2014 Volatility Outlook Final

8/9/2019 2014 Volatility Outlook Final

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EQUITY DERIVATIVES STRATEGYMarket Commentary

January 14, 2014

Edward K. [email protected](212) 325 3584

Stanislas [email protected]+44 20 7888 0459

Terry [email protected](212) 325 4511

Mandy [email protected](212) 325 9628

(212(

2014 U.S. Equity Volatility Outlook

Braking Bad?

Equity Derivatives Strategy

In the wake of the equity market’s best year since the dot-com heydays, one would think equity investors would begripped with euphoria. Instead, the pervasive sentimentseems to be that of cautious optimism – grateful to be atthe market’s high, but wondering if we should be.

We thus enter 2014 at a potential inflection point with theFed poised to tap the brakes on its accommodativemonetary policy. Despite obvious macro risks, the recentshift towards a low correlation regime implies that volatility

this year will largely be defined by investors’ quest forvalidation of current market valuations. As a result, weexpect to see increased incidences of “market-betainversion” in which sector and index volatilities arecatalyzed by single stock earnings.

Over the course of this report, we explain the rationale forour 2014 volatility outlook: a steady state forecast of

VIX at 15, but with increased skew convexity (i.e., vol ofskew) magnifying macro shocks that could drive the VIX in excess of 25.

Our report is divided into four parts:

1) Volatility: In the first section, we define our level forbaseline realized volatility by analyzing relevant underlyingeconomic fundamentals. We then examine potentialmacro catalysts such as a spike in US interest rates, EMcontagion, and a meltdown in China’s shadow bankingsector – all of which are likely to inflate the premiumaccorded to implied volatility over baseline volatility.

2) Skew & Term-Structure: In the second segment, wediscuss investment trends in the derivatives markets todetermine how the supply and demand for volatility fromhedge funds, banks, institutions, insurance companies,

pension funds, and retail investors shape our views forindex volatility skew and term structure.

3) Sector Volatility & Correlations: In the third part, wediscuss developing themes within the specific sectors thatare likely to influence volatility at the single-stock level andhow these changes could affect inter-stock correlations.

4) Trade Recommendations: Finally, in section four, wewrap up by proposing trades that best reflect our views.

Exhibit 1: S&P Expected Volatility Scenario Analysis

Source: Credit Suisse Equity Derivatives Strategy

Exhibit 2: A “Steady-State” VIX Forecast at 15


Exhibit 3: Sector Volatility Outlook for 2014


Weight in

S&P

1Y Impl

Volatlity Sector

Volatility

Outlook

19% 16.1 Technology ▲▲

16% 17.3 Financials ▼▼

13% 15.0 Healthcare ▲▲

13% 16.5 Consumer Discretionary ▼

11% 17.4 Industrials ▼▼

10% 18.4 Energy ▼▼▼

10% 13.1 Consumer Staples ▲

3% 14.6 Utilities ▲▲3% 17.4 Basic Materials ▼

2% 14.3 Telecom Services ▲

Lower volatility ▼

Higher volatility ▲


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EQUITY DERIVATIVES STRATEGY

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Executive Summary

Baseline Volatility: The new normal is squarelyupon as we exit 2013 with the lowest realizedvolatility since 2006. Accommodative globalmonetary policies, accelerating economic growth,and record corporate earnings combine to provide

a constructive backdrop for equities. Lookingahead, our Global Equity Strategy team has a2014 S&P target of 1960. Using that target price,we forecast a baseline S&P realized volatility of10.8% for 2014.

Potential Volatility Shocks: From surging USyields to a collapse in China’s shadow bankingsector, there remain a number of macro catalyststhat could drive implied volatility up to 30%. On theother hand, accelerating economic growth reducesthe kurtosis premium currently embedded in

implied volatility. Volatility Supply & Demand: Anticipated macro

shocks will likely manifest via skew and increase itsshock sensitivity. Against this backdrop, aforecasted decline in institutional & pension fundoverwriting, increased hedge funds' use of optionsto express directional views, and the shortenedduration of insurance hedges should increase skewconvexity. Absent a liquidity event, the declininginventory of “legacy” variable annuity exposures willresult in an increasingly illiquid and “sticky” back-end term structure.

Sector Volatility & Correlations: Whilecorrelations are determined by co-movements atthe single stock level, there are three sectors S&Pdispersion traders should focus on in particular:Tech, Financials & Energy. We believe Financialsand Energy sector volatilities will move lower in2014, while Tech will see an increase in volatility.On correlation, we expect last year’s lowcorrelation regime to persist, favoring stockselection and sector allocation to generate alpha.

Framework for Analyzing Volatility

Our discussion will utilize a framework that decomposesimplied volatility into 3 components:

1. Baseline volatility – Our expectations for realizedvolatility driven by economic fundamentals;

2.

Kurtosis - The excess premium volatility traderscharge to account for the uncertainty of tail-events;

3. Skew – The excess premium implied volatilitiestrade above realized owing to the supply anddemand for volatility as an asset class.

Illustration of Volatility Framework

To illustrate this technique, we apply the methodologyto the VIX at three instances in 2013: Mar 14th (lowestVIX reading), Jun 20th (height of tapering fear), andDec 31st (year-end).

Exhibit 4: Example Decomposition of VIX in 2013


The sample decomposition above shows two notabledevelopments. First, as one would expect, the premiumstemming from the supply and demand for volatility(skew) was significantly higher during the Fed taperingsell-off in June than it was at the other two instances.Secondly, although we exit 2013 at a higher impliedvolatility level than in March, when the VIX fell to a 6-year low of 11.3, that difference is entirely due tohigher skew and kurtosis premiums (+0.9 pt and 1.4pts, respectively). Baseline volatility remains the same.

0

5

10

15

20

25

Lowest Vol Fed Tapering Dec 31st

V I X

Skew Premium

Kurtosis Premium

Baseline Volatility

2014 Trade Recommendations

Top Macro IdeasEEM zero premium hedgeEurope vs. US OutperformanceLong TBT call spreadsBullish Japan (vanilla & exotic)Long SX5E/Euro Hybrid CallShort Index Straddles

Top Thematic IdeasShort energy volatility, long USO (oil) volatilityM&A basket and risk reversal ideasLong European dividends

***Risks: The risks to buying a put, a call or a put or call spread is limited to the premium paid. The risk to selling a put can be significant. The risk of selling a

call can be unlimited. The risk to selling a variance swap or straddle could be unlimited. The risk to buying a variance swap is that variance could go to zero.


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Establishing Baseline Volatility

Baseline volatility, the type inherent in a liquid, continuousmarket, is largely a function of underlying economicfundamentals. With that in mind as we look ahead to2014, there are many reasons for equity investors toremain optimistic.

The global economy is expected to be the most orderly inyears. A stable balance of growth, low inflation, andaccommodative policies will support a cyclical accelerationin activity. We expect higher household wealth to drive apick-up in consumer spending, and an ECB backstop toboost the recovery in Europe.

While it’s tempting to turn cautious after a year when theS&P rose 30%, history is squarely on the bull’s side.Historically, previous annual rallies of 25% or more weresubsequently followed with an increase in the S&P of11%, on average.

For 2014, our US economics team is forecasting a realGDP growth of 3.0%, a stable inflation rate at 1.4%, andan average unemployment rate of 6.8% (vs. 7.4% in2013).

2014 Baseline Volatility @ 10.8%

Against this backdrop, our Global Equity Strategist, Andrew Garthwaite, continues to see upside in equitieswith a 2014 S&P target of 1960, which is an increase of6.0% from the 2013 closing level. To arrive at thisnumber, Garthwaite probability weights three distinct

scenarios ranging from a China slowdown which dampensUS growth to a bullish “sunshine” scenario where the S&Preaches 2300 (bubble valuations).

Accordingly, to develop our estimate for baseline volatility,we analyze the volatility of the price paths (via a boot-strapped Monte-Carlo) required for the S&P to reachGarthwaite’s S&P year -end target of 1960. As shown inExhibit 5, the average of the required volatility is 10.8% -our expected baseline for 2013.

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


Bootstrapped Monte-Carlo

Calculate forecasted S&P return target

Calculate daily historical returns for S&P-500 from 1928 tothe present (21,168 data points)

Calculate rolling-window of one-year daily compounded

returns (20,916 data points)

Construct a normal density (bell-curve distribution) of theone-year price paths centered on the forecasted index returntarget

Draw 10,000 samples of the price paths from theconstructed distribution

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

Baseline volatility = the mean of the sampled realizedvolatilities

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


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


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


2014 Scenarios ProbabilityS&P level at 2014

year-endS&P return

Core Scenario 60% 2000 8.2%

Downside Scenario 20% 1500 -18.8%

Sunshine Scenario 20% 2300 24.5%

Baseline Vol = 10.8% 1960 6.1%


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4

Potential Tail Catalysts (Kurtosis)

While we forecast baseline volatility at a benign 11%,there are a number of macro catalysts that mayprecipitate volatility shocks in the coming year. In thefollowing section, we explore in detail the top 3 macrocatalysts that we believe could have a significant impact

on equity volatility over the next 12 months:

Potential Catalysts That Could Drive VIX Higher

A Spike in US Rates: Last year volatility surged to a1-year high at the mere suggestion of tapering. Thisyear, we believe a bigger risk is the Fed unexpectedlyraising (or talking about raising) interest rates. If thatwere to happen, we could see the VIX jump 5-8 volpts higher.

Turmoil in the Emerging Markets: With slowinggrowth, rising US yields, and mounting political risks,the Emerging Markets could face a bigger crisis thisyear than last year’s taper -induced sell-off. Potentialcontagion could send the VIX up 5 vol pts.

China Shadow Banking Meltdown: China has seen abigger credit expansion, relative to GDP, than anyother country in modern history. However, its credit-driven growth looks increasingly unsustainable. Weexplore three key risks in the upcoming year thatcould turn this boom into a bust – and send globalvolatility surging.

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



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1. Rising Interest Rates

Interest Rate Contagion

With the December launch of Fed tapering, interest raterisk is the most obvious candidate for a potential macro

volatility catalyst. The question for 2014 is what is thedegree of sensitivity of the equity markets to interest ratelevels and interest rate volatility?

An analysis of last year’s interplay between rates andequity volatility shows us that the cross-asset sensitivity ofthe equity markets to interest rate volatility is dependentnot merely on the magnitude of interest rate volatility, butalso the level of cross asset contagion. (Cross assetcontagion quantifies the degree to which volatility fromone asset class propagates to another).

Exhibit 1: Interest Rate – Equity Volatility Contagion

Source: Credit Suisse Research

As seen in Exhibit 1, volatility contagion between interestrates and equities actually began increasing in the weeksleading up to Bernanke’s surprise announcement in Maythat the Fed was considering tapering its bond purchases.Contagion steadily rose from 10% in April to 40% in earlyMay, then surging over 30 pts to a 1-year high of 71%after Bernanke’s announcement.

Current Equity-Interest Rate Volatility Sensitivity

What is the current degree of equity-interest ratesensitivity? As shown in Exhibit 1, while contagion risk

remained elevated for most of 2013, it has declinedmeaningfully since the Fed embarked on tapering.Volatility spillover between interest rates and equities morethan halved after the Fed announced it was reducing itsasset purchases by $10bn in December.

Because Bernanke left open the pace of futurereductions, we expect tapering to continue to dominateheadlines this year. However, because of the decline involatility contagion, we do not expect it to be a significantdriver of equity implied volatility. Uncertainty over tapering

has evolved from whether it will occur to how it willprogress. Small changes to the scale of the program (e.g.a $10bn vs. $15bn taper) may affect the VIX on themargin, but are unlikely to cause a spike of the magnitudewe saw in May.

Rate Hike a Bigger Risk than Tapering

Instead, the bigger risk is when the Fed will raise interestrates. CS Economics team believes that will occur in mid-2015, which is in-line with the Fed’s own projections. Asshown in Exhibit 2 below, the vast majority of the Fed’spolicymakers expect the first rate hike to happen in 2015.Only 2 of the 17 members at the last December meetingexpected a hike in 2014.

Exhibit 2: Fed Policymakers’ Projections for Fed Funds Rate


Even though an increase in the Fed Funds rate is notlikely until next year, the Fed may start preparing marketsfor it this year, especially if economic data continue tosurprise to the upside. However, talking about a futurepolicy change can be a policy change itself – and marketswill react as we saw with the taper talk last May.

Exhibit 3: Equity & Rate Vol Reactions to Taper



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Volatility reaction to talk of taper: The VIX recorded itsbiggest increase of the year – from 13.4% to 20.5% – inthe weeks after Bernanke first mentioned the possibility ofscaling back QE (see Exhibit 3). This happened eventhough Bernanke took pains to emphasize that taperingwas not imminent and would only happen after we sawevidence of a “real and sustained” economic recovery. Yetinvestors still panicked. Interest rate implied volatility, asmeasured by the Credit Suisse Interest Rate Volatility(CIRVE) Index, almost tripled to 114.7% in the aftermath.Equity implied “vol-of-vol”, as measured by VIX impliedvol, surged over 37 vol pts to 104% in the month after.

Volatility reaction to actual taper: In contrast, when theFed did finally taper in December, the VIX actually fell 2.4pts while interest rate vols declined over 7 pts that day, asmarkets largely shrugged off the event after having hadover six months to prepare for it.

Will Markets Believe the Fed’s Dovish Guidance?

Whether we see a repeat of the volatility spike we saw in2013 will depend on how successfully the Fed canconvince markets that tapering is not tightening. In otherwords, that reducing asset purchases does not mean animminent increase in the Fed Funds rate. To accomplishthis, the Fed will need to be more dovish in its forwardguidance. We saw signs of this strategy at the Decembermeeting when Bernanke coupled the taper announcementwith a change in the rate guidance, saying the Fed willremain on hold even if the unemployment rate falls “well

below” its 6.5% target. Going forward, the Fed couldconceivably move the level down to 6.0% or below.

Exhibit 4: Fed Policymakers’ Projections for Fed Funds Rate


But will markets believe the Fed? Exhibit 4 suggestsmaybe not. After the December FOMC meeting, interestrate investors actually priced in a higher likelihood of anearly rate hike, despite the dovish guidance. Theprobability of a rate hike in 2014, as implied by the

Dec’14 Fed Fund futures contract, increased from 10%before the announcement to over 19% afterwards. Bondyields also continued to climb, with the 10-year rate risingfrom 2.83% to over 3.0%.

Impact on Equity Volatility

Core Scenario: Our core scenario is that the Fed, with Janet Yellen at the helm, will continue to be extremelydovish in its forward guidance this year even as it windsdown QE. However, especially if economic growth picksup, the market may doubt the Fed’s commitment topersistent low rates and respond by taking interest rateseven higher. But we do not expect this to cause an abrupt

jump in implied volatility. Instead, we see small increasesof 1-3 vol pts for both VIX and VSTOXX over eachincremental better-than-expected economic report (seetext box on the next page for the labor market indicators

Janet Yellen will be watching) as investors gradually refine

their expectations for the timing of the first Fed Fundsrate hike.

Bearish Scenario: In our bearish scenario, we see the Fedmaking a surprise announcement that it is consideringraising interest rates sooner than expected, eitherbecause unemployment rate is falling rapidly or becauseinflationary pressures are picking up. Even if the plannedrate hike won’t happen for some time (actual taper didn’tstart until six months after Bernanke’s first mention), themarket reaction will be immediate and severe. In a paperBernanke co-authored, he found that historically S&P sold

off over 2.4% the day of an unexpected rate hike (seeExhibit 5). Implied volatility is also likely to jumpsignificantly in this case. We expect both the VIX andVSTOXX to rise to the 20-25% range, similar to what wesaw in May with tapering.

Exhibit 5: Historical Market Performance on Rate Hike

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


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2. Turmoil in the Emerging Markets

Since the start of QE in late 2008, Emerging Marketshave been the beneficiary of increased foreign capitalinflows, as negative real yields in the US have forcedinvestors to look elsewhere for returns. CS Global Equity

Strategy team estimates that Emerging Markets haveseen total net portfolio inflows of ~3% of GDP. Thus, it’snot surprising that when the Fed began its taper talk inMay, EM countries took the biggest hit. EM equities andcurrencies tumbled 10-25% in the months after (seeExhibit 1).

Exhibit 1: Emerging Markets Sold Off Across the Board


Asian Financial Crisis Redux?

The taper-induced EM sell-off last year certainly broughtback memories of the 1997 Asian Financial Crisis. Both

were fueled by hot money and large current accountdeficits. Each unraveling caused big swings in stock andcurrency prices. Yet there is one significant difference.The 1997 Asian Financial crisis caused a morepronounced reaction in global equity vol markets, with theVIX doubling from 19 to over 38 in the span of just aweek. In contrast, at the peak of the EM sell-off in 2013,the VIX increased by just 4 pts to 20%. Other globalvolatility benchmarks also showed no panic, with theVSTOXX and VNKY rising 5-6 vol pts to 25% and 46%,respectively.

Exhibit 2: Volatility Contagion Between EM vs. US Equities


The Yellen Indicators

In a March 2013 speech, then Federal Reserve ViceChair Janet Yellen highlighted the five labor marketindicators she considered most informative. As shetakes over at the Fed, the announcement of these

statistics could become volatility catalysts, as themarket tries to guess when the Fed may start raisinginterest rates.

Janet Yellen’s Favorite Labor Market Indicators:

1. Unemployment rate

2. Payroll employment

3. Hiring rate (JOLTS survey)

4. Quit rate (JOLTS survey)

5. Real GDP growth

Top Interest Rate Hedge

For equity investors looking to hedge the risk of

rising interest rates, we recommend buying call

spreads on TBT (Ultrashort US Treasury 20+ Year

Bond Index). Currently, implied volatility is trading at

a 1-year low while skew is inverted, making call

spreads particularly attractive. We recommend

buying the Jun’14 85-95 call spread for $1.50 (spot

ref 77.72) for a max payout ratio of over 6.5x. See

trade details on pg 34.

***The risk of buying a call spread is limited to the premium

paid.

https://doc.research-and-analytics.csfb.com/doc?language=ENG&format=PDF&document_section=1&document_id=805496850https://doc.research-and-analytics.csfb.com/doc?language=ENG&format=PDF&document_section=1&document_id=805496850https://doc.research-and-analytics.csfb.com/doc?language=ENG&format=PDF&document_section=1&document_id=805496850https://doc.research-and-analytics.csfb.com/doc?language=ENG&format=PDF&document_section=1&document_id=805496850


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Why did US equity investors largely shrug off theEmerging Markets turmoil last year? It was not becausethe US became less sensitive to EM risk. In fact, volatilitycontagion between EM and US markets reached similarextremes both times: in 1997, spillover 1 surged to a highof 80% while last year it reached 77% (see Exhibit 2).Instead, the difference lies in the magnitude of theshocks. At its peak in 1997, Emerging Markets volatilityincreased sevenfold to a high of 42% versus 28% in2013 (Exhibit 3). The reason for the lower volatility lastyear was that EM countries have become better equippedto handle financial shocks due to their increased currencyreserves.

Exhibit 3: EM 1M Realized Volatility 1997 vs. 2013


Since 1997, EM governments have deliberately built uptheir foreign reserves, which allows them to cover short-

term external debt when financing conditions deteriorate. As shown in Exhibit 4, FX reserves are now at least twiceas large as short-term debt in these countries; that ratiostood at less than one for most of them prior to the AsianFinancial Crisis. Low coverage of short-term external debtwas a key trigger for the 1997 crisis.

Exhibit 4: Reserve Coverage of Short-Term External Debt


Why 2014 Could Be Worse

While the impact of the EM sell-off on US equity volatilitywas relatively contained in 2013, we see potential forhigher contagion this year as US yields climb higher.

Three potential volatility catalysts are:

Deteriorating current accounts: Many Emerging Marketscountries are running significant current account deficits,which increases their vulnerability to Fed tightening. Inparticular, Turkey, India, and Indonesia are projected tohave larger deficits this year than they had even in therun-up to the Asian Financial Crisis.

Exhibit 5: EM Current Account Balances: Now vs. 1997


Increasing sensitivity to rising US yields: Worryingly, EMcurrencies have become more sensitive to rising US ratesnow than at the height of the crisis last May/June (seechart below). With the Fed winding down QE this year,and 10-year yields projected to climb higher (CS 2014year-end forecast is 3.35%), EM currencies are likely todepreciate even further.

Exhibit 6: Sensitivity of EM Currencies to US Rate Increases



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Mounting political risks: 2014 is an important election yearin many EM countries. Political instability could exacerbatethe capital outflow from the region. Three key countries towatch are:

− Turkey: A corruption scandal has already createdquestion marks about the government. Twocontentious elections (local and parliamentary)this year will further test Erdogan and his party.

− Thailand: It looks increasingly likely there will be judicial intervention to appoint a caretakergovernment. This will likely lead to further streetprotests, slower growth, and more capitaloutflows.

− Brazil: Loose fiscal policy is expected to helpPresident Rousseff win reelection. This couldtrigger credit downgrades.

1 Volatility spillover measures the degree of co-movement betweenequity volatility and another asset class’s volatility. For example, aspillover number of 80% between the VIX and EM volatility in thiscase means that whenever EM vol rises, 80% of the time the VIX

will also increase.

3. China’s Shadow Banks: a Crisis in Waiting?

Opaque financial products that promise “guaranteed” highreturns. Lax lending standards. And an unprecedentedcredit boom fueled by surging property prices. Is this theUS circa 2004 or China in 2014? More importantly, is

China about to have its own subprime meltdown – and if itdoes, will it send world markets into cardiac arrest?

Since the 2008 Global Financial Crisis, China’s economicengine has undergone an abrupt transformation fromexport-led to credit-led growth. In the last decade, Chinahas seen a bigger credit expansion, relative to GDP, thanany other country in modern history. Total credit nowstands at 185% of GDP. However, as shown in Exhibit 1,much of that has come from non-traditional lenders – i.e.the shadow banks.

Exhibit 1: China’s Shadow Banking Boom


These unregulated lenders include trusts, wealthmanagement products, underground lenders, as well astraditional banks’ off-balance-sheet lending arms (seeExhibit 2). Credit Suisse China Economics team estimatesthat shadow banking activity has surged in recent years toa total size of RMB 22.8T, or 44% of GDP. It nowaccounts for 25% of all outstanding credit and over half ofnew credit issued in the past year.

Exhibit 2: Major Players in China’s Shadow Banking System


Top Emerging Markets Hedge

Emerging Markets equities were the most impactedby Fed tapering last year, down over 17% from peakto trough. We believe another meltdown is possiblethis year as EM countries battle slower growth, higherUS yields, and mounting political risks. As a hedge,we like buying the Dec’14 36-30 put spread fundedby selling the 44-strike call for net zero premium (spotref 39.78). See trade details on pg 34.

*** The risk to buying a put spread is limited to the premium

paid. The risk to selling an uncovered call is unlimited.


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However, like the US in the 2000s, China’s shadowbanking sector suffers from poor transparency, highleverage, and exposure to frothy property markets. Wesee three key risks in the upcoming year that could turnthis boom into a bust – and send global volatility surging.

Rising Inflation: Our China Economics team views this asthe greatest near-term danger as higher inflation couldforce the PBoC to raise interest rates. They expectheadline inflation to pick-up “meaningfully” this year, andproject CPI to exceed 4.0% around the summer. If ratehikes occur, fund inflows into shadow banks will slow asinvestors would be able to get higher yields elsewhere.This could push some of the more leveraged lenders intobankruptcy, setting off sector-wide redemptions.

Exhibit 3: Inflation is Forecast to Rise “Meaningfully” This Year


Preemptive Deleveraging: The central government hasbeen trying to rein in the explosive credit growth. It letSHIBOR rates spike twice last year (the overnight rate

almost tripled in June), in order to “teach the market alesson” and weed out the most leveraged of theunregulated lenders. But this concern about moral hazardcould be misplaced. Whenever governments try to teachmarkets a lesson, it almost never ends well. Case in point,Lehman Brothers. It’s too easy for the government tomisjudge how severe a credit crunch can be and howexpensive it can be to fix. When it comes to China, thePBoC could semi-deliberately create a crunch in theshadow banking sector that quickly spills over into thetraditional one.

Exhibit 4: SHIBOR Rates Almost Tripled Last June


Falling Property Prices: Many of these shadow lendersare highly levered to the property market, so anymeaningful decline in price could lead to massbankruptcies. The resulting credit crunch wouldn’t just hitdevelopers, but local governments too. They rely onshadow lenders to finance infrastructure projects, and onland sales to fill their coffers. Any decline in propertyprices would thus strangle revenues and liquidity. Theywould likely need the central government to bail them outof some their debt, currently at 33% of GDP (includingboth direct and contingent liabilities).

Exhibit 5: Local Government Debt Has Surged Since 2008


Impact on Equity Volatility

We believe that a 2008-style unraveling in China’s

shadow banking system is, for the moment, unlikely. Thecentral government will almost certainly bail out the state-owned companies to prevent an all-out panic. Even ifthere were a financial meltdown, contagion would likely belimited because China’s banking sector isn’t that tightlyintegrated into the global financial system.

Instead, we believe any turmoil in the shadow bankingsystem would reverberate as an economic, and not afinancial, crisis. In the worst case, where the centralgovernment has to bail out state-owned banks andcompanies, there would still probably be a lingering credit

crunch. China’s investment-led growth would take asignificant hit – and so would its trading partners,especially ones that supply it with raw materials. Theseripple effects on global growth could sink markets andsend volatility surging. Indeed, a recent IMF studyestimates that China accounted for a quarter of globalgrowth in 2013.

As the US’s second largest trading partner, a slowdown inChina could potentially pull the US back into a recession.In fact, CS Global Equity Strategy team believes China to


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be the biggest risk to US growth in 2014. Recessionstypically result in some of the largest increases in equityvolatility. Over the past 70 years, US recessions haveproduced on average a 19 pt surge in S&P realizedvolatility.

We believe a good historical parallel is the collapse of Japan’s credit-fueled asset bubble in the early 90s. At thetime, Japan was also the US’s second largest tradingpartner. During the first phase of the correction, NKY 1Mrealized volatility surged over seven times to a high of47%, yet S&P volatility barely reacted. It wasn’t until USeconomic growth slowed in response and eventuallyslipped into a recession that we saw a significant spike inUS equity volatility (+13 pts to 26%; see Exhibit 6). Webelieve a shadow banking crisis in China this year couldcause a similar jump in the VIX, up 12-15 pts to a high of30%.

Exhibit 6: NKY vs. SPX Volatility at Peak of Japan’s Crisis


0

10

20

30

40

50

60

70

Jan-90 Mar-90 May-90 Jul-90 Sep-90 Nov-90 Jan-91

V o l a t i l i t y

NKY 1M Realized Vol

SPX 1M Realized Vol


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Structural Skew Outlook

Evaluating Skew Opportunities in 2014

Within the equity derivatives markets, the richness orcheapness of skew is often a major consideration indetermining how broad market directional views are

expressed. The strategy one implements to express abullish view in a low volatility environment with “rich” indexskew may completely differ from the strategy one uses toexpress a comparable view with “cheap” index skew. Due to recent changes in the behavior ofequity index skew in response to market conditions in2013, however, derivatives traders may need to reassesshow to quantify the richness or cheapness of skew goingforward.

Skew Convexity

Of the three primary aspects of the volatility surface, skew

is the one that is most inconsistently defined. Even withinthe same firm, the precise definition of skew may varyfrom trader to trader and can refer to one of the following:1) a volatility differential by moneyness (e.g.: 90%-110%strikes); 2) a volatility ratio (e.g.: 90%/110%); or 3) avolatility differential by delta (e.g.: 25 delta put – 25 deltacall).

The common feature among these definitions is that theyall involve taking the difference of 2 points along the skewsurface. Although in relatively stable volatilityenvironments (i.e., low to moderate vol-of-vol and a VIXlevel close to its historical average of 20), relative

differences in the determination of richness or cheapnessof skew between the varying definitions is negligible, theyare all based upon a common assumption: that equityindex skew is downward sloping. 1

Recent developments regarding the likelihood of an“upside tail-event” and the current low volatility regimemay challenge this assumption going forward. Specifically:

1) last year’s decisive market rally, a 3-standarddeviation event with the VIX averaging 14

2) lack of interest in selling calls given the low vollevels and opportunity cost of missing a rally

As a result, skew has become increasingly convex (morebowed), especially in recent months.

1 Recall that downward sloping equity index skew has held sway since theCrash of ’87 to compensate for the empiricism that 1) large 3+ standarddeviation market moves are usually associated with market declines ratherthan increases 2) portfolio managers are willing to pay a premium fordownside protection 3) investors tend to harvest yield by selling calls.

Exhibit 1: Equity Index Skew Typically Downward Sloping


… But Has Recently Embedded More Upside Curvature


Quantifying Skew ConvexityWe believe the effects of skew convexity will be especiallyacute in 2013. Recall that in our framework, skewincludes the probability of 2-standard deviation moves(daily returns), whereas 3+ standard deviation movesmanifest themselves within the tails (kurtosis). Wehypothesize that if the market has built-in expectations forshocks arising from the previously mentioned macrocatalysts, shocks that would normally precipitate a “fat-tailed” market move in excess of 3-standard deviationsand would now have a more muted impact upon themarket, resulting in smaller, 2-standard deviation moves

instead. We therefore expect volatility markets willexperience higher rates of change in skew convexity (highvol of skew) than in years past.

In these situations, measures of skew that reply uponsimple put-call volatility difference calculations can differvastly from measures that take into account its curvature.If this effect persists in 2014 we suggest supplementingtraditional measure of skew with a probability distilled fromthe implied distribution which represents likelihood ofdecline below a certain level.


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Structural/ Transient Skew Decomposition

In order to discuss the time series of skew acrossdifferent (high vs. low) volatility regimes, we reference adefinition of skew that is relatively insensitive to spotvolatility and takes into account the curvature of skew.Specifically, we define skew using a modified form of the

variance swap calculation in which skew refers to thepremium of weighted volatilities across a range of strikesover at-the-money implied volatility.

In this framework, the time series of skew is subdividedinto two components: 1) a “structural” componentrepresenting the volatility premium attributable to impliedvolatility through investors’ desire to hedge or generateyield under “normal” market conditions and 2) a “transient”component of skew referring to the volatility attributable toimplied volatility via the desire to hedge in times of marketduress (see Exhibit 2).

Exhibit 2: “Structural” Skew ~ 1.0% in 2013


While admitting that the process of translating structuraldemand to volatility requires a combination of art andscience, we attempt to do so by surveying each of ourmajor client groups in the following sections: hedge funds,asset managers, insurance funds, structured retail, andpension funds. We conclude by extrapolating implicationsof emerging derivatives trends.

Our survey reveals that as volatility is likely to remain lowin 2014, institutions and fundamental long-short hedgefunds will likely rein in call-overwriting and other skew-suppressing yield-enhancement strategies. Furthermore,

we expect to see an increase in option use to expressdirectional views. These activities should reinforce theeffects of increased skew convexity discussed earlier,resulting in increased skew “beta” sensitivity relative tospot vol.

.

Exhibit 3: Estimates of Volatility Contribution by Client Type

Source: Credit Suisse Equity Derivatives Trading

Vol Funds,30%

Long Only/HF,30%

Insurance,15%

Pensions, 5%

StructuredRetail, 10%


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Institutional/ Fundamental Long-Shorts

General Outlook

Since the post-Crisis recovery in 2009, the primaryderivatives strategies employed by institutional and long-short equity PMs have been premised upon 1) astructurally elevated correlation regime and 2) aleptokurtotic drift (rising markets likely to be subdued butfalling markets likely to be abrupt). Thus, leading up to2013, volatility savvy accounts generally focused on indexhedges or index level volatility/skew based yieldenhancement strategies that typically returned 200 to300bps p.a.

To Heck with Hedging: Needless to say, after last year’sdecisive 30% market rally and the disappointingperformance of hedges in 2012, the vast majority ofinstitutional hedgers have now capitulated. Although anumber of catalysts (sequester, tapering, debt ceiling) did

in fact cause volatility spikes in 2013, they were toomuted and too short-lived for hedgers to effectivelymonetize. Accordingly, hedging-related flow heading into2014 was generally either unwinds or implemented withthe purpose of “hedging the hedge”.

Levered Delta: The more relevant dynamic for 2014,however, has been investors’ response to the decline ofequity correlation. As shown in Exhibit 1 which mapscorrelation against the CS Alpha Availability Index, ascorrelation declines to post-Crisis lows, the returndifferential between the highest and lowest decileperformers in the S&P widens – increasing the rewards

for superior stock-picking. As such, the exceptionallystrong market conditions amidst a backdrop of decliningcorrelation last year shifted investors away from indexlevel “volatility arbitrage” strategies towards the use ofoptions (mostly calls) primarily as levered delta(directional) single stocks bets. 2

2014 Derivatives Trading Implications

Given our forecast for modestly higher equity markets andlow correlation, we anticipate 1) a re-emphasis on volatilitypremium capture as a 200-300bps return is moremeaningful when market performance is modest and 2) a

focus on single stocks. This is likely to culminate inincrease in 1) sector level “dirty dispersion” (selling sectorstraddles to buy calls on single stocks) and 2) skew basedoverlay strategies to establish long delta positions (e.g.selling puts to enter into long positions when put skewsteepens and buying calls to replace stock positions whencall skew flattens).

2 The shift away from gamma towards delta has triggered a decline in optionvolume as delta based strategies incur lower turnover. Exhibit 2

Additionally, as investors become more confident in theirglobal equity investments, we would expect to see areturn in interest for European underlyings, in particularlong delta/long vol trades such as outperformance optionsor simply outright long vanilla call options which havebecome increasingly popular in the last months of 2013.

At current low implied volatilities, such structures offercheap participation in European outperformance in 2014.

Exhibit 1: Alpha Availability Increases as Correlation Declines

Source: Credit Suisse Equity Derivatives

Exhibit 2: Options Turnover Declines as Delta Bets Increase

Source: Credit Suisse Equity Derivatives Strategy, Bloomberg

Exhibit 3: Opportunities for Skew Based Stock Replacement



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Investment Bank Trading Desks

General Outlook

Basel III Credit and Equity Hedging Requirements3

New capital rules for global broker dealer banks underBasel III have systematically increased the aggregate

market demand for credit risk protection and tail riskprotection for equity indices, particularly in the most liquidindices such as the S&P500. In calculating risk weightedassets (RWA) under Basel III, market-risk stress VaR andthe new credit valuation adjustment (CVA) requiresignificantly higher capital from banks. To partially off-setsome of the increased capital requirements for marketand counterparty credit risks in market-making portfolios,banks have been incentivized to purchase and carrygreater levels of credit risk and tail risk protection.

Credit: Given the reduced liquidity in credit marketsfollowing the London Whale incident and responses to

Dodd-Frank, we can most easily see the impact thatBasel III requirements have had on European ITraxx IGand US CDX IG - two credit indices widely used tomitigate credit risk exposure at broker-dealer banks.Credit risk capital is measured via quarter-end snapshots.Note in Exhibits 1-2 that these two credit indices havetended to spike at quarter-ends vs. other trading days.

Equities: Market risk capital is measured using a 60-dayrolling average; thus the incremental demand for marketrisk hedges is more evenly distributed across the quarter.Moreover, as a percentage of total capital usage within

banks, equity exposures are far smaller thancorresponding credit exposures. As a result, we do notobserve corresponding monthly or quarterly lumpinessattributed to Basel III in either S&P or VIX options.


Although many banks are relatively far along in adaptingto Basel III capital requirements, others are still at thebeginning of this transition. Thus, it’s possible that creditindices experience even more outsized hedging demandat quarter-end this year as more banks adopt the newcapital requirements. This could force some banks to

consider using equity index put options to hedge theircredit exposures. This dynamic suggests the possibility ofintermittent liquidity-induced increases in volatility nearquarter end for equity indices such S&P.

3 Dan Rodriguez, CRO Systematic Market Making Group

Exhibit 1: iTraxx 5Y Spread Widens at Quarter-End …


Exhibit 2: ... as do CDX Spreads …


Exhibit 3: … but not VIX



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Volatility Hedge Funds

General Outlook

In a year in which the VIX repeatedly flirted with GreatModeration lows, volatility hedge funds had a dichotomyof outcomes. The key factor was vol of vol. Although themedian volatility in 2013 was near 2004-2006 lows, volof vol realized at middling (near 50th percentile) levels. Forvolatility carry funds that systematically sell volatility riskpremium (i.e. capturing the difference between impliedand realized volatility), a moderate vol-of-vol environmentis actually beneficial as it allows them to opportunisticallyreset their short vol positions at higher levels. Exhibit 2shows the performance of a rolling short vol strategy overthe course of last year. It maps the VIX againstsubsequent 1-month realized volatility. As you can see,with the exception of 2 weeks in March (sequester) andagain in May (taper), a systematically short vol strategywould have performed very well.

In contrast, volatility long-short funds typically thrive in ahigher vol-of-vol environment where arbitrage and spreadopportunities are more plentiful. This explains thedichotomy in performance between the two groups lastyear. While volatility carry funds had their second bestyear since 2007 (Hedge Fund Research HFRX data),long-short vol strategies recorded a 2.5% loss for theyear.


Correlation: Earnings period may provide vol fundsopportunities to conduct sector correlation trades.However at the broad index level, vol funds generallyconsider the selling of correlation levels below 60 to bestatistically unattractive, we expect correlation to be anopportunistic rather than systematic trade for vol funds in2014.

Relative Value: With increased illiquidity in long-datedvolatility, term structure opportunities will likely be drivenby term structure inversion. If our view of higher skewsensitivity bears out, vol funds will likely focus on

exploiting dislocations in skew & skew term structure.

Vol of Vol: The rise in liquidity of exchange-listed volatilityproducts such as VIX options, futures & ETFs boosted thegrowth of a variety of strategies. In addition to tacticallyusing products to express directional views andoccasionally hedge, funds have been exploring dynamicapproaches to systematic volatility investing and potentialarbitrage opportunities arising from broad-based volatilitydemand/supply. With low levels of volatility across assetstrategies, higher moment directional (vol of vol) and

relative value VIX futures and options trades are likely tobe one of the few obvious ways for volatility hedge fundsto source alpha within equities. More advanced strategiesin the space, particularly those related to the vol of volsurface skew and term structure arbitrage have remainedmostly unexplored due to lack of appropriate instruments.

Exhibit 1: Volatility Hedge Fund Performance vs. VIX Level


Exhibit 2: PnL of a Systematic Short Vol Strategy Last Year


Exhibit 3: VIX Vol Surface a Potential Source of 2014 Alpha


1M2M3M

6M

1Y

50

80

100

120

15020

40

60

80

100

120

MaturityStrike (% of Spot)

V o l a t i l i t y


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Insurance Companies General Outlook

Against a backdrop of stringent solvency requirementsand a diminished supply of long-dated vega, the insuranceindustry witnessed a significant retrenchment in variable

annuity (VA) activity. Two major carriers – Hartford andSun Life – completely withdrew from the variable annuityarena last year, while ING and John Hancock both greatlyreduced the size of their VA books.

Even insurers who nonetheless remain committed to theVA business continue to de-emphasize variable annuitiesin their product mix and have gravitated towards equityindex annuities and other products with a more benign riskprofile. Thus, although VA sales have only trended downby an average of 4% per annum over the last two yearsas shown in Exhibit 1, the potential vega footprint of VAs

have decreased (the current product mix embodies lessconvexity risk as insurers continue to charge more forproducts with comparatively less optionality). Comparedto the variable annuities sold pre-Crisis, current equityvariables annuities 1) are sold at a higher premium tocompensate for the excess costs of hedging required and2) embed additional risk control features to obviate theneed for long-dated protection. From a volatilityperspective, the upshot of this two-pronged approachcoupled with the outright sale of some legacy VA blocks isthat insurers have been able to steadily reduce theirpotential vega footprint.


Because of the abovementioned product redesigns, thebulk of the need for long-dated vega in 2014 arises notfrom new sales but from the need to hedge legacy GMxBstructures. The extent of this demand in turn hinges uponthe moneyness of legacy guarantees.

With the market at record highs, however, the vastmajority of the implicit index put options underwritten byinsurers are currently deep out-of-the-money. As shownin Exhibit 2, which gives an estimation of the moneyness

of the implicit index puts embedded into the guarantees,most GMxB written over the last five years currently rangefrom 10% to 50% out-of-the-money.

Moreover, as interest rates rise, the present value of VAliabilities will be further reduced. As a result, barring asteep market sell-off of 30 to 50%, insurers will likelyremain net buyers of short-dated (0 to 2 year) volatility butwill be relatively elastic with respect to long-dated (7 to 10year) vega.

Exhibit 1: Insurers Continue to Temper VA Sales

Source: LIMRA

Exhibit 2: Variable Annuities Sold Post-Crisis are Deep OTM4

Source: LIMRA, Bloomberg, CS Equity Dérivatives Strategy

Exhibit 3: Declining Demand: S&P Long Dated Skew At 5Yr Lows

4 To quantify the moneyness of recent guarantees, we used the median level of the S&P for each

quarter weighted by that quarter’s new sales percentage contribution to produce the current average

moneyness of post-Crisis guarantees by vintage.

Avg: 1.5%

+2 Std: 1.7%

-2 Std: 1.4%

31-Mar-13 30-Jun-13 30-Sep-13 30-Dec-13

1.4%

1.5%

1.6%

1.7%

V o l a t i l i t y ( % )

.SPX Skew Avg(.SPX Skew) ±2*Std(.SPX Skew)

Source: Credit Suisse Locus


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European Insurance Solvency Requirements

In Europe, insurance companies’ news flow continuesto center around the application of the Solvency IIdirective. Omnibus II (the update of the 2009 SolvencyII European Directive) was agreed on by Europeanpolicy-makers on November 13, confirming that

Solvency II will be implemented starting January 2016.

While the final text has not yet been made public,Credit Suisse EMEA Structuring believes that lifeinsurers will be granted a 16-year transition period,during which the Solvency Capital Requirement (SCR)will be set as a pro rata temporis mix between SolvencyI and Solvency II SCRs. Although Scandinavian insurersare ready for Solvency II and could opt for immediateimplementation if this is rendered possible by theirregulators, German insurers who have more long-termrate guarantees in their liabilities are likely to choose

the slow path instead. Some technical adjustmentscould also be defined in order to reduce the impact ofinterest rate volatility, which will prove positive again forGerman insurers.

Overall, a more stringent SCR is likely to keep equityallocations close to their current record low levels of 5to 10% of assets across Europe (with anecdotalevidence that allocations in Italy or Germany could beas low as 3%). Additionally, the new regulatoryframework is expected to put a larger emphasis ondiversification and dynamic hedging strategies,

generally reducing the overall long-term vega footprintof the Insurance sector in Europe.

Over the last couple of years, hedging activities byEuropean insurers have only been fractions of their pre-crisis levels, and as such, are only a marginal driver ofvolatility. We do not expect the volatility footprint ofEuropean insurers to increase in 2014, mainly because

as discussed above, allocations to Equitycontinues to be at historical lows with littlescope for increase (with the exception of GreatBritain and Scandinavian countries)

an even lower portion of this Equity exposure isactually systematically hedged, and more capital has been allocated to alternative

strategies, which are typically net short equityvolatility.

Exhibit 4: Current Capital vs SCR (per country)

Source: LIMRA, Bloomberg, CS Equity Dérivatives Strategy


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Pension Funds General Outlook

Back in Black…almost. Following the Credit Crisis, UScorporate’s defined benefits (DB) pension plans spentyears quagmired in an industry-wide funding shortfall inexcess of $350 billion. Over the last year however,

funding levels were buoyed by two elements:

1) Stock market: the 32% S&P rally increased the38% of plan assets linked to equities

2) Interest rates: the 84 bps increase in high-gradecorporate bond yields from 3.96% to 4.8%,coupled with legislative reform via the Moving

Ahead for Progress in the 21st Century Actreduced the present value of liabilities.

As a result, a recent Towers Watson study finds that thefunding status of Fortune 1000 DB plans has in

aggregate risen $285 billion, increasing funding levelsfrom 77% in 2012 to 93% at 2013 year end. Basedupon earlier precedents, as the funding levels improve, weare likely to see corporate plans begin to de-risk by either1) shifting their exposures away from equities into bondsor 2) initiate buybacks via lump sum offers and annuitypurchases for formerly vested participants.

Similarly, the increase in rates and strong equityperformance has improved pension funding levels inEurope and notably in the UK, which traditionally has astrong proportion of assets invested in equities (45%).The aggregate UK funding gap based on IS19

calculations has fallen to circa £100bn despite adverseimplied inflation moves (most UK benefits are inflation-linked). Because European pension funds tend to bemore geographically diversified than US, most of theperformance in 2013 was linked to overseas equityinvestments, with a clear overweight in US equities.


Although pension plans pulled back on hedging during lastyear’s equity market rally, with the market currently atrecord highs, we expect the abovementioned de-riskingas a catalyst for a pick-up in pension hedging activity in

2014. Although pensions have traditionally been open tohedging via a range of strategies, an increasing sensitivityto premium expenditure will probably induce pensions tofocus on short-duration, zero-premium strategies suchput-spread collars. However, given that 1) only about 1%of pension plans actually hedge and 2) the typical put-spread collar strategies utilized by pensions usually havelow vega, we expect minimal vega impact at the marketlevel on behalf of US/Euro pensions in 2014.

Exhibit 1: Pension Funding Deficit Below $100M

Source: Millliman

Exhibit 2: Corporate Pensions are Currently 93% Funded

Source: Towers Waston

Exhibit 3: Pension Deficit Forecasted to be Erased By 2014 YE

Source: Millliman

Exhibit 4: Allocation Away from Equities Capped Returns

Source: Towers Watson, Milliman


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Structured Products

General Outlook

The bulk of global structured product issuance continuesto be defined by the search for yield. However, theissuance of income-bearing structures have been

complicated by 1) the low level of interest rates, whichreduces the amount of premium available to be spent incapital guaranteed products and limits the couponavailable in income-generating notes and 2) low levels ofvolatility which reduces the premium generated by sellingthe embedded equity option. (A 3-year down-and-inequity index put option with a 30% downside barriercurrently generates a coupon of only ~5% p.a., vs formerlevels of 7 to 9%5). In response, issuers have beenincorporating a number of innovations to improve theoptics including 1) increased use of barriers and othercontingent structures and 2) shifting maturities further up

the term structure.Going into 2014, however, as equity markets extend theglobal rally, we anticipate 1) a shift away from incomebearing (short optionality) notes towards uncappedparticipation (long optionality) structures such as bufferedleveraged notes and 2) increased callbacks onautocallables, many of which were issued during therange bound markets of 2010-2012.


Given the subdued outlook for rates in 2014, we expect

the bulk of the impact of notes upon the volatility marketsto stem from the inventory of income notes. In generalthe risk profile tends to make structured trading deskslong volatility, short skew, short repo, long implieddividends and short correlation.

Volatility: as shown in Exhibit 3, issuers are short volatilityas the underlying underperforms, as long as it staysreasonably far from the down-and-in barrier, driving(rolling) at-the-money volatility down6. In strong equitymarkets, issuers become long volatility and are exposed toimplied-realized volatility decay.

Skew: Income notes push down implied volatilities forstrikes lower than spot, and push up implied volatilities forstrikes higher than spot. The large footprint of income

5 Underlyings: Eurostoxx 50, FTSE, S&P-500, Nikkei. Maturity: 2 to 3years in Private Banking where trading is more dynamic, 5 to 8 years formass retail. Autocall feature knocking out the trade if an upside barrier isbreached – the barrier is typically set at 100% with annual observationsCoupon: reverse converts (5%), worst-of puts (8+%)

6 beyond a certain point however, trading desks would find themselves tooshort vega, and therefore become large buyers of volatility

notes thus depresses skew across all major globalbenchmarks.

Long Divs: structured trading desks are typically shortlong-term forwards which are hedged by going longshorter term instruments such as futures or synthetics.While this trade is on average expected to generatepositive carry, it also makes trading desks long implieddividends and short repo. The latter created significantlosses in 2013 due to added friction costs (in particularthe financial transaction tax in Europe), unfavorablefunding conditions, and dividend taxation.

Exhibit 1: Low 3-8 Year Implied Volatility Reduces Note Benefits

Exhibit 2: 4Y SPX RTY Cert Plus (Short Correlation)

Source: Credit Suisse Equity Derivatives Structured Products Group

Exhibit 3: Vega Profile of a 1Y DOI SX5E Put (Barrier 2,000)

Source: Credit Suisse Equity Derivatives Structured Products Group

Avg: 19.1%

+2 Std: 20.2%

-2 Std: 17.9%

31-Mar-13 30-Jun-13 30-Sep-13 30-Dec-13

17.0%

18.0%

19.0%

20.0%

V o l a t i l i t y ( % )

SPX 3Y 100Pct Imp Vol Avg(SPX 3Y 100Pct Imp Vol)

±2*Std(SPX 3Y 100Pct Imp Vol) SPX 3Y Hist Vol

Source: Credit Suisse Locus


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Systematic Investment Strategies

General Outlook The use of systematic indices continued to grow rapidly in2013, as investors sought to package various strategiesinto index format, and achieve the transparency, liquidityand lower costs associated with these products. The

evolution of index products took an accelerated turn postfinancial crisis, when investors went beyond better stockpicking methods (also referred to as “smart beta” or“intelligent indices”) to embed actual systematic strategieswithin indices. Today, these tools have found applicationsacross a wide swath of users from pension funds, to assetmanagers, and even retail investors.

Prevailing Themes Based on recent flows and inquiries, we expect that the 3areas of focus in 2014 will be:

risk premia capture

tail-hedging, and cross-asset portfolio investment strategies.

Risk PremiaThe concept of capturing risk premia today includes therealm of structured derivatives. Once the domain of hedgefund traders, sophisticated derivative ideas can now befound embedded into indices which have distilled thosestrategies into its essential elements, via systematic rules-based trades. Examples of these systematic strategiesfor capturing risk premia include:

volatility risk premium,

dividend yield curve, and mean-reversion

Volatility Risk Premium: attempts to capture the volatilityrisk premium of the equity markets. Derivatives tradershave long held the belief that the implied volatility used inequity option pricing typically often trades at a premium toits realized volatility. This is typically explained by thenatural and persistent imbalance of investors seeking tobuy protection, and the general overpricing of futureexpected risk. 7

Dividend Yield Curve Arbitrage: takes advantage of thestructural imbalances in the dividend yield curves of globalindices.Mean Reversion: captures mean reversion properties ofthe market.

7 In 2009, Credit Suisse launched its Global Carry Selector Index(Bloomberg Ticker: GCSCS), which utilizes equity index variance swaps tocapture this view, and given its strong performance, AUM in this productincreased five-fold in 2011-2012. Despite more turbulent performance in2013, the index still experienced net inflows as investors maintained theirconfidence in the strategy.

Tail HedgingLong the bane of every nervous portfolio manager, tailhedging has also been addressed by the growing realm ofsystematic investment strategies. Amongst the greatestchallenges of installing a systematic tail hedging programis “paying for decay” when purchasing options – that is tosay, option premium is expensive, options often expireworthlessly, and the net cost impairs performance to thepoint where not hedging is often the path chosen.

Investment banks, exchanges, and asset managers haveall assumed the challenge and over the past few years,tail risk indices have proliferated with various profiles andcharacteristics. As the US market rose over 30% in2013, predictably, these indices exhibited negativeperformance – some severe.8

Cross-Asset Portfolio Investments As investors sensed the end of the Fed’s QE program,conversations about rotating out of bonds and intoequities and other asset classes became more prevalentthroughout 2013. Moreover, there has been a growingdesire by institutions and private investors alike, to findsystematic and disciplined approaches to managing cross-asset portfolios, by using either index swaps or ETFs ascomponents of a balanced investment strategy.

In many of these indices, the size of each constituentexposure is determined using the core disciplines ofmodern portfolio theory, and this dynamic portfolio alsohas an overall volatility target to control the cost of the

options linked to it.

Packaging these portfolio strategies into a single indexproduct enables the investor to have a systematic, yetactive, approach to its assets, and reap the benefits ofthe convenience of what is traditionally considered apassive instrument (i.e. an index). The appeal toinvestors of cross-asset portfolio indices remainsunabated, and we anticipate further growth of AUM insuch products this year.9

8 In order to combat the drag of decay, Credit Suisse launched its AdvancedDefensive Volatility Index (Bloomberg Ticker: CSEAADVL) in 2012 whichtakes positions along the VIX futures curve where the futures roll carry isminimized, and based on proprietary signals, the investor rapidly becomeslong volatility in times of market distress. Since its inception, this riskhedging index remains our most talked about, and most traded indexproduct.

9 Credit Suisse launched its TEMPO (“Tactical Efficient Markowitz PortfolioOptimizer”) index (Bloomberg Ticker: CSEATMPE) in 2013, to address thegrowing desire of investors to not only achieve a dynamic cross-assetportfolio, but also obtain exposure to the VIX – an “asset” that provides abuilt-in tail hedge in times of market stress.


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Summary: VIX Forecast For 2014

Given our underlying positive economic outlook, our 2014VIX forecast reflects what we see as a continuing trendtowards a low volatility regime. Our core scenario uses theframework detailed on page 2 of this report, whichdecomposes implied volatility into 3 components: baseline

volatility (see pg 3), kurtosis premium (pg 4-11), andskew premium (pg 12-17). We then analyze the possiblerange the VIX could trade in over the next year byoverlaying potential shock scenarios.

Our “steady-state” scenario evaluates the case where nomajor macro catalysts occur and the current economicrecovery continues unimpeded. In three other scenarios,we estimate the increase to kurtosis and skew if one ofour top 3 macro catalysts – rising US yields, EMcontagion, and China shadow banking meltdown – wereto happen.

Our findings are summarized below. In our “steady-state” scenario, we estimate the VIX will trade at an

average of 15 over the next year, representing amarginal increase from the 2013 average. However, ifany of the negative macro shocks we outlined were tooccur, we estimate the VIX could trade in the 20-30range.

Exhibit 1: “Steady-State” VIX Forecast of 15%



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2014 Equity Sector Volatility Outlook

As we enter the 6th year of a bull market, it’s hard tobelieve that the current streak has lasted almost as longas the run in the mid 2000’s. Since its March 2009 low,the S&P has returned over 170% and is 17% above itspre-financial crisis high. Yet, not everyone is in on the

party. Only 5 out of 10 sectors have regained the groundsonce lost, with Financial, Utilities, and Telecom still a waysaway. But with correlation having (finally!) broken down in2013, the environment is geared for sector/stockselection and fundamentally driven alpha generation.Catching the shift from defensives into cyclicals last year,for example, would have added 15% alpha vs. the S&P.In this section we identify the key performance drivers forthe S&P and the major sectors that will help frame thefundamental outlook and our resulting sector volatilityviews.

Economic Outlook: CS expects the global economy tobe the most orderly in many years. A stable balance ofmodest growth, low inflation, and accommodative policieswill help global GDP growth accelerate to 3.7% in 2014after rising 2.9% in 2013. In the US, growth shouldincrease at a steady pace of 3%, driven by improvementsin housing and consumer spending. The key uncertainty isthe timing and magnitude of Fed taper. CS base case isfor a reduction of $10b per meeting but in reality the pathwill be bumpier. Much stronger economic growth could,ironically, be the catalyst that pushes the VIX higher as itbrings forward the Fed’s tightening timeline.

Earnings Growth: CS expects S&P earnings to grow7% in 2014 to $116. Growth will be strongest for theEnergy, Consumer Discretionary, and Industrial sectors;while Consumer Staples and Financials are expected tolag (although still positive). We have a year-end S&Pindex target of 1960 which would put the market at 17xearnings – a level we believe is reasonable given lowinterest rates, strong corporate balance sheets, andaccelerating economic momentum. With margins alreadyat record levels, companies will need to demonstratetopline growth in order to meet consensus expectations.

Interest Rates: CS expects 10-year Treasury yields toincrease to 3.35% by year-end. Rising interest rates wasa key reason for sector differentiation last year. Up untilMay when Bernanke first hinted at tapering, the defensivesectors such as Utilities, Staples, and Healthcare wereleading the market with YTD gains of 15% or more (seeExhibit 1). Following the taper talk, relative performancesreversed with cyclical sectors drastically outperformingdefensives. In fact, most of the defensive sectorsrecorded negative returns for the rest of the year (seeExhibit 2).

Exhibit 1: 2013 Performance Up to May 1st


With rising interest rates and an accelerating economy,

we expect sector divergences to continue. We see theFinancial sector as one of the key beneficiaries of thepositive macro environment, especially banks (high netinterest margins) and life insurance companies (betterportfolio returns). We also expect the Industrial sector – the best performing group in 2H’13 – to continue to dowell as it has one of the highest correlations to USTreasury yields. In contrast, industries with high financialleverage and low operating leverage will underperform(rising costs and minimal sensitivity to economy). Thesegroups include Utilities, Telecom, Tobacco, Beverages,and Food.

Exhibit 2: 2013 Performance After May 1st


In general, we expect cyclical sector volatility to driftlower, while the outlook for the defensives is morechallenged. We detail our key sector volatility views in thenext few pages.


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Key Sector Volatility Views

Financials: We expect Financials’ volatility to movelower given improving fundamentals and lowerearnings variability. It has the potential to approach its2004-2006 lows this year.

Energy: We see an opportunity to pair a short Energysector vol position against a long crude oil vol hedge.The outlook for energy companies is constructive,despite the fact that we see downside risks to oilprices in 2H 2014.

Utilities: With rising interest rates and competitionfrom renewable power sources, the utility sector couldexperience more volatility than its traditional low betastatus would imply.

Technology: Disruptive technology along with theimpact of Amazon’s expansion in the cloud storagebusiness should keep a bid to tech sector volatility in2014. We also see increase M&A as a vol catalyst.

Exhibit 3: 2014 Sector Volatility Outlooks


Weight in

S&P

1Y Impl

Volatlity Sector

Volatility

Outlook

19% 16.1 Technology ▲▲

16% 17.3 Financials ▼▼

13% 15.0 Healthcare ▲▲

13% 16.5 Consumer Discretionary ▼

11% 17.4 Indust rials ▼▼

10% 18.4 Energy▼▼▼

10% 13.1 Consumer Staples ▲

3% 14.6 Utilities ▲▲

3% 17.4 Basic Materials ▼

2% 14.3 Telecom Services ▲

Lower volatility ▼

Higher volatility ▲

2014: The Year of the Buyout?

Since the beginning of December 2013, there havebeen 9 billion-dollar deals where the acquirer ’s stockprice jumped higher by more than 5% on the day ofthe announced (e.g. Fiat, Avago, Sysco, Textron,

Forest Labs, etc). The average increase is astaggering 17%. This could be the much neededpositive reinforcement from investors to corporatemanagement for increased M&A after a long period ofmuted transactions.

While IPOs had a banner year in 2013, M&A deals arestill running more than 50% below normal levels.Leading indicators of M&A including higher equitymarkets and increasing CEO business confidence aredecidedly positive. Recent surveys indicate CEOwillingness to increase M&A in 2014. Further, FCF

yield remains significantly above corporate bond yields,suggesting M&A should be cash EPS accretive. Weexpect the recent performance of M&A stocks to helpdrive an acceleration in corporate activity.

CS has a Delta One basket comprised of top analystpicks for potential M&A targets: CSUSUSMA Index.This index outperformed the broader market by 10points in 2H’13.


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Energy: Shale We Dance?

The energy sector enters 2014 with an improvingfundamental outlook, albeit with downside oil price riskemerging in the second half of 2014. 1-year impliedvolatility for the energy sector, currently at 19%, is thehighest of all major sectors. We expect the sector ’s

volatility to compress in 1H due to improving companyfundamentals, with some upside risk from potential higheroil supply in the second half.

Exhibit 1: Sector Scoreboard


Oil Outlook: 2014 is all about the potential return of oilsupply from constrained/offline international sources,particularly Libya and Iran. Potential supply increaseswon’t occur until 2H’14 which means CS expects Brent

oil prices to remain around $110 per barrel until then. IfLibyan political risks subside, export production coulddouble from current levels by the end of the year. In Iran,negotiations on sanctions are expected to be completedby the end of Q2’14, and exports could rise by 0.5Mb/dby year end. Taken together, CS sees about $10/barrelof oil price risk in 2H if all goes well with returning supply.Depending on the path, historically falling oil pricestranslates into a 2-4 point increase in realized volatility forthe energy sector.

Natural Gas Outlook: US natural gas prices will remainchallenged as growth in supply continues at a staggeringpace from shale assets. For example, in just 4 years theMarcellus region in the North East has grown to be themost productive US shale asset, delivering ~13 billionBcf/day (from virtually zero). Gas demand won’t rescuethe oversupply situation, as power and industrialconsumption remain sluggish. CS expects natural gasprices to remain around $4/MMbtu for most of 2014.There is however some upside to prices longer term asnew export LNG terminals come online.

Despite a relatively muted outlook for underlying energycommodities, the fundamental outlook for energy stocks

is more positive.

Integrated Oil: CS upgraded its view on the majorintegrated oil companies to market weight for 2014. Aftermaking only half of the S&P’s gains in the past five years

(trailing by 60%), CS believes the integrated oil stocks aredue for a period of outperformance and expects the keydrivers to be the following:

Cash Flow: After spending $250b per year (!) oncapex since 2011, the integrateds are approachingthe sweet spot for cash flow growth in 2015-2017.This should pave the way for an increase individends and buybacks.

Restructuring: Should the market not recognize theprogress the integrateds have made, we could seeadditional breakups (e.g. between upstream and

downstream) to unlock shareholder value.Exploration & Production: The US onshore boom fromshale continues and CS remains bullish on the outlook fordomestic E&P. They key drivers of performance for 2014will be:

Valuation Disconnect: There is a disconnectbetween the strong growth outlook for US E&Pcompanies and their inexpensive valuation. Tradingat 5.8x cash flow, the E&P group has the samemultiple as the major oil companies despite highergrowth and return prospects. CS believes E&P

multiples should grow to 8-14x this year dependingon the underlying assets, providing significant upsidefor the group.

Efficiency: Improvements in shale technology meanthat costs keep coming down and IRR rates keeprising. IRR rates for several regions are now through50% with few projects generating less than 15%returns. Improvement in efficiency, especially for oilsensitive assets, could spur additional upside for thegroup.

Exhibit 3: E&P Trade Inline with Majors, Despite Higher Growth


2013 Implied

Vol

2013 Realized

Vol

2014 Implied

Vol

Energy Sector 21.4 14.8 19.1

Exhibit 2: CS Brent Oil Forecast

Source: Credit Suisse Equity Research


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Oil Field Services: The transformation from a traditionalservices industry to a “technology” based group continuesfor the OFS companies. CS expects the stocks of thelargest and most diversified companies to outperform in2014 as increased technical capabilities lead to betterreturn on investment. We anticipate the shift totechnology-rich products will be recognized, pushingstocks higher given that the group trades near historicallylow P/B and P/E valuation multiples.

Trade Recommendation

Implied volatility for the energy sector stands at 19%.With improving company fundamentals (especially forthe integrateds) we expect the sector to realize vollevels similar to 2013 (15%). Further, with risk to oilprices later in the year, we would recommend a longposition in crude oil vol as a pair to our short energy vol

trade. The 1Y implied vol spread between the two isnear a 5-year high (energy vol rich, crude vol cheap)providing both a fundamental and vol opportunity. Fordetails, please see pg 35.

***The risk to selling a variance swap is unlimited. The risk to buying a variance swap is that variance could go to zero.

Utilities – Renewed Trouble?

Long viewed as a low beta sector, Utilities were in factthe 5th most volatile sector in 2013. The increasedvolatility came as a result of cylical headwinds fromhigher interest rates, and structural challenges from thelong awaited cost competitiveness for renewableenergy. We expect the following factors could againmake 2014 a bumpy year for this group:

Interest Rates: Utilities have one of the strongestinverse relationships to US treasury yields. CSexpects rates to rise in 2014, which will provide aheadwind for the group, especially regulatedutilities. With high financial leverage and astructurally challenged operating model, utilitiesare faced with rising costs with minimal changes inrevenue.

Renewable Energy: The long awaited

competitiveness from renewable energy is finallyupon us. While still small vs. traditional powergeneration, improvements in technology havemade solar and wind energy cost competitive.Generally, only natural gas generation is cheapernow than wind and solar. As a result, CSestimates that renewable energy could meet~85% of future utility demand growth. This islikely to hurt the earnings outlook for thecompetitive power generators.

Exhibit: Solar and Wind Are Cost Competitive

Source: CS Equity Research

1.00

1.50

2.00

2.50

3.00

3.50

160

170

180

190

200

210

220

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

N o v - 1 3

D e c - 1 3

U t i l i t y I n d e x

Utility Sector vs. 10-Year Yield


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Financials: Yielding to Regulation

The impact of regulatory reform is now evident for thefinancial sector. Increased capital, along with tighter riskcontrols, are reducing the variability of corporate resultsand creating a system better able to withstand downsideshocks. As we forecasted last year, the financial sector

broke a streak of 6 consecutive years as the most volatilemajor S&P group. We expect this trend to continue, andargue that volatility could approach something closer tothe 2004-2006 lows when the sector ’s vol realized anaverage of 12%.

Exhibit 1: Sector Scoreboard


US Banks. CS remains constructive on the outlook forbanks, although the bullishness is tempered versus last

year following a 38% rally for the group. We view thefollowing factors as drivers of 2014 bank performance:

Capital: Five years post credit-crisis, banks have metBasel I standards and are making progress towardsmeeting stricter Basel III capital requirements. TheFed stress test in March should again provideadditional clarity for the banks and allow them tocontinue returning capital to shareholders.

Revenue: Our tempered bullishness stems from amuted revenue outlook, as banks are facingheadwinds from slowing mortgage refinancing, and

sluggish loan growth.Expense control will again a focus, and should help drive10% EPS growth in 2014. Valuations remain supportive,with the group trading at 10.8x 2014 estimated earningsand 1.4x tangible book value. The key upside surprisecould come from faster than expected economic growth,as bank results are highly levered to loan growth andhigher net-interest margins.

Exhibit 2: Large Cap Banks- Fundamentals Continue to Improve

Source: Credit Suisse estimates. Peer group includes BAC, C, JPM, PNC, USB, WFC.

Brokers/Capital Markets Outlook: The outlook for thebrokers this year is bullish for the following reasons: Banking activity: Banking transactions have

increased and CS forecasts 10% growth in M&Adeals next year. IPO volumes last year were thesecond best post crisis and should stay strong in

2014. Recent performance of M&A deals shouldfuel investor enthusiasm.

Regulations: Key headwinds from enactedregulations (Dodd-Frank, Volcker), as well aslitigation risks (mortgages), are largely in the rearview mirror. This should allow investors to refocus on

improving trading and banking results and reducethe regulatory risk premium. The Fed stress test inMarch is a central driver for the brokers as it couldpave the way for a significant increase in return ofcapital (dividends or buybacks) for shareholders.

Valuations are supportive with the brokers trading at 1.2xtangible book value.

US Insurance. Following a 47% return in 2013, CSbelieves we are in the late innings of the re-rating trade.However we still believe the sector is moderately attractivegiven cheapish valuation and favorable macro conditions.

We see the following as the key drivers for the sector: Rising Yield Play: The insurance sector is positively

levered to rising bond yields as it increases thereturn on the investment portfolio and reduces thepresent value of liabilities.

Non-Bank SIFI Rules: In mid-to-late 2014, clarity onthe new capital rules for non-bank SIFI companieswill begin to emerge. We expect the rules will favorthe P&C group over the Life companies given theyhave lower leverage and less VA exposure.

Exhibit 3: Strong Correlation Between Insurance and Yields

Source: Credit Suisse Equity Research, Thompson Reuters

Trade Idea Recommendation

We recommend a long delta and short vol position forthe Financial sector. 1Y implied vol is currently at 18%,and we expect the sector to realize below 15% thisyear, with a chance of falling below 13%. Note thatdue to new regulations, there are few natural sellers ofFinancial sector vol, providing an edge for those whoare able to execute the trade.

2013 Implied

Vol

2013 Realized

Vol

2014 Implied

Vol

Financial Sector 19.9 14.6 17.7

2012 2013E 2014E

Capital (B1 Tier Comm) 10.6% 11.0% 11.8%

Capital (B3 Tier Comm) 8.7% 9.6% 10.5%

Profitability (ROE) 10.9% 9.7% 10.8%

Credit Quality (NCO) 1.2% 0.7% 0.6%

Valuation (P/E) 14.4 x 11.9 x 10.8 x


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Technology: It’s a Jungle Out There

The Technology sector, along with Consumer Staples,was the lowest volatility sector in 2013. However, we donot expect a repeat of this in 2014. A muted IT spendingoutlook, disruptive technologies, and potential acceleratingM&A are poised to keep a bid to technology sec

2014 Volatility Outlook Final

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