INVESTMENT MANAGEMENT & GUIDANCE

AHMED S. HASNAT, VP, PORTFOLIO STRATEGIES DESK

SULTAN KHAN, AVP, PORTFOLIO STRATEGIES DESK

ANIL SURI, CIO, MULTI-ASSET CLASS MODELED SOLUTIONS

The global economic crisis of 2008 was a humbling and painful experience for many. In its wake, more than ever investors are seeking non-correlated assets that can deliver consistent returns and help protect against downside risks. One such type of asset that is familiar to everyone, but is typically not thought of as an investment, is currencies.

KEY IMPLICATIONSThe foreign exchange (FX) market is the largest and most liquid financial market in the world, playing a critical role in the functioning of the global ecoonomy.

■■ Uses of foreign exchange Governments, corporations, institutions, and individuals are all, directly or indirectly, players in the vast FX market. They utilize currencies for a variety of reasons both mundane and exotic. Four basic uses are:

1. For transactional purposes 2. As a tool for hedging exchange rate

risk 3. As an instrument for speculation 4. As a portfolio asset The focus of this paper is largely on

this last and most recent development in FX thinking, which is opening up opportunities for investors to integrate currencies into their strategic asset allocation framework.

■■ Currency as a portfolio asset Analyzing the performance of currencies, we find that adding FX exposure to a traditional portfolio of stocks and bonds can potentially enhance returns, reduce volatility, and increase portfolio diverfication. Significantly, we find that currencies tend to be most effective in a portfolio during periods of market distress, when other assets are falling in lock-step.

■■ Gaining exposure to currencies Investors, today, can gain exposure to currencies through a growing variety of channels, direct or indirect, passive or active. The most important ways are:

1. Investments in foreign stocks and bonds

2. Currency derivatives 3. Currency baskets and strategic

indexes 5. Structured/market-linked products 6. ETFs/ETNs 7. Actively managed funds (mutual

funds, commodity trading advisors, global macro and currency-specialist hedge funds)

It is difficult to overstate the importance of foreign exchange for the world economy. From the price of gas at the local pump to the cost of a vacation abroad, changes in the foreign exchange (FX) market affect governments, corporations, and individuals on a daily basis. Each day a staggering $4 trillion

in trades take place in currency markets around world; by comparison, U.S. stock trading averages just $135 billion a day, and U.S. bonds about $1 trillion.1

Ironically, the largest financial market in the world is also one of the least understood. In this paper, we attempt to demystify this important market by examining the basics of currency investing and its impact on a traditional portfolio.

EVOLVING ROLES OF FOREIGN EXCHANGEHistorically, currencies have performed two functions critical for society: serve as a unit of account and act as a medium of exchange. And since money assumed different forms in different places, there was always a parallel need for foreign exchange. For millennia, the foreign exchange market has provided a forum for commercial activities between peoples.

Not much changed through the ages until the early 1970s, when the breakdown of the Bretton Woods system of fixed exchange rates gave birth to the modern FX market. For the first time, the price of currencies would be set according to the forces of supply and demand. Exchange rate risk became an inescapable consequence of cross-border commerce and investing. Currency suddenly had two new roles: as a tool for hedging foreign exchange exposure and an instrument for speculation — the most famous example being the $1.2 billion in profits hedge fund manager George Soros netted shorting the British pound in 1992.

1 Bank of International Settlements (BIS), Securities Industry and Financial Markets Association (SIFMA)

JULY 2012

Currencies: A Primer

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This material was prepared by the Investment Management & Guidance Group (IMG) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of IMG only and are subject to change. This information should not be construed as investment advice. It is presented for informational purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation.

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© 2012 Bank of America Corporation. All rights reserved.

Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value

2 W H I T E P A P E R

There is now broad consensus among academics and practitioners alike of yet another role for currencies: as a form of portfolio investment. This new understanding of foreign exchange is based on two well-documented attributes. First, currencies exhibit low correlation to established asset classes; and second, strong evidence that (contrary to economic theory) certain currency strategies can offer sustainable returns over time. The focus of this paper will largely be on this new development in FX thinking, which enables investors to integrate currencies into their strategic asset allocation framework.

THE CURIOUS CASE OF CURRENCY MARKETSThe idea of currencies as a separate asset class was initially controversial because, among other things, the FX market is a zero-sum game. Since currencies are always traded in pairs (e.g., USD/EUR, EUR/JPY, etc.), every long position automatically has an offsetting short position. That meant, unlike the equity or fixed-income markets, the FX market as a whole should not increase/decrease in value as gains in some currencies are offset by losses in others. Technically speaking, the FX market had no beta.2 For a long time, the conventional view was that foreign exchange represented uncompensated risk in a portfolio. Exchange rates might temporarily move in one’s favor, but over the long run the efficiencies of the market ensured that gains and losses would “wash out.”

Yet the track record of active currency strategies shows they are capable of garnering consistent returns over time. If the currency markets offered no systematic returns, the gains would have to be purely the result of managerial skill, or alpha.3 But if the FX market was “efficient” it should not offer such opportunities. What explains the incongruity? For an answer we turn to poker.

Ante up: Segmenting the FX marketConsider a regular game of poker played among friends. Whatever one player wins some other loses, with the winnings and losses summing to zero. In any such group there are usually some players who are more skilled than others, and those players would be expected to win money on average. If profits were the sole purpose of playing, the “rational” behavior would be for the weaker players to quit. However, many people play simply because they enjoy doing so, even when they consistently lose. In such a scenario, the less skilled players are effectively paying a premium for the external benefits of playing (such as entertainment).

Likewise, participants in the FX market also have different objectives, expertise and resources. They can be divided into two broad groups: profit-seekers and liquidity-seekers. The former aim to gain from currency trading, while the latter primarily want to ensure they have access to the FX market to conduct international transactions. Studies confirm that profit-seekers are generally better informed about currency prices than liquidity-seekers. And like the less skilled poker players, liquidity-seekers are willing to pay a currency premium to attract profit-seekers into the FX market. That means, as a group, profit-seekers gain from currency trading, while liquidity-seekers lose. The latter are not overly concerned by such an outcome as they do not necessarily view trades in terms of profit-and-loss and are accomplishing other goals.

Hedge funds, CTAs, sovereign wealth funds, etc. are examples of profit-seekers who devote considerable time and resources to analyzing the “fair value” of currencies. On the other hand, corporations that want to import merchandise or repatriate profits from operations abroad, investors seeking to purchase foreign securities or hedge exchange rate risk, central banks that intervene in the FX

Figure 1: Brief history of currency markets

9000–6000 B.C. 500 B.C. 1800s-1930s Post WWII–1970s 1980s–2000s Present

UNIT OF ACCOUNT and MEDIUM OF EXCHANGE

The concept of money arises. Livestock and grains earliest forms of currency.

Advent of modern coinage in Imzir (modern-day Turkey) that is portable and durable.

Paper currency (“fiat” money) is common. To be fiscally sound, countries back currency with gold reserves. But during the Great Depression, gold standard adds to deflationary pressure, hampering economic recovery.

Post WWII the gold-to-USD rate is fixed, while all other major currencies are pegged to the USD. In 1971 U.S. abandons ties to gold and floats currency, ending system of fixed rates.

Speculative currency trading grows. Evidence of persistent returns among currency traders attributed to manager alpha.

Wide acceptance of currency as a stand-alone asset class, recognition of alpha and beta components to returns.

PORTFOLIO INVESTMENT

PORTFOLIO HEDGING TOOL and SPECULATIVE INSTRUMENT

2 The concept of beta is akin to a “rising tide raising all boats.” It represents the market return.3 Financial theory says returns on any portfolio can be decomposed into these two basic components, alpha (α) and beta (β), and an error term, epsilon (ε), which denotes random

events or “noise” (which may sometimes be positive, sometimes negative). Statistical analyses can help differentiate whether a portfolio’s excess return over the market (beta) is the result of true managerial skill, α, or chance, ε.

W H I T E P A P E R 3

market, and foreign tourists, are examples of liquidity-seekers. Significantly, the presence of these two distinct groups means that a currency beta can, in fact, exist.

Of course, the above description ignores an important component of the FX market: dealer banks that act as intermediaries between the profit-seekers and liquidity-seekers. These are usually large commercial and investment banks that take the other side of transactions initiated by either party. For providing liquidity to the market, they receive a positive “bid-ask” spread.4 (Note, our poker example still holds in this tri-party framework. It is the equivalent of playing poker at a club, where the house “dealer” takes a percentage of the winnings or charges a fixed fee per hand.)

From theory to practice: Are profit-seekers profitable?The idea of a two-tier market of profit-seekers and liquidity-seekers is intuitive, but is it an accurate description of the FX market in practice? Empirical studies using futures data published by the Commodity Futures Trading Commission (CFTC) indeed confirm that one group systematically profits at the expense of the another. The results of one such study by the Reserve Bank of Australia are reproduced in Table 1.

If the structure of the currency markets provide systematic returns to those willing to assume the risks, then one question is what portion of the existing market consists of profit-seekers? Figure 2, below, highlights the relative size of the different segments of the FX market. Notice that not only has the FX market nearly tripled in size over the past decade, but it has undergone significant structural changes as well. Today, profit-seekers, such as hedge funds, are responsible for the majority of FX trading. Their increased presence makes price discovery more efficient. While that’s good news for liquidity-seekers, it also means shrinking premiums for profit-seekers.

Common FX Styles: The hunt for “beta” A feature of any asset class is that a significant portion of their returns can be correlated to a set of distinct investment styles or rules. In the case of equities, for example, research shows that consistent returns are possible by being systematically long small-cap stocks and short large-cap stocks, buying value stocks and shorting growth stocks, and purchasing recent winners and shorting recent losers (momentum). That meant returns that were formerly unexplainable (and considered alpha), could be re-categorized as different forms of stock market beta. The implications of these findings extend beyond just academic interest. For one thing, it allows managers to better understand and control the risks in their equity portfolios. For another, it opens the possibility for investors to gain exposure to returns less expensively through standardized products.

4 The bid-ask spread is difference between the price at which a dealer is willing to buy, and the price at which he is willing to sell a currency pair. Note, that in addition to their role as market makers, dealings banks have traditionally run separate proprietary trading desks that take directional bets on currency movements using the bank’s own capital. These activities have generally been small compared to the client business and have shrunk further in light of new legislation that limits proprietary trading by banks, such as the Volcker Rule.

Table 1: Average weekly profits by trader type 1993-2003 (in US$ millions)*

Non-commercial/profit-seekers

Commercial hedgers/ liquidity-seekers

Gross Profit Net Profit** Gross Profit

Australian Dollar 0.45 0.41 -0.72

British Pound 0.05 -0.21 -0.58

Canadian dollar 0.62 0.46 -0.63

Euro (1999-2004) 4.97 4.51 -7.71

German mark (pre-1999) 3.63 2.93 -5.71

Japanese yen 5.42 4.65 -8.62

Swiss franc 1.85 1.43 -3.52

Total 12.72 10.44 -20.84

Source: Kearns, J. and Manners, P. (2004). The Profitability of Speculators in Currency Futures Markets. Reserve Bank of Australia. *The CFTC data only report the positions of large speculators and hedgers (holding more than 400 contracts). These large traders account for about 70% of the total value of positions in the currency futures markets considered in the study. The remaining contracts fall into a residual category so that total profits sum to zero.**Assumes transaction costs of 0.03%.

1998 2010

Banks Investment Funds Corporates and Central Banks

10%0%

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

100%

$1,000

$1,500

$300$1,900

$300 $500

Figure 2: Daily turnover in the FX market by source (in $billions)

Source: Bank of International Settlements (BIS), 2010

4 W H I T E P A P E R

Structure of the FX marketThe currency “market” that we commonly refer to is really a decentralized network of large banks around the world operating 24 hours a day, five days a week.

The vast majority of FX trading is done over-the-counter (OTC), where every trade is a private transaction between the dealing bank and client, akin to the interaction between a bank teller and a customer standing at the counter. The closed nature of the arrangement means that, unlike in the equity markets, there is no certainty that the quote received for a particular currency pair is the best available. Traders may contact multiple dealers to establish best price. The mechanics of currency trading are illustrated in Chart 1, below.

A small amount of FX trading also takes place on public exchanges, such as the Chicago Board of Exchange (CBOE), involving standardized currency futures and currency swaps.

Key FX trading instrumentsOTC products can be tailored according to the buyer’s needs by amount, maturity, and currency. The trade-off is that with greater customization comes correspondingly less liquidity and higher transaction costs for contracts. Three types of currency instruments commonly utilized in OTC transactions are spot, forwards, and FX swaps (see Chart 2).

A spot transaction is the most straightforward, and simply involves exchanging one currency for another at the prevailing exchange rate (similar to a tourist changing money at the local bank). Spot transactions usually settle in one to three business days.

A forward transaction is an agreement between two parties to exchange one currency for another at a fixed rate at some date in the future.

An FX swap combines a spot transaction with the benefits of a forward contract. One currency is swapped for another (usually a spot transaction) and swapped back (via a forward contract) to the original currency at a future date.

The most common exchange-traded FX instruments are futures and currency swaps. Futures are simply standardized versions of forwards. Currency swaps are

contracts that involve the exchange of principal and interest in one currency for another.

In addition, there is a thriving FX options market in both the OTC inter-bank market and on futures exchanges. Options provide investors with an efficient way of gaining exposure to currencies. Exchange-trade options are based on futures prices and have standardized strike rates, contract size, and maturities; which are all negotiable in the case of OTC options, which use the spot currency as the underlying asset.

Most popular currenciesWhile there are more than 170 currencies, ten currencies are responsible for more than 90% of the total daily FX turnover. These include the U.S. dollar (USD), euro (EUR), Japanese yen, British pound (GBP), Swiss franc (CHF), Australian dollar (AUD), Canadian dollar (CAD), Swedish krona (SEK), Norwegian krone (NOK), and the New Zealand dollar (NZD).

The USD is by far the most popular currency. The size of the U.S. economy, its deep financial markets, and reputation for stability ensure its prominence in the FX market. Over half of all international debt securities and more than 60% of the foreign reserves of central banks are denominated in USD.5

Moreover, a majority of FX transactions involve the U.S. dollar on one side because it is usually cheaper for parties to make payments indirectly through the USD than directly through thinly traded currencies. For example, exchanging Malaysian ringgits (MYR) for Brazilian reals (BRL), in practice, actually involves two separate trades: one from MYR to USD and another from USD to BRL. The USD is the vehicle currency in the exchange. Dominance by one currency has long been a feature of the international monetary system, because of the increased efficiencies and network externatilities involved. Prior to World War II, for example, the pound sterling was the world’s premier currency, and before that, it was the Dutch gilder.

Factors impacting currency marketsThe two most important factors influencing currency prices are interest rates and inflation. Countries with higher interest tend to attract investors, increasing

demand for the local currency and causing it to rise in value. Conversely, lower interest rates decrease demand and depress value.

Inflation reduces the purchasing power of a currency and makes it less valuable. Currencies of countries where inflation is high, generally underperform those of countries where it is low. Other short– to long-term variables that impact currency markets include: Gross Domestic Product (GDP) growth, unemployment rate, consumer confidence, balance of trade (level of exports relative to imports), and geopolitical events. In many ways investment in foreign exchange is an investment in the relative growth of a country or region.

In addition to the above fundamental factors, day-to-day FX activity is also affected by traders reacting to technical indicators that utilize past prices and trading volumes to predict where currencies will be in the near future. Commonly followed technical signals include: support and resistance support levels, moving average crossovers, head-and-shoulder formations, etc. Tellingly, more than 90% of FX traders report using some form of technical analysis to make trading decisions.6

The rise of machines: the future of the FX market Technological advances, such as electronic trading platforms, are transforming FX markets by reducing transaction costs, increasing market liquidity, and transparency, and encouraging the adoption of new strategies, such as algorithmic trading, where computers execute trades based on complex mathematical rules at very high frequencies (often on the order of hundreds or even thousands of trades per second). The Bank of International Settlements (BIS) estimates that algorithmic trading was responsible for 45% of the total FX turnover in 2010, up from just 2% in 2004. That figure is only expected to grow in the future.

Box 1: The nuts and bolts of the FX market

₤1,000,000

$1,499,500

Fund manager believes the pound is overvalued.Shorts GBP.

Replaces GBP inventory @$1.4996

Hedges GBP exposureby selling to Bank 1@$1.4996Buys GBP @$1.4995

Hedge Fund

Sells GBP @1.5000 to ABC Co.

Network of FX dealers

$1,500,000

�₤1,000,000

ABC requires pounds to import goods from U.K.

ABC Co.

Bank 2

Bank 1

$1,499,600 �₤1,

000,

000

$590$820

$1,190$1,527

$1,239

$1,934

$3,324

$3,980

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

1989 1992 1995 1998 2001 2007 2010

in B

illio

ns

Spottransactions

Outrightforwards

Foreign exchangeswaps

Other

2004

Chart 1: Illustration of typical FX market transactions Chart 2: Daily turnover in the FX markets by instrument

Source: Merril Lynch Investment and Guidance (IMG) Source: BIS

5 Eichengreen, B. (2011, March 1). Why the dollar’s reign is near an end. The Wall Street Journal

6 Osler, C. (2000). Support for Resistance: Technical Analysis and Intraday Exchange Rates. FRBNY Review

W H I T E P A P E R 5

If foreign exchange is indeed an asset class, we can expect currency returns to be similarly amenable to a fixed set of rules (that is to say, we should be able to identify currency betas). Binny (2005), Pojarliev and Levich (2007), and Hafeez (2007), among others, have identified several styles that help explain a significant portion of the variability in the returns of currency managers. They include value, carry, trend, and volatility.

Value forecasting involves using fundamental inputs, such as inflation, interest rates, productivity growth, etc., to take positions in currencies that deviate from their fair value in the expectation that they will revert back toward their long-run equilibrium price. Traders sell the overvalued currency and buy the undervalued one. The concept of purchasing power parity (PPP) often serves as a useful benchmark for determining “value” (see Box 2 for a more detailed explanation).

The risk in this type of strategy is that currency pairs may stay misaligned for long periods of time or even deviate further before reverting to their mean. In some cases, the change may even be permanent. Research shows that value forecasting tends to work best when misalignments are extreme (such as during periods of hyperinflation), and is progressively less effective when deviations are smaller.

Possibly the best known currency strategy is the carry trade. It is essentially a search for yield. Traders buy high-interest rate currencies and sell low-interest ones, earning the interest rate differential between them. A great example was the AUD/JPY trade in the mid-2000s, when the commodity-rich Australian economy was booming on the back of surging global demand for natural resources. Short-term interest rates in Australia stood at 4.75%. By contrast, interest rates in Japan, still recovering from its “lost decade,” were at 0%. Currency traders took

Purchasing power parity (PPP) and interest rate parity (IRP) are two fundamental concepts in exchange rate theory.

Purchasing Power ParityBased on the law of one price, PPP holds that in competitive markets identical goods should have the same price when valued in the same currency (otherwise the opportunity for arbitrage or risk-free returns would exist). Empirical tests of PPP often employ hundreds of consumer items in an effort to produce a “market basket” that is consistent across countries. But the concept can be illustrated more easily.

The Economist magazine’s Big Mac Index is a light-hearted but instructive application of PPP. The index compares the price of McDonald’s famous burger around the world with its average U.S. price to arrive at valuations for currencies. The Big Mac is an effective proxy for an identical basket of goods because it is available in 120 countries and its composition is generally the same everywhere. For instance, in January 2012, the price of a Big Mac was $4.20 in the U.S. and £2.48 in the U.K. The implied PPP based on these prices is 1.69 (4.20/2.48). Since the actual exchange rate of 1.54 USD/GBP was lower than the implied PPP, it suggested that the GBP was undervalued. According to theory, the currency should appreciate until it reaches the implied PPP.

We can make similar comparisons for other currencies. The chart at right suggests the Swiss franc is overvalued against the U.S. dollar, while the Chinese renminbi is undervalued. Specifically, the index estimates that, in dollar terms, a Big Mac costs $6.81, or 60% more in Switzerland and just $2.44, or 40% less in China. Under PPP, we would expect the franc to depreciate and renminbi to appreciate

against the USD until the price of a Big Mac is the same as in the U.S.

Interest Rate ParityIRP states that expected returns on deposits in currency A must be equal to the expected returns on deposits of the same maturity in currency B when measured in the same currency (otherwise the opportunity for arbitrage would exist). For example, if interest rates on 1-year euro deposits are 5% and at the same time 1-year U.S. dollar deposits pay 2%, we can expect the dollar to appreciate 3% against the euro in one year. In such a scenario investors would be indifferent to holding either currency (5% total returns in both cases).

On the other hand, if the expected U.S. dollar appreciation was only 2%, then investors could borrow in dollars, convert the loan to euros at the spot rate, and invest the proceeds in higher-yielding 1-year euro deposits. They could negate the exchange rate risk and lock in the 1% profit risk-free by simultaneously selling a forward contract.

Gap between theory and practiceWhile theoretically sound, as an empirical matter PPP and IRP

have not been effective predictors of exchange rate movements. Studies indicate PPP works best when deviations are at extremes (e.g., in hyper-inflation environments) and is progressively less effective over smaller misalignments. Violations of uncovered interest rate parity are equally well documented. In fact, the carry trade, described above, is possible precisely because in many cases higher-yielding currencies actually appreciate against lower-yielding ones. So not only can investors profit from the interest rate differential between the two currencies, but they can also capture capital gains from currency appreciation.

Even so, the PPP and IRP remain powerful and intuitive tools for understanding the FX market and is a good starting point of any currency analyses. So the next time you’re in Paris, London, or Dubai, step into a McDonald’s for lunch and to get a handle on the FX market.

Box 2: The Big Mac Guide to the FX Market

Price in $

-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 70%

BrazilSwitzerland

South Africa

AustraliaCanada

U.S.JapanBritainTurkey

MexicoEgypt

RussiaIndonesia

China

6.81

5.68

4.94

(3.82)

(3.54)

(2.70)

(2.57)

(2.55)

(2.46)

(2.45)

(2.44)

4.73

0.00

(4.16)

Chart 3: Local currency over/under valuation against the USD, %*

Source: The Economist (http://bigmacindex.org/2012-big-mac-index.html) *Exchange rates as of January 12, 2012.

6 W H I T E P A P E R

advantage of the difference in interest rates by going long the AUD and shorting the JPY (the net interest earned or “carry” would be added to the trader’s account at end of each day the position was held).7

The carry trade is a medium- to long-term investment and works best in low volatility environments. That’s because traders are not only looking to buy currency pairs that offer a positive carry but, equally, are seeking pairs where that relationship is likely to hold or even improve. In the AUD/JPY case, interest rates in Australia climbed to 7% between 2003 and 2008, while essentially staying the same in Japan. That growing difference in interest rates led to a substantial appreciation of the AUD against the JPY and significant capital gains for carry traders. However, the trade broke down rapidly with the onset of the financial crisis in late 2008, with the currency pair giving up five years of gains in a matter of months, as shown in Figure 3.

Most currency managers employ some form of trend-following or momentum strategy. Currencies often exhibit trending behavior (i.e., display serial correlation) that suggests past prices can be informative of future movements. Rather than forecast where currencies are headed, trend-following managers seek to “ride” existing trends until they reverse.8 Managers often employ technical indicators to detect trends. One basic technique is the simple moving average (SMA). Applying a 50-day SMA to the USD/JPY pair in Figure 4, an investor would buy the pair anytime the exchange rate crossed its 50-day moving average from below and sell it whenever price crossed the same from above.

Trends can endure over a wide range of time periods, appearing and disappearing in less than a day to lasting for months. Furthermore, not all currency pairs trend (e.g., USD/CAD,USD/AUD, and EUR/CHF), and others may do so only over certain periods. A key deficiency of trend-following models is that they are (by necessity) backward-looking and work on the assumption that the near future will be similar to the recent past, potentially exposing managers to sharp market corrections and false trading signals that add to costs.

Finally, volatility-based strategies are non-directional strategies that seek to profit regardless of the direction currencies take. Just as traders utilize derivatives to take advantage of the equity market’s implied volatility, traders make use of equivalent measures in the FX market. One counterpart to the well-known VIX index is Deutsche Bank’s CVIX, which tracks the expected future volatility in currency markets, and can be used to take directional views on FX fluctuations. Volatility strategies typically

7 Conceptually, all that is happening is that a trader borrows yen from a Japanese institution, converts the loan into Australian dollars (AUD), and invests in higher yielding Australian government securities. Once the investment matures the investor converts the proceeds back into Yen to pay back the original loan.

8 For a general discussion on the why trends exists in financial markets contrary to theory, see the whitepaper Hedge Fund Strategies: A Managed Futures Primer (2011) from Merrill Lynch Global Wealth Management

AUD/

JPY

Exch

ange

Rat

e

5045

60

70

80

90

100

110

55

65

75

85

95

105

Rush to unwindthe carry

Capital Gain: $23,500Interest income: $25,208Total Pro�t*: $48,708

Sell AUD/JPY

Buy AUD/JPY

Jan-01 Jan-03 Jan-05Jan-04Jan-02 Jan-07Jan-06 Jan-09Jan-08

Figure 3: Illustrative example of an AUD/JPY trade

* Calculations are based on the purchase of 1 standard lot of AUD/JPY with notional of 100,000 units. We assume no leverage was used.

Source: Bloomberg, IMG

USD/

JPY

74

78

82

86

76

80

84

Buysignals(green)

SELL signals (red)

USD/JPY 50-day MA

Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12

Figure 4: Example of an SMA trend-following strategy*

* Simple moving-average. Source: Bloomberg, IMG

VIX

Inde

x

VIX Index CVIX Index

Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-110

10

20

30

40

50

60

70

80

90

579

111315

17

19

21

23

25

DB C

VIX

Inde

x

Figure 5: Volatility in the FX market

Source: Bloomberg, IMG

W H I T E P A P E R 7

involve implementing an options straddle that entails selling call or put options and collecting the premium when managers expect currency movements to stay within a narrow range or involves buying calls and puts to profit from large swings in volatility.

HOW DO THE FX STRATEGIES PERFORM?In a decade marked by the bursting of two asset bubbles and increased volatility, the currency strategies described above performed rather well. We used four Barclays investable FX indexes — the Barclays Intelligent Carry, Barclays Adaptive FX Trend, Barclays FX Value, and Barclays Tactical SBeta — as respective proxies for these styles, and examined their performance over the twelve year-period from 2000-2011.9 Table 2 displays the results of our analyses. The “FX composite” in the table is simply an equal–weighted average of these four strategies.

The first statistic that stands out is that currencies clearly outperformed equities in our sample period, which included both historic bull and bear markets. Moreover, the discrepancy in performance between foreign exchange and stocks was higher during bear markets. Second, we see that foreign exchange, as measured by the composite, has lower volatility than equities, giving rise to substantially stronger risk-adjusted returns.

Looking deeper, we find that within currencies, the volatility-based FX strategies performed best posting

annual returns of 9.5% with a standard deviation of 6.1% and maximum drawdown of 6.4% over the twelve years covered. Next best were trend-following strategies with 6.1% returns and 5.4% annualized volatility. Interestingly, the popular carry strategy performed on par with the volatility strategy until 2008. Its subsequent unraveling and weaker performance is not all surprising given that the carry-trade strategy works best in non-volatile markets. Trend-following strategies, by comparison, do well in markets with clear direction — up or down, but suffer in “choppy” or sideways markets.

THE ROLE OF CURRENCIES IN A PORTFOLIOWhile the potential for enhanced returns is certainly an attractive proposition for investors, ultimately the most important contribution of currencies may be their ability to reduce portfolio volatility and drawdown.

Harry Markowitz’s (1952) mean-variance framework is a good starting point for any discussion of portfolio allocation. The key lesson of Markowitz’s seminal work was that within a portfolio it is not essential what the risks of the individual assets are, but rather what is crucial is the extent to which the returns of those assets are correlated with one another.

In that regard currencies can be particularly effective portfolio diversifiers. From Table 3, we can clearly see that currencies exhibit extremely low or even negative correlation to most other asset classes.

9 Full definitions of these strategies are available in the glossary at the end of this report.

Table 2: FX Strategy Performance (2000–2011)

Source: Bloomberg, IMG. Carry, Trend, Value, and Volatility indexes represented by Barclays Intelligent Carry USD, Barclays Adaptive FX Trend TR, Barclays FX Value Convergence, and Barclays Tactical SBeta Indexes, respectively. *FX Composite based on the equal-weighted average of the four strategies described above.Past performance is no guarantee of future results.

Carry Trend Value Volatility FXComposite*

U.S.Equities

Annual Returns 6.9% 6.1% 3.7% 9.5% 6.7% 1.0%

Volatility 6.1% 5.4% 5.9% 6.1% 3.3% 16.3%

Sharpe Ratio 0.77 0.71 0.27 1.15 1.28 0.01

Max Drawdown -19.7% -6.2% -16.4% -6.4% -3.9% -50.9%

Kurtosis 0.39 0.30 6.34 2.40 0.48 0.69

Skew -0.29 0.03 1.13 0.47 -0.18 -0.45

Returns (Volatility)

2000-2003 14.8% 12.1% 10.5% 14.0% 13.0% -4.2%

(6.0%) (5.7%) (4.9%) (7.8%) (3.3%) (17.9%)

2004-2007 8.9% 3.9% 2.4% 9.7% 6.3% 9.2%

(5.9%) (5.1%) (5.4%) (4.0%) (2.9%) (7.6%)

2008-2011 -2.1% 2.7% -1.1% 5.1% 1.2% -1.6%

(5.5%) (5.1%) (6.8%) (5.9%) (3.1%) (20.6%)

Currencies U.S. Bonds

U.S.Credit

U.S. Equity

U.S. High Yield

Commodities Cash

Currencies 1.00

U.S. Bonds -0.06 1.00

U.S. Credit -0.05 0.87 1.00

U.S. Equity -0.04 -0.08 0.19 1.00

U.S. High Yield -0.07 0.15 0.51 0.65 1.00

Commodities 0.05 -0.01 0.13 0.30 0.28 1.00

Cash 0.25 0.07 -0.03 -0.06 -0.15 0.02 1.00

Table 3: FX correlations with major asset classes (2000-2011)

Source: Bloomberg, IMG. Currencies, US Bonds, US Credit, US Equity, US High Yield, Commodities, and Cash are represented by the FX Composite calculated in Table 2, BarCap US Aggregate Bond Index, BarCap US Aggregate Credit Index, S&P 500 Index, BarCap US Corporate High Yield Index, SP Goldman Sachs Commodities Index, and Citigroup 3 Month Treasury Bill Index, respectively.Past performance is no guarantee of future results.

8 W H I T E P A P E R

Yet, readers who remember the global panic of 2008 may be skeptical of the value of average correlations.10 If the true test of an asset’s independence is how they relate to other assets in turbulent markets, currencies pass. As Figure 6 highlights, even traditionally uncorrelated assets such as commodities and high-yield debt can begin to move in lockstep with traditional assets in volatile markets. By comparison, correlation between currencies and the S&P 500 turns more negative the greater the stress on the financial markets. It is not surprising then that currencies have easily outperformed both stocks and bonds during bearish periods in both the equity and fixed-income markets, as shown in Figure 7.

No less important for diverfication purposes is the fact that currency strategies themselves display low correlations not

just with other assets, but also with each other. We found that the average pair-wise correlation of the four currency strategies was just 0.10 from 2000 through 2011.

An oasis of liquidityAnother characteristic of currencies that should be very appealing to investors is the liquidity of the FX market. During the last credit crisis, many financial markets experienced significant disruptions and spikes in volatility. While bid-ask spreads on major currency pairs did rise, much of the FX market functioned relatively smoothly during the crisis. In fact, according to the Bank of International Settlements (BIS), many investors turned to the FX market to hedge risks in other asset classes with limited market liquidity. For instance, investors reportedly attempted to hedge losses in U.S. equities by purchasing the Japanese yen (which was gaining as the carry trade was being unwound). Unlike in other financial markets, where participants may choose to sit on the sidelines during periods of high uncertainty, staple players of the FX market such as corporations, governments, tourists, etc., (liquidity-seekers) do not enjoy the same luxury. The FX market essentially has “captive” participants, whose presence allows investors to realize gains even in the most difficult circumstances.

Quantifying the portfolio impact of currenciesTo demonstrate how foreign exchange can affect the risk and returns of a conventional portfolio, we examined the performance of a portfolio of U.S. stocks and bonds with different allocations to currencies from 2000 through 2011. This particular period includes both historic bull and bear markets and is helpful in highlighting the impact of currencies over different segments over the market cycle.

12 M

onth

Rol

ling

Corre

latio

ns

Global CreditCrisis

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

-1.00

-0.80-0.60

-0.40-0.20

0.000.200.400.60

0.80

1.00

CurrenciesGlobal HY (USD) Global Equities

Commodities

Figure 6: 12-month rolling correlations of the S&P 500 with other assets (2001-2011)

Source: Bloomberg, IMG. Currencies, commodities, global equities, and global high yield represented by the FX composite as defined on page 7, SP Goldman Sachs Commodity Index, MSCI AC World Index xUS, and BofA ML Global High Yield USD Index, respectively. Past performance is no guarantee of future results.

Bottom 20% Bottom 5%Bottom 10%

Monthly U.S Stock Returns

FX Composite S&P 500

-10%

-12%

-8%

-6%

-4%

-2%

0%

2%

4%

Aver

age

Mon

thly

Ret

urns

Figure 7: Performance during the worst U.S. stock and bond periods (2000–2011)

Source: Bloomberg, IMG. Past performance is no guarantee of future results.

Bottom 20% Bottom 5%Bottom 10%

Monthly U.S Bond Returns

FX Composite BarCap

-2%

-2%

-1%

-1%

0%

1%

Aver

age

Mon

thly

Ret

urns

10 We are reminded of the cautionary tale of the statistician who drowned while crossing a river that was on average just three feet deep.

W H I T E P A P E R 9

For our analysis we used an equal-weighted composite of the four common FX styles described previously.

From Table 4, we can see that adding foreign exchange enhanced returns and reduced portfolio volatility in all cases. In addition, risk-adjusted returns rise progressively higher with higher allocations to currencies. For example, in the case of a $1 million portfolio, a 20% allocation to currencies at the beginning of 2000 would have increased total portfolio returns by approximately $125,000 by the end of 2011.

For a more robust and forward-looking outlook on the effects of incorporating currencies into a traditional portfolio, we ran a 10-year Monte Carlo wealth simulation (utilizing 10,000 iterations). The resulting probability distributions confirm our previous empirical analysis. Assuming the same $1 million initial investment, the median terminal value for a traditional portfolio was $1,464,000 for a portfolio with 10% FX allocation and $1,408,000 for a 60:40 portfolio of stocks and bonds. Moreover, the simulations provide us with better insight into the ability of currencies to mitigate “fat-tail” events or the risk of large-scale losses. For this purpose, we use Conditional Value at Risk (“CVaR”) as our measure of risk, calculated by averaging the worst 1% of losses from our 10,000 scenarios.11 We find that a 10% allocation to foreign exchange can help reduce significant downside risk by 9%.

Our results suggest that there is potentially ample scope for investors to improve their portfolio’s risk-return profile by introducing a small amount of foreign exchange.

GAIN EXPOSURE TO CURRENCIESOur analyses confirm many academic findings that currencies can be an effective diversifying agent. The question then is, how do investors actually allocate to foreign exchange? In years past, there were few direct options. Foreign exchange was the domain of institutional investors, where currency pairs were traded in lots whose minimum investment size was prohibitive to all but the biggest investors. Fortunately, an important transformation in the FX market in recent years has been its increased accessibility. Technological innovation and product development now provide investors with a variety of channels into foreign exchange.

Here, we list the basic ways investors can take on currency exposure. A common but indirect way is through the purchase of foreign securities. The returns on any foreign stock or bond have two components that can be viewed as “assets” within a portfolio: performance of the asset itself and the change in exchange rate relative to the home currency. How important is latter? Historically, FX volatility has contributed more than 35% of the total volatility of an international equity portfolio and more than 70% of the volatility of an international bond portfolio.12

To hedge or not to hedge?To complicate matters, individual currencies can have diverse and often complex relationships with local and international financial markets. Certain currencies, such as the U.S. dollar or Canadian dollar, are generally negatively correlated with both local and global equity markets. Others, such as the euro and yen, on the other hand tend to be positively correlated (see Table 5). In general, when correlations between these two components are negative (positive), foreign investors realize a lower (higher) volatility compared to their local counterparts in the same security.

11 Additionally, CVaR overcomes a key drawback of standard deviation by capturing only downside risk and investors’ asymmetric aversion to losses.12 State Street Global Advisors industry estimates, 2009

Table 4: Benefits of adding FX to a traditional 60:40 portfolio

Source: Bloomberg, IMG

Traditional Portfolio

10% FX Allocation

15% FX Allocation

20% FX Allocation

U.S. Bonds 40% 36% 34% 32%

U.S. Large Cap Equities 60% 54% 51% 48%

Currencies 0% 10% 15% 20%

Annualized Return 3.5% 3.9% 4.0% 4.2%

Annualized Volatility 2.8% 2.5% 2.4% 2.2%

Max Drawdown -33% -29% -28% -26%

Return/unit of Volatility 1.27 1.55 1.71 1.89

Table 5: Correlations of major currency pairs with world equity markets

Source: Bloomberg, IMG

Dollar Index Euro Japanese

YenBritish Pound

Swiss Franc

Canadian Dollar

Australian Dollar

S&P 500 -0.19 0.17 0.21 0.18 -0.05 -0.48 0.53

Euro Stoxx 50 Price -0.11 0.07 0.25 0.13 0.08 -0.43 0.44

Nikkei 225 -0.15 0.11 0.23 0.20 -0.01 -0.38 0.47

FTSE 100 -0.14 0.11 0.25 0.11 0.04 -0.46 0.49

Swiss Market Index -0.05 0.00 0.27 0.11 0.16 -0.32 0.39

S&P/TSX Composite -0.23 0.20 0.16 0.23 -0.09 -0.47 0.54

S&P/ASX 200 -0.21 0.17 0.19 0.24 -0.05 -0.42 0.48

MSCI ACWI -0.36 0.32 0.15 0.33 -0.15 -0.59 0.65

1 0 W H I T E P A P E R

Naturally, the decision to hedge FX risk will depend on the particular investor’s base currency. For example, over the last 35 years U.S. residents investing abroad could have reaped on average an additional 2% per year from the secular decline in the dollar, as measured by the trade-weighted U.S. dollar index. (Of course, within this larger decline, there have been significant bullish trends in the U.S. dollar that have hurt domestic investors, most recently during the 2007-2009 global credit crisis).

Currency overlay techniques attempt to manage such risks by hedging exposure when foreign currencies are expected to weaken and by allowing exposure to work in their favor when foreign currencies are expected to strength relative to the home currency. Conveniently, such returns are easily “portable,” allowing investors to add a currency overlay to almost any type of portfolio.

Growing array of foreign exchange productsMore directly, investors may choose to gain FX exposure through individual trading accounts, exchange-traded funds, and a growing array structured products, and investible indexes.

In the last decade, technological advances have spawned numerous online FX trading platforms geared toward individual investors, who are now the fastest growing segment of the FX market. Daily retail trading volume

jumped to $313 billion in 2010 from just $300 million in 2000. Today, customers can trade over 50 different currency pairs with minimum account balances as low as a few dollars.13 Furthermore, investors have the option of trading not just individual currencies but also a basket of currencies through various FX indexes. Currency baskets diversify FX exposure across multiple currencies through a single investment, and allow investors to more efficiently express broad macroeconomic views.

There are also synthetic products that attempt to replicate common FX styles such as the investible carry, value, and momentum indexes using a combination of cash and derivatives. The advantage of these rules-based currency products is that they offer a cost-effective way to access forms of currency returns that were not previously available except through expensive and often illiquid, actively managed investment vehicles. To be sure, they can prove very profitable in certain environments, but also very expensive in others (as in our AUD/JPY example).

For investors with more specific needs, structured products can offer defined rates of return linked to the performance of designated currency pairs or baskets. Typically, these products have a fixed maturity and are comprised of a fixed-income component and a derivative component. Currency-linked products can also feature varying degrees of capital protection that allow investors to participate in

13 Bernard, L. S. (2011, July 9). Is Currency Trading Worth the Risk? The Wall Street Journal.

Table 6: Comparing different vehicles to access currencies

Source: IMG

Mgmt Style Potential Benefits Potential Drawbacks

Foreign stocks Passive LiquidityDividends

Exposure to equity market risk Stock-specific risk exposure

Foreign bonds Passive LiquidityIncome

Interest-rate riskCredit risk of issuer

FX indexes (currency baskets)

Passive Efficiently express macro views on multiple countries or an entire regionSimultaneous hedging of multiple currencies through options

No alpha generationInterest-rate risk

FX structured products Passive CustomizableAccessible to most investorsMay offer some principal protection

No alpha generationCapped upside gainsInterest-rate risk

ETFs/ ETNs Passive LiquidityAccessible to most investors

No alpha generationETNs subject to credit risk

Currency derivatives Active LiquidityLeverage (up to 100:1)

Not accessible to all investors

Commodity Trading Advisors (CTAs)

Active Potential for alphaTransparent

Not a pure play on currencies as mandate extends beyond FXPoor liquidity and not accessible to all investors

Global macro funds Active Potential for alphaAble to utilize wide array of instruments to execute trades

Mandate extends beyond FXIlliquid and not accessible to all investorsTax inefficientManager selection critical

Currency-specialist hedge funds

Active Deep expertise in currenciesAble to utilize wide array of instruments to execute trades

Less fund diversificationIlliquid and not accessible to all investorsTax inefficientManager selecion critical

W H I T E P A P E R 1 1

some of the upside potential of a currency basket, while helping to preserve capital in difficult periods.

But, by far, the most popular way to invest directly in currencies in recent years has been through currency-based exchange traded funds (ETFs). These vehicles trade like equities and are designed to capture exchange rate fluctuations. Depending on the investor’s objective, ETFs can provide exposure to either a single currency or a basket of currencies, with or without significant leverage. Exchange-traded currency notes, or ETNs, are similar in function to ETFs except they are actually debt notes that carry the credit risks of the issuer and are taxed less favorably.

“Alpha hunters” over “beta grazers?”If investors want additional returns unrelated to the beta strategies discussed earlier, they should consider actively managed currency funds. Active currency managers seek to capture currency market alpha through investment flexibility and effective risk management. Whereas beta is representative of returns available from general trends in the market, alpha is a reflection of an individual manager’s skills (commonly measured as the returns in excess of a benchmark). A currency manager can earn alpha through a variety of ways, including:

■■ Opportunistically choosing which currency pairs to trade and which currency strategies to employ

■■ Adeptly weighting those positions in a portfolio

■■ Selecting the most efficient financial instruments to establish positions and execute trades

■■ Timing when to enter and exit trades

■■ Competently managing portfolio risks, including the use of leverage

Active currency managers can include mutual funds, hedge funds, and commodity-trading advisors (CTAs). However, they come at a cost. Hedge funds and CTAs, for example, generally charge fees of 2% of assets under management and 20% of profits, are generally not very liquid, and often require large investment minimums.14 Moreover, there can be large discrepancies in the performance of the managers themselves, highlighting the importance of identifying the “right” managers.

SOME RISKS TO CONSIDERWhile foreign exchange can offer significant portfolio benefits, readers should understand that investing in currencies also involves considerable risk and may not be

suitiable for all investors. Given the size of the FX market and the propensity for small daily changes in exchange rates, exposure to currencies often involves significant use of leverage to make trades sufficiently profitable — anywhere between 50-100x the initial investment. While leverage can significantly enhance returns when currency pairs behave as anticipated, it can also have far more damaging effects if a trade turns sour.

Investors also need to be aware of certain nuances of the FX market. Unlike in other markets, government intervention in the FX market is not an uncommon occurrence. Central banks will from time to time intervene in the open market to effect change in the price of their currency to implement certain economic objectives. Such interventions can have immediate and considerable impact on the FX markets.

Besides exogenous factors like government intervention, the FX market is also prone to herding effects. As FX trading is often limited to a handful of currency pairs, it can lead to investors pursuing similar trades, that can become very crowded — e.g., the AUD/JPY carry. When fundamentals warrant a small change in the price of the currencies, a wave of selling may occur as investors seek to unwind the trade ahead of others (and is usually exacerbated by the use of leverage).

CONCLUSIONThe foreign exchange market is the largest and most liquid financial market in the world. It is also one of the most poorly understood and underexploited markets. While the role of currencies has traditionally been limited to hedging FX risks and speculation, there is now a growing consensus that currencies can also make good portfolio investments.

A large body of evidence suggests that the heterogeneity of the FX market gives rise to inefficiencies that can be systematically exploited. Data from the last twelve years show currencies handily outperforming equities both nominally and on a risk-adjusted basis. While returns are important, possibly the greater appeal of currencies is their ability to reduce portfolio volatility and limit drawdown. Currencies exhibit low correlation to traditional assets throughout the market cycle, even during periods of extreme market stress.

For these reasons, we believe that understanding the dynamics of the FX market and making informed allocations to currencies can help investors better navigate difficult markets.

14 Many hedge funds offer investors, at best, only quarterly redemptions, may require investors to lock up their investments for 1-2 years, and have minimum investments of $100,000 or more.

1 2 W H I T E P A P E R

REFERENCESBernard, L. S. (2011, July 9). Is Currency Trading Worth the Risk? The Wall Street Journal.

Binny, J. (2005). Currency Management Style through the Ages. The Journal of Alternative Investments, Vol. 8 (3), 52-59.

Currency Management in a Volatile World (2012). State Street Vision Series.

Eichengreen, B. (2011, March 1). Why the dollar’s reign is near an end. The Wall Street Journal.

Hafeez, B. (2007). Currency Markets: Money Left on the Table? Deutsche Bank.

Hafeez, B. (2007). Currency Indices in a Portfolio Context. Deutsche Bank.

Harris, L. (1993). The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity. Institute for Quantitative Research in Finance Spring 1993 Seminar. Wesley Chapel, FL.

King, M. R., Osler C. & Rime, D. (2011). Foreign exchange market structure, players and evolution. Norges Bank.

King, M. R. & Dagfinn, R. (2010, December). The $4 trillion question: what explains FX growth since the 2007 survey? BIS Quarterly Review, 27-42.

Markowitz, H. (1952). Portfolio Selection. Journal of Finance, Vol. 7 (1), 77-91.

Nadig, D. , Hougan, M. & Crigger, L. (2009). Currencies: The Overlooked Asset Class. Journal of Indexes, 10-18.

Nasypbek, S. & Rehman, S. S. (2011). Explaining the returns of active currency managers. BIS Papers No. 58. http://www.bis.org/publ/bppdf/bispap58j.pdf

Osler, C. (2008). Foreign Exchange Microstructure. Encyclopedia of Complexity and System Science.

Osler, C. (2000). Support for Resistance: Technical Analysis and Intraday Exchange Rates. Federal Reserve Bank of New York Review, Vol. 6 (2), 53-68.

Pakko, M. R. & Pollard, P. S. (2003). Bugernomics: A Big MacTM Guide to Purchasing Power Parity. The Federal Reserve Bank of St. Louis Review.

Pojarliev, M. and Levich, R. (2007). Do Professional Currency Managers Beat the Benchmark? NBER Working Papers 13714, National Bureau of Economic Research, Inc. http://www.nber.org/papers/w13714.pdf

This document was prepared by GWIM Investment Management & Guidance (IMG) and is not a publication of BofA – Merrill Lynch Global Research. Global Wealth & Investment Management (“GWIM”), a division of Bank of America Corporation, includes the GWIM Investment Management & Guidance (“GWIM IMG”), which provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. The views expressed are those of GWIM IMG only and are subject to change. This document is neither reviewed nor approved by BofA – Merrill Lynch Global Research. The views and opinions expressed may differ from those of BofA – Merrill Lynch Global Research or other departments or divisions of Bank of America and its affiliates. Investors are urged to consult their financial advisor(s)/private wealth manager(s) before buying or selling any securities. This information may not be current and GWIM IMG has no obligation to provide any updates or changes.

This document is being provided for educational and informational purposes only. Nothing herein is or should be construed as investment, legal or tax advice, a recommendation of any kind, a solicitation of clients, or an offer to sell or a solicitation of an offer to invest in alternative investments. An investment in an alternative investment may be offered only pursuant to a fund’s offering documents. Certain information herein has been obtained from third-party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy, completeness or timeliness of this document.

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IMPORTANT DISCLOSURE INFORMATION

Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

Some or all alternative investment programs may not be suitable for certain investors. No assurance can be given that any alternative investment’s investment objectives will be achieved. Many alternative investment products are sold pursuant to exemptions from regulation and, for example, may not be subject to the same regulatory requirements as mutual funds. In addition to certain general risks identified below which are not exclusive, each product will be subject to its own specific risks, including strategy and market risk. Certain alternative investments require tax reports on Schedule K-1 to be prepared and filed. As a result, investors will likely be required to obtain extensions for filing federal, state, and local income tax returns each year.

Currency Note: The currency market affords investors a substantial degree of leverage, which provides the potential for substantial profits or losses. Such transactions entail a high degree of risk and are not suitable for all investors. Currency fluctuations may also affect the value of an investment.

Commodities: There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investing in commodities or the securities of companies operating in the commodities market involves a high degree of risk, including leveraging strategies and other speculative investment practices that may increase the risk of investment loss, including the principal value invested. Investments may be highly illiquid and subject to high fees and expenses.

Derivatives: Derivative instruments may at times be illiquid, subject to wide swings in prices, difficult to value accurately and subject to default by the issuer. The risk of loss in trading derivatives, including swaps, OTC contracts, and futures and forwards, can be substantial. There is no guarantee that this objective will be achieved. The use of hedging strategies may, in certain circumstances, cause the value of a portfolio to appreciate or depreciate at a greater rate than if such techniques were not used, which in turn result in significant loss.

Diversification: Diversification does not ensure a profit or protect against loss in declining markets.

Hedge Funds: Hedge funds are speculative and involve a high degree of risk. An investor could lose all or a substantial amount of his or her investment. There is no secondary market nor is one expected to develop for investments in hedge funds and there may be restrictions on transferring fund investments. Hedge funds may be leveraged and performance may be volatile. Hedge funds have high fees and expenses that reduce returns. The characteristics discussed in this paper are typical attributes, as hedge funds and traditional funds vary. Other key characteristics such as fees, minimum investments and liquidity should also be carefully considered. A hedge fund generally uses more aggressive strategies than a traditional fund and entails a higher level or risk.

Managed Futures: Managed futures funds are speculative, involve a high degree of risk and are subject to substantial fees and expenses, which may offset trading profits. There can be no assurance that any managed futures fund will achieve its objectives or avoid substantial or total losses. Since underlying positions held in managed futures funds may fluctuate widely in value, individual funds can be highly volatile. Managed futures funds may also make significant use of leverage, adding to the volatility of a fund’s performance. Man-aged futures funds may trade on unregulated markets lacking the regulatory protection of exchanges. Single-manager funds lack diversification and thus may involve higher risk. Since many managed futures funds employ trend-following strategies, periods without clear trends in the market will typically be highly unfavorable to these funds. Managed futures funds are subject to large drawdowns. The minimum margin requirements for various futures markets may subject investors to significant leverage. While margin-to equity levels are closely managed to historic volatility ranges by the funds, investors should note that they are investing in securities on a leveraged basis. Be sure to read the entire Confidential Program Disclosure Document as defined, which contains information concerning risk factors, conflicts, performance information and other material aspects.

W H I T E P A P E R 1 3

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INDEX DEFINITIONS

Indexes are unmanaged and their returns do not include sales charges or fees, which would lower performance. It is not possible to invest directly in an index. They are included here for illustrative purposes. Performance represented by a hedge fund index is subject to a variety of material distortions, and investments in individual hedge funds involve material risks that are not typically reflected by an index, including the “risk of ruin.” The indexes referred to herein do not reflect the performance of any account or fund managed by Merrill Lynch or its affiliates, or of any other specific fund or account, are unmanaged and do not reflect the deduction of any management or performance fees or expenses. One cannot invest directly in an index.

Barclays Aggregate Bond Index: The Barclays Aggregate Bond Index comprises of government securities, mortgage-backed securities, asset-backed securities, and corporate securities to simulate the universe of bonds in the market. The maturity of the bonds in the index is over one year.

Barclays FX Value Convergence Index: The index takes long and short positions in G10 currencies. The underlying portfolio rebalances on a monthly basis, taking long positions in currencies that appear undervalued against their PPP level, and short positions in overvalued currencies.

Barclays Capital Adaptive FX Trend Index: The index takes long and short positions in G10 currencies based on the direction of trend and individual currency pair volatility. The index is rebalanced daily and has a target volatility of 5%.

Barclays Capital Tactical SBetaVol Index: The index uses a systematic ranking model to determine the weights of each of the forward volatility agreements in the index. The ranking model generates buy or sell signals based on the expected return of each asset taking trading costs into account.

Barclays Capital Intelligent Carry Index: The index seeks to capture returns from the “carry trade” among the G10 currencies through interest rate differentials and forward bias. The index is mean variance optimized, rebalanced monthly and constrained to a target volatility of 5%.

Barclays Currency Traders Index: An equal-weighted index of managed programs that trade currency futures and/or cash forwards in the inter bank market. As of 2012, there are currently 108 managers included in the index.

Barclays US Corporate High Yield Total Return Index: The Barclays US Corporate High Yield TR Index is comprised of fixed-rate, publicly issued, non-investment grade debt.

BofA ML Global High Yield USD Index: The index tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the major domestic or eurobond markets.

Deutsche Bank Currency Volatility Index (CVIX) is the Deutsche Bank Currency Volatility Index. Similarly to the Chicago Board Options Exchange Volatility Index (VIX), which measures the implied volatility of equity markets (based on the S&P 500), CVIX measures the implied volatility of currency markets. Thus, it is a measure of the market’s expectation of future currency volatility and can be used as a benchmark of risk appetite. In order to give a broad representation of expected future volatility in currency markets, CVIX is calculated based on a the 3m implied volatilities of 9 major currency pairs. The currency pairs and their weights are listed below: EURUSD 35.90% USDJPY 21.79% GBPUSD 17.95% USDCHF 5.13% USDCAD 5.13% AUDUSD 6.14% EURJPY 3.85% EURGBP 2.56% EURCHF 1.28% CVIX contracts trade as futures.

MSCI AC World Index: The index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. It consists of 45 country indexes comprising of 24 developed and 21 emerging market country indexes.

S&P 500 Index: The S&P 500 Total Return Index is a market-weighted index that measures the total return, including price and dividends, of 500 leading companies in leading industries of the U.S. economy. This index is often used as a reference for the performance of the U.S. equities market.

S&P Goldman Sachs Commodity Index (GSCI): The Goldman Sachs Commodity Index is composed of futures contracts on 24 physical commodities. It reflects the return on fully collateralized future positions. The index is calculated primarily on a world production-weighted basis and is comprised of the principal physical commodities that are the subject of active, liquid futures markets.

The indexes referred to in the paper do not reflect the performance of any account or any specific fund, and do not reflect the deduction of any management or performance fees, or expenses. One cannot invest directly in an index. The indexes shown are provided for illustrative purposes only. They do no represent benchmarks or proxies for the return of any particular investable product. The alternative universe from which the components of the indexes are selected is based on funds that have continued to report results for a minimum period of time. This prerequisite for fund selection interjects a significant element of “survivor bias” into the reported levels of the indexes, as generally, only successful funds will continue to report for the required period, so that the funds from which the statistical analysis or the performance of the indexes to date is derived necessarily tend to have been successful. There can, however, be no assurance that such funds will continue to be successful in the future.

Merrill Lynch assumes no responsibility for any of the foregoing performance information, which has been provided by the index sponsor. Neither Merrill Lynch nor the index sponsor can verify the validity or accuracy of the self-reported returns of the managers used to calculate the index returns. Merrill Lynch does not guarantee the accuracy of the index returns and does not recommend any investment or other decision based on the results presented.

1 4 W H I T E P A P E R

TECHNICAL TERMS

Alpha: The difference in return above or below the return of a target index.

Beta: A measure of the sensitivity of the returns of the fund to the comparative index. For example, a Beta of 2.0 would indicate that for every 1% move up in the comparative index, the fund moved up 2% on average.

Bull Market: A condition marked by increased confidence and optimism in the market as reflected in the rising prices of securities. Many consider a 20% or more rise in prices in multiple broad market indexes a bull market.

Correlation: Measures the extent of linear association of two variables. It quantifies the extent to which the fund and a comparative index move together.

Efficient Frontier: The “efficient frontier” tracks the relationship of rate of return and performance volatility (as measured by standard deviation). While performance volatility is one widely accepted indicator of risk in traditional investment strategies, in the case of alternative investment strategies, performance volatility is an indicator of only one dimension of the risk to which these actively managed, skill-based strategies are subject. There is a “risk of ruin” in these strategies, which has historically had a material effect on long-term performance but which is not reflected in performance volatility. From time to time, extremely low volatility alternative investments have incurred sudden and material losses. Consequently, any comparison of the efficient frontiers of traditional and alternative investments is inherently limited. In addition, any comparison of actively managed strategies and passive securities indexes is itself subject to inherent material limitations, as is the selection of what index should be used as representative of alternative investment strategies.

Tail risk (fat-tail): Defined as scenarios in which an asset or portfolio moves more than three standard deviations from its current price.

Futures: A contract obligating the buyer to buy an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts are standardized contracts that trade over an exchange.

Kurtosis: A statistical concept that describes the shape, more specifically the “peakedness,” of a probability distribution.

Max Drawdown: A term used to describe a peak to trough decline during a specific time period.

Monte Carlo Simulations are the result of running a large number of random scenarios in an attempt to determine the most probable performance results of a given portfolio. These simulations may be based not only on past performance information, which is not indicative of future results, but they may also be based on hypothetical performance for certain periods and for certain underlying funds or accounts. Monte Carlo simulations do not purport to represent the actual performance of any account, but attempt to indicate the most repeated hypothetical performance results of a large number of different hypothetical accounts. No actual account has performed in the manner indicated in the Monte Carlo simulations, and the hypothetical scenarios used in the simulation may omit entire categories of relevant scenarios. There can be no assurance that any given account will in fact perform in a manner materially consistent with the probabilities indicated by the simulation. No representation is or could be made that the probabilities indicated by these simulations are based on any fundamental economic or market characteristics, and in the absence of such characteristics, there is no reason that these probabilities will be representative of any actual account.

Sharpe Ratios and Standard Deviation of returns are commonly used measures of the risk-reward profile of traditional portfolios and broad market indexes. However, these statistics may materially understate the true risk profile of a fund because hedge funds are subject to a “risk of ruin” which may not be reflected in the standard deviation of returns. The markets in which hedge funds trade, the liquidity characteristics of the traded securities, the risks of leverage, the use of derivative securities with nonlinear risk sensitivities, the use of nonrepresentative historical data for estimating standard deviation, manager error, bad judgment and/or misconduct create the possibility of sudden, dramatic, and unexpected losses — losses that may not be adequately reflected in Sharpe ratios or standard deviations. Prospective investors must recognize this risk of ruin, which is a material risk involved in investing in any alternative investment, and which may not be adequately reflected in such performance statistics as the Sharpe ratio.

Short: The sale of a borrowed security with the expectation that the security will fall in value and the borrower will be able to purchase the security at a lower price.

Straddle: An options strategy in which the investor holds both a call and a put with the same strike price and expiration date anticipating volatility in the underlying security.

VIX (Chicago Board Options Exchange Volatility Index): An index that measures 30-day expected volatility of the market (S&P 500 Index). The VIX is a commonly used measure of market risk.

Recent Publications from Investment Management & Guidance

July 2012 Non Traditional Mutual Funds Sussman

July 2012 Hedge Fund Due Diligence Kosoff

June 2012 Commercial Real Estate Bowden/ Smith

Spring 2012 What Behavioral Finance Has to Say About Generations X, Y and Z Liersch

Spring 2012 Innovations in Behavioral Finance: How to Assess Your Investment Personality Liersch/Suri

Spring 2012 Dynamic Asset Allocation Suri/Almadi/Maclean

W H I T E P A P E R

Lisa Shalett, GWIM CIO and Head of Investment Management & Guidance

lisa.shalett@ml.com • 212-449-0544

THE CIO TEAM

Spencer Boggess, CIO, Alternative Investments212-449-3043

Tom Latta, Global Head, Traditional Manager Due Diligence201-557-0258

Anil Suri, CIO, Multi-Asset Class Modeled Solutions212-449-3385

Chris Wolfe, CIO, PBIG and Ultra-High Net Worth Customized Solutions212-236-3159

Jim Russell, CIO, Portfolio Construction and Multi-Manager Solutions201-557-0079

Rick Galiardo, Global Head, Advice, Guidance and Research Strategy212-449-3348

Bill O’Neill, CIO, EMEA44-20-79955745

Victoria Ip, Chief Investment Strategist, Asia-Pacific Rim852-3508-5305

IMPORTANT DISCL0SURE INFORMATIONThis piece was prepared by the GWM Investment Management & Guidance (“IMG”). The views expressed are those of IMG. This is not a publication of BoA-Merrill Lynch Global Research. In addition, these views are subject to change. This material contains forward-looking statements about plans and expectations for the future. These statements may be identified by the use of words such as “may,” “will,” “expect,” “anticipate,” “estimate,” “believe,” and “continue”. These statements are based on current plans and expectations. There is always the risk that actual events may differ materially from those anticipated and that the forward-looking views may not come to pass. This document is current as of the date noted, is solely for informational purposes and does not purport to address the financial objectives, situation or specific needs of any individual reader. Market information provided herein was generally prepared by sources unrelated to Merrill Lynch. Such information is believed to be reasonably accurate and current for the purposes of the illustrations provided but neither Merrill Lynch nor any of its affiliates has independently verified this information. Opinions and estimates expressed herein are as of the date of the report and are subject to change without notice. Neither the information nor any opinion expressed represents a solicitation for the purchase or sale of any security.

Any statements regarding market events, future events or other similar statements constitute only subjective views, are based upon expectations or beliefs, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond Merrill Lynch’s control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these statements. In light of these risks and uncertainties, there can be no assurance that these statements are not or will not prove to be accurate or complete in any way.

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The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This document does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

Alternative investments are intended for qualified and suitable investors only. Alternative Investments such as derivatives, hedge funds, private equity funds, and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk. Alternative Investments are speculative and involve a high degree of risk.

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice.

There may be conflicts of interest relating to the alternative investment and its service providers, including Bank of America, and its affiliates, who are engaged in businesses and have clear interests other than that of managing, distributing and otherwise providing services to the alternative investment. These activities and interests include potential multiple advisory, transactional and financial and other interests in securities and instruments that may purchase or sell such securities and instruments. These are considerations of which investors in the alternative investments should be aware. Additional information relating to these conflicts is set forth in the offering materials for the alternative investment.

Investors should bear in mind that the global financial markets are subject to periods of extraordinary disruption and distress. During the financial crisis of 2008-2009, many private investment funds incurred significant or even total losses, suspended redemptions or otherwise severely restricted investor liquidity, including increasing the notice period required for redemptions, instituting gates on the percentage of fund interests that could be redeemed in any given period and creating side-pockets and special purpose vehicles to hold illiquid securities as they are liquidated. Other funds may take similar steps in the future to prevent forced liquidation of their portfolios into a distressed market. In addition, investment funds implementing alternative investment strategies are subject to the risk of ruin and may become illiquid under a variety of circumstances, irrespective of general market conditions.

Economic and market forecasts presented herein reflect our judgment as of the date of this document and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, based on assumptions, and are subject to significant revision and may change materially as economic and marketing.

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