolanovic (1-212) 272-1438 MKolanovic@jpmorgan.com

Global Equity Derivatives & Delta One Strategy 07 December 2010

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