Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.

Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2LEHMAN to request a copy of this research.

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PLEASE SEE ANALYST(S) CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 5.

Index Volatility Commentary

• The end of summer saw yet another lackluster week for equity volatility, with the last two weeks being the quietest this year.

• Last week, the cheapening of front month implied vols was led by smallcaps, which is not surprising in light of their 2.2% outperformance over largecaps.

• The last 3 weeks have seen signs of another smallcap rally after their middle of August troughs, accompanied by a rally in higher beta industry groups within the S&P 500.

• However, the smallcap vol compression is at odds with the bid for higher quality assets in credit markets.

• Lehman’s Global Equity strategists have highlighted that largecap valuations look extremely cheap relative to smallcaps. A bullish long-term stance on largecaps combined with the cheapening in smallcap vols should increase the marginal propensity to use puts on smallcap indices as a means of portfolio protection.

September 5, 2006

Ryan Renicker, CFA 1.212.526.9425

ryan.renicker@lehman.com

Devapriya Mallick 1.212.526.5429

dmallik@lehman.com

Equity Derivatives Strategy | Index Volatility Commentary

September 5, 2006 2

Largecaps vs Smallcaps - A Closer Look

The end of summer saw yet another lackluster week for equity volatility, with the last two weeks being the quietest this year for broad market indices. Wednesday and Thursday saw trading in an extremely tight range (Thursday’s high-low range was the smallest for the year) as investors held back ahead of Friday’s employment report, and a non-farm payrolls number in line with consensus was not a significant catalyst at the end of the week.

Consistent with the gamma evaporation, front month vols have cheapened and term structures have steepened, a trend led initially by largecaps. Last week, the cheapening was led by small cap vols and IWM1 1-month implied vol finished more than 1% lower while 1-month implied vols for OEX2 were almost flat (Figure 1).

This is not surprising considering the 2.2% outperformance of the IWM relative to the OEX. A closer look at regression expectations using weekly returns vs changes in 1-month implied vol since 20033 reveals that last week’s drop in the IWM-OEX ATM implied vol spread is in line with the historical drop following similar smallcap rallies relative to largecaps (Figure 2).

Figure 1: Smallcap Vols Cheapened Relative to Largecap…

Figure 2: … As Expected Given Last Week’s Outperformance

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Weekly 1m Implied Vol Change (OEX)Weekly 1m Implied Vol Change (IWM)

y = -0.4284x + 0.0015R2 = 0.2719

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Relative 1Wk Return (IWM vs OEX)

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EX V

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Source: Lehman Brothers, OptionMetrics Source: Lehman Brothers, OptionMetrics

2006 has been a year when getting the largecap vs smallcap call correct has been more important than the average year. Since the selloff in October 2005, the RTY outperformed the OEX by almost 15% over a 6-month period. Almost all of this outperformance was reversed over the subsequent 3 months (Figure 3).

The last 3 weeks have seen signs of another reversal, with the smallcap rally being accompanied by greater demand for other riskier assets. This can be seen by the outperformance of higher beta industry groups within the S&P 500 over the same period (Figure 4).

1 We consider IWM implied volatility as a proxy for the RTY because of greater option liquidity. 2 Using OEX returns and implied vols permits us to isolate the behavior of the larger cap names within the S&P 500. 3 Note that while the regression between vol spreads and relative returns of two indices is not as strong as that between weekly returns and weekly vol changes for a single index, it still results in a reasonable fit.

Equity Derivatives Strategy | Index Volatility Commentary

September 5, 2006 3

Figure 3: Signs of the Oct-May Smallcap Rally…

Figure 4: …Consistent With Recent Bid For Higher Beta Sectors…

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OEX

RTY

Reversed almost all of it by mid Aug

Smallcaps outperformed by about 15% till early May

GICS Industry Group

Beta vs SPX (04-

05)

Return (3Jan - 5May)

Return ( 5May - 11Aug)

Return (11Aug-

1Sep)S&P 500 Industry Groups With Lowest Betas (2004-2005)Food, Beverage & Tobacco 0.66 3.5% 5.2% 3.3%Household & Personal Products 0.71 -1.5% 4.6% 2.9%Utilities 0.77 -0.1% 5.3% 2.4%Food & Staples Retailing 0.80 2.6% -0.6% 2.7%Pharmaceuticals & Biotechnology 0.82 -0.7% 3.0% 4.2%S&P 500 Industry Groups With Highest Betas (2004-2005)Semiconductors & Semiconductor Equipment 1.50 -3.7% -18.3% 11.3%Technology Hardware & Equipment 1.27 9.2% -15.9% 10.7%Automobiles & Components 1.25 2.0% 5.5% 4.2%Materials 1.22 11.9% -11.3% 4.6%Retailing 1.21 5.3% -11.4% 2.3%

Source: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg

However, the small cap vol compression relative to large cap vols is at odds with the bid on higher quality assets in credit markets. Figure 5 plots the spread between the Lehman US Credit Index OAS and the Lehman Corporate High Yield OAS, against the 3-month implied vol spread between the IWM and the OEX. Historically, these two spreads have not been very strongly correlated but they have moved together during the flight to quality over the last few months. The recent break-down of the relationship could be a sign of equity markets pricing in a more conducive investment regime for riskier assets than credit markets.

Lehman’s Global Equity strategists have highlighted that largecap valuations based on median forward P/Es are currently at extremely cheap levels relative to smallcaps4 (Figure 6). While such a valuation premium for smallcaps can persist for several years (as in the early 90s), a bullish long-term stance on largecaps combined with the cheapening in smallcap vols should increase the marginal propensity to use puts on smallcap indices as a means of portfolio protection.

Figure 5: … But At Odds With Continued Flight to Quality in Credit

Figure 6: Valuation Argument Remains Compelling for Largecaps

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)Lehman HY OAS - Lehman US Credit OASIWM-OEX Imp Vol Spread (3m)

Spreads highly correlated during period of anxiety

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Median Fw d PE(Largecap vs Smallcap)

Source: Lehman Brothers, OptionMetrics Source: Lehman Brothers Equity Strategy

4 Please see Large-Cap Outperformance, Global Strategy Weekly, August 14, 2006.

Equity Derivatives Strategy | Index Volatility Commentary

September 5, 2006 4

Figure 7: Macro Volatility Summary

S&P 500 Put-Call Skew

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ETF Rich/Cheap Analysis

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Implied Volatility History (NDX, RTY)

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NDX Implied Vol (3-month)RTY Implied Vol (3-month)

Note: For each ETF, we calculate the number of standard deviations by which the current 3-month implied-realized volatility spread differs from its 1-year average. We repeat the calculation for the ETF implied vs S&P 500 3-month implied volatility.

Note: The 20-delta skew is calculated as the difference between the 20-delta put and 20-delta call implied volatililty. Weekly changes of implied volatility at the 90% and 110% strike versus the at-the-money strike are a measure of richening/cheapening of skew.

Source: Lehman Brothers, OptionMetrics, Bloomberg, FAME

Equity Derivatives Strategy | Index Volatility Commentary

September 5, 2006 5

Analyst Certification: I, Ryan Renicker, hereby certify (1) that the views expressed in this research email accurately reflect my personal views about any or all of the subject securities or issuers referred to in this email and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this email. To the extent that any of the conclusions are based on a quantitative model, Lehman Brothers hereby certifies (1) that the views expressed in this research email accurately reflect the firm's quantitative research model (2) no part of the firm's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Disclosures Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this email communication.

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