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Index Volatility Commentary

• Equity markets traded in an extremely tight range last week and 1-month realized vol remains extremely low across indices, at under 8% for the SPX and about 16% for the NDX.

• This was helped by last week being the lightest week of the year in terms of both cash and derivatives volumes.

• The term structure of large cap vols remains steep with the sell-off in near-dated implied volatility.

• Weak housing data brought the spotlight back on homebuilders last week. This group has become more sensitive to shifts in market sentiment around monetary policy, and has realized more volatility than almost any other sub-industry in the S&P 500.

• The recent pullback in implied volatility provides an opportunity to purchase cheap protection in the space, ahead of expected future volatility.

August 29, 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

August 29, 2006 2

All Quiet on the Equities Front

Equity markets traded in an extremely tight range last week, with the S&P 500 closing in an average absolute range of approximately 3 points. 1-month realized vol remains extremely low across indices, at under 8% for the SPX and about 16% for the NDX.

This has been helped by the lack of activity in markets with investors on vacation. Excluding July 3:

• In terms of equity volumes on the NYSE, the last 6 trading days are among the 7 lightest days for the year so far.

• Last week, average single stock option volume (for constituents of the S&P 500) was lower than in any other week of 2006.

Short-dated implied vols have been under pressure and term structures have steepened, especially for largecaps. Yet investors who bought front month options after the cheapening would not have managed to compensate for their decay and our long gamma position from two weeks back has taken a fair amount of pain.

We recommend holding on to the position as sufficient catalysts remain for higher realized vol once market activity picks up after the holiday season. The relentless beating down of large cap vols also means that October and December vols still look extremely cheap. 37% of S&P 500 companies (by weight) are scheduled to report earnings before the October expiration yet SPX ATM Oct implieds trade around 11%. The December expiration covers an entire earnings cycle and 3 FOMC decisions, and these are trading at under 12%. Either expiration looks attractive on a hedged basis or as a means of obtaining downside protection in a market trading at the higher end of its range since May.

Figure 1: Lightest Week of the Year For Cash and Derivatives…

Figure 2: … Kept Implied and Realized Vols Subdued

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

Homebuilders – More Uncertainty Ahead

The housing market was in the spotlight again last week, with both Existing Home Sales and New Home Sales recording month on month decreases of over 4%. This was the largest simultaneous drop in both indices this year and provided further confirmation of a housing slowdown.

Macro indicators paint a gloomy picture for homebuilders. Monthly sales are off 10-20% from their peaks and unsold homes’ inventory is increasing as home prices begin to flatten (Figure 3).

Equity Derivatives Strategy | Index Volatility Commentary

August 29, 2006 3

In a data-dependent environment, shares of homebuilders have been more sensitive to shifts in market sentiment around monetary policy, as seen by the increasing betas relative to the S&P 500 (Figure 4).

Figure 3: A Gloomy Macro Picture for Homebuilders1…

Figure 4: … And Higher Betas2 in a More Rate-Sensitive Market

Indicator Last Value

Month of Peak/Trough

% off Peak/Trough

% Change YoY

Existing Home Sales Total 6.33 Jun-05 -12.9% -11.2%Existing Home Sales Months Supply 7.3 Jan-05 97.3% 58.7%Existing Home Sales Median Price 230 N/A N/A 0.9%Pending Home Sales 113.9 Aug-05 -11.2% -9.4%New Home Sales 1072 Jul-05 -21.6% -21.6%New Home Sales Months Supply 6.5 Aug-03 85.7% 54.8%New Home Sales Median Price 230 Apr-06 -10.5% 0.3%Housing Starts 1795 Jan-06 -20.8% -13.3%Homebuyer Affordability Index 103.7 Feb-03 -27.6% -7.8%Total Residential Construction Spending 650,785 Dec-05 -3.5% -0.6%Private Residential Construction Spending 641,602 Dec-05 -3.6% -0.8%30-year Mortgage Rate 6.38 N/A N/A N/AMBA Purchase Index 382.2 Jun-05 -27.8% -18.8%OFHEO House Price Index 393.78 N/A N/A 8.6%

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Not surprisingly, short term realized volatility for homebuilders has been among the highest across sub-industries in the S&P 500 (Figure 5). With valuations for the group still some distance from reaching a floor, we expect names in the space to remain volatile with short-term risks to the downside.

Historically, homebuilders have been particularly sensitive to Fed actions. Since 1989, the group has outperformed the S&P 500 by an average of 26% (not annualized) during easing cycles and underperformed by about 26% during tightening cycles (Figure 6). While implied vols for the group have risen alongside the selloff, the recent pullback provides an opportunity to purchase protection. Continued uncertainty around any remaining hikes in the current cycle and speculation around any subsequent eases should keep vols bid in this space.

Figure 5: … Makes Them the Second Most Volatile Sub-Industry

Figure 6: Homebuilders Historically Sensitive to Monetary Policy

S&P 500 GICS Sub-IndustryRealized

Volatility (22-day)

Realized Volatility (66-

day)Photographic Products 58.5% 41.9%Homebuilding 38.8% 38.3%Home Entertainment Software 37.2% 32.9%Tires & Rubber 37.2% 31.5%Wireless Telecommunication Services 36.7% 26.5%Electronic Equipment Manufacturers 34.6% 33.4%Oil & Gas Drilling 33.7% 37.6%Steel 33.5% 46.5%Specialized Consumer Services 33.5% 23.1%Internet Retail 33.4% 58.5%

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

1 We consider troughs for no of months’ supply of new and existing homes. For other indicators, we consider the peak. 2 We caveat that betas calculated using daily returns over a 1-month time frame are not as stable as those using a longer history. Yet they provide a better picture of recent changes in sensitivity to market returns.

Equity Derivatives Strategy | Index Volatility Commentary

August 29, 2006 4

Figure 7: Macro Volatility Summary

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ETF Rich/Cheap Analysis

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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

August 29, 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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