EQUITY RESEARCH Equity Linked Strategies | U.S.

Derivatives Strategy | July 26, 2010

INDEX VOLATILITY WEEKLY

Correlation, Correlation everywhere, but
not a drop to sell…
Maneesh Deshpande
Volatility View: VIX Grinds Lower +1 212 526 2953
maneesh.deshpande@barcap.com
„ VIX continues to trend lower and is now trading at its cheapest since the first week
BCI, New York
of May 2010. VIX has historically been the best predictor of where shorter dated VIX
futures settle. There is enough macro uncertainty to keep a floor on how low Rohit Bhatia
implied volatility can go and we find buying VIX Sep10 22.5-20 1x2 put spreads for +1 212 526 0367
~$0.25 an attractive trade. rohit.bhatia@barcap.com
BCI, New York
„ XLB (VolCenter Link) is trading cheap relative to its realized volatility and SPX and
appears to be the most attractive volatility buy amongst sector ETFs, in our view.

„ Gold (VolCenter Link) is trading with cheap volatility and rich skew and investors
who believe there will be renewed bearish sentiments regarding Europe sovereign Link to US VolCenter
debt can buy GLD OTM calls Vol Center is a premier Equity Derivatives
application providing Market Data, Analytics,
„ GDX (VolCenter Link) is trading cheap relative to GLD and SPX implied volatility and Market Insight and Research
GDX options are a good buy to take a delta view or volatility view in the case of
hedged options.

Correlation, Correlation everywhere, but not a drop to sell…

„ Equity correlation is close or higher than its high levels scaled during the credit
crisis. This has profound implications even for non-derivatives investors in that it
indicates that stock-picking skills are less useful in the current environment.

„ While much of the variation in equity correlation is driven by equity volatility, from a
long term perspective it appears to have had a secular increase in value.

„ Since 2005, equity correlation has had a close relationship with the increased ETF
volumes relative to the volumes in the underlying stocks.

„ Option implied correlation, which has traditionally traded at a premium to realized,

is currently trading at a discount which would indicate that the option market is
loathe to believe that the current high correlation is likely to persist. However, the
fact that long dated implied correlation is also equally high and almost equal to its
short dated version appears to provide a conflicting signal.

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

Investors should consider this report as only a single factor in making their investment decision.

PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 11

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

VOLATILITY VIEW

VIX Grinds Lower

VIX continues to trend lower and is now trading at its cheapest since the first week of May
2010. In our previous Index Volatility Weekly, we had commented about how the current
steep upward sloping term structure of VIX futures (Figure 1) makes selling VXX and buying
VXZ an attractive trade. On a similar theme, VIX has historically been the best predictor of
where shorter dated VIX futures settle, which makes buying VIX puts an attractive trade in
such environments. VIX option implied volatility has moderated from triple digit levels in
May but is still trading close to 80%. While VIX has shown some sharp downside moves
over the past month, we feel VIX will struggle to go too much below the 20 handle at least
over the next few months. There is enough macro uncertainty to keep a floor on how low
implied volatility can go and we find buying VIX Sep10 22.5-20 1x2 put spreads an
attractive trade. The spread costs ~$0.25 and the trade makes money if VIX settles in the
range 22.25-17.75 as of Sep 15, 2010.

Figure 1:VIX Futures term structure remains steep

34

32

30

28

26

24

22
VIX Aug10 Sep10 Oct10 Nov10 Dec10 Jan11 Feb11 Mar11
VIX Futures
Source: Barclays Capital, OptionMetrics, Bloomberg

Basic Materials appears to be the Cheapest Sector to Buy Volatility

Implied volatility spiked much more than the corresponding realized volatility in May, and
for most of May and June 2010, implied volatility for most indices and ETFs was trading at a
premium to realized volatility. With the moderation in implied volatility, the situation has
changed, and many sector implied volatilities are now trading at a discount to their realized
volatility. Energy and Health care are the only two sectors where 3-month implied volatility
is at a premium to realized volatility, which is not surprising considering the continuing
catalysts for these sectors.

In our view, comparison of sector implied volatilities with SPX implied volatility can give a
better idea of the relative cheapness of sector implied volatilities in the current environment.
As shown in Figure 2, XLB implied volatility looks cheap relative to both its trailing realized
volatility and SPX implied volatility. In Figure 3 we show the spread of XLB 3-month implied
volatility relative to SPX implied volatility going back a few years. As we can see, the
spreading is trading close to the lowest it has ever traded.

July 26, 2010 2

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

Investors looking for long volatility exposure can buy XLB straddles. With XLB skew trading
the richest amongst sectors (relative to their history), XLB Sep10 27-30 put spread for $0.45
is a cheap hedge to protect against a pullback in equity markets.

Figure 2: XLB Implied volatility appears cheap relative to its Figure 3: XLB – SPX 3-Month implied volatility spread has
realized volatility as well as SPX implied volatility cheapened recently

3M Implied
Skew 3M Implied vs 21%
3 Month 1 Month 3 Month vs SPX
percentile AdjRealized
Ticker Implied Realized Realized Spread : 19%
(2Y Spread :
Vol Vol Vol Percentile
history) Percentile 2Y 17%
2Y
15%
SPX 23% 24% 27% 92% 4% 50%
XLB 29% 32% 34% 99% 1% 6% 13%
XLE 27% 26% 33% 92% 8% 1% 11%
XLF 31% 33% 36% 85% 16% 16%
XLI 27% 29% 33% 84% 1% 55%
9%
XLK 24% 26% 27% 93% 2% 59% 7%
XLP 17% 16% 18% 87% 1% 70% 5%
XLU 20% 19% 22% 92% 1% 37%
XLV 21% 15% 19% 86% 12% 85% 3%
XLY 27% 30% 31% 88% 1% 27% Jan-08 Jun-08 Dec-08 Jun-09 Nov-09 May-10
XLB - SPX 3 Month Implied Volatility

Source: Barclays Capital, OptionMetrics Source: Barclays Capital, OptionMetrics

Volatility Trades in the Gold Space

Gold has continued to be negatively correlated to movements in EURO and has lost 6% over
the past month as Euro rebounded from trading below1.2 to almost touch 1.3. Gold skew 1
has been richening for a while now and currently trades at its richest ever since the launch
of options on GLD (Figure 4). GLD implied volatility is trading in line with its realized
volatility, while historically it has traded at a significant premium to its realized volatility
(Figure 5). Investors who believe that the there will be renewed bearish sentiments
regarding Europe sovereign debt can buy GLD OTM calls which look cheap due to the rich
skew and the cheap implied volatility. We recommend buying GLD Oct10 120 call for $2.45.
The spread can be made cheaper by selling $108 put to go short GLD Oct10 108 120 risk
reversal for a cost of $0.9.

1
Skew is defined as the difference between the implied volatility of 25 delta put option and 25 delta call option divided
by 50 delta implied vol

July 26, 2010 3

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

Figure 4: GLD skew is trading at its richest ever Figure 5: While GLD implied volatility is at a lower premium
to realized volatility compared to history

0.1 55%
50%
0.05
45%
0 40%
35%
-0.05
30%
-0.1 25%
-0.15 20%
15%
-0.2 10%
-0.25 6/10/08 12/10/08 6/10/09 12/10/09 6/10/10
Aug-08 Feb-09 Aug-09 Feb-10
3 Month GLD Implied Volatility
GLD 3 Month Skew 3 Month GLD Realized Volatility

Source: Barclays Capital, OptionMetrics Source: Barclays Capital, OptionMetrics

Implied volatility of GDX, which is an ETF tracking gold miner stocks has historically had a
close relationship with implied volatility of gold options and implied volatility of SPX options.
GDX options have been cheapening relative to gold options and SPX options and currently
trade close to 2 standard deviations cheap over a 1-year history as shown in Figure 6. They
also have a rich skew similar to gold options. While not as direct a play as gold on
continuing sovereign debt difficulties in Europe since it is also affected by equity markets,
OTM call options look cheap and can be used to either take a directional view or delta
hedged to take a volatility view.

Figure 6: GDX implied volatility is trading cheap relative to SPX and Gold

12
10
8
6
4
2
0
-2
-4
-6
-8
-10
Jul-09 Sep-09 Oct-09 Dec-09 Jan-10 Mar-10 Apr-10 May-10 Jul-10

GDX 3M Vol ~ SPX 3M Volatility + GLD 3M Vol Residual (Volatility Points)

Source: Barclays Capital, OptionMetrics, Bloomberg

July 26, 2010 4

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

SPOTLIGHT

Correlation, Correlation everywhere, but not a drop to sell…

One of the striking features of the current equity derivatives landscape is the high value of
realized and implied correlations. Indeed, while equity volatility is nowhere close to its highs
set at the peak of the credit crises, correlation is close or higher than its high levels scaled
during that period. This obviously has profound implications even for non-derivatives
investors in that it indicates that stock-picking skills are less useful in the current
environment.

In this section, we take a close look at this phenomenon. We show that while much of the
variation in equity correlation is driven by equity volatility, from a long-term perspective it
appears to have had a secular increase in value. We hypothesize that this is perhaps driven
by the corresponding increase in popularity of index funds and ETFs. In order to quantify
this we construct a new metric to measure the excess volume in ETFs. We call this the
normalized ETF volume and it is simply the ratio of the total value traded in an ETF over a
period of time and the value traded in each of its constituent stocks. Our calculations show
that while this measure increased steadily until 2005, after that it has moved in tandem with
equity correlation.

We next try to glean some insight from the option market. Option implied correlation, which
has traditionally traded at a premium to realized, is currently trading at a discount which
would indicate that the option market is loathe to believe that the current high correlation is
likely to persist. However, the fact that long dated implied correlation is also equally high
and almost equal to its short dated version appears to provide a conflicting signal.

A (very, very) long-term perspective

In this section, we take a long-term perspective of stock correlation using proprietary data
provided by Barclays Quantitative Portfolio Strategy team (U.S. Equity Quantitative
Strategies: Market Commentary & Portfolio Rebalance). Obviously, the correlation between
different stocks is not equal and hence several different ways of defining the “average”
stock correlation are possible. In Appendix A, we detail the standard definition of stock
correlation used in the equity derivatives market. Figure 7 plots the realized correlation for
Russell 1000 index constituents and compares it to monthly SPX realized volatility. Note
that these calculations are completely based on stock returns and hence the term “realized”.
Several interesting conclusions can be drawn from this graph:

„ In general the stock correlation is highly correlated (pun not intended) with stock
volatility. This makes sense intuitively since a high volatility environment is by and large
also a top-down macro (as opposed to bottoms-up fundamentals) driven environment.
Indeed a formal regression (in log space) results in an r-square of ~56%

„ However, this relationship does not always hold. A case in point is the technology
bubble period (1998 – 20002) when volatility rose but correlation stayed low. This is of
course because the overall volatility was concentrated in technology stocks whose
movement to a large extent was decoupled from other sectors.

July 26, 2010 5

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

Figure 7: Stock correlation and volatility: A long-term perspective

70% 0

60% -0.5
-1
50%
-1.5
40%
-2
30%
-2.5
20%
-3
10% -3.5
0% -4
Jul-50 Jul-55 Jul-60 Jul-65 Jul-70 Jul-75 Jul-80 Jul-85 Jul-90 Jul-95 Jul-00 Jul-05 Jul-10

R1000 Monthly Realized Corr Log SPX Monthly Realized Vol (RHS)

Source: Barclays Capital Quantitative Portfolio Strategy, Bloomberg

„ After the bursting of the tech-bubble and during the telecom subsequent recession,
correlation again rose and then dropped again during the rally during 2003-2007. Note
that while equity volatility dropped to the same levels as during the early 90’s,
correlation did not and appears to have been reset to a new level. As we will discuss in
more detail below, in our opinion this is driven by the increasing popularity of passive
index indexing and (broad market) ETFs.

„ During the credit crises, correlation (along with volatility) spiked to levels not seen
during over the past decades.

„ During the subsequent rally in 2009, it dropped back but once again not to the pre-
crises levels.

„ With the onset of the European debt crises, correlation has spiked again but this time to
levels even higher than during the credit crises. This is also in the context that volatility
did not reach the levels seen during the crises.

The picture that thus emerges from the above analysis is that of a steadily ratchet up of
equity correlation which is not fully explained by a concurrent increase in equity volatility.

An important structural shift in the equity markets over the past few decades has been the
advent of index funds as an alternative to actively managed mandates Figure 8. The
remarkable rise in (broad market based) ETFs over the past decade is of course another
manifestation of the same phenomena. Since the dominance of this kind of index-based
component in the equity fund flows should logically lead to an increase in equity correlation,
it is tempting to theorize that the secular shift in equity correlation documented above is
driven by this effect.

July 26, 2010 6

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

Figure 8: Assets under management indexed to S&P 500

1600
1400
1200
1000
800
600
400
200
0
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

S&P 500 Indexed Assets ($Bn)

Source: Standard & Poors

Given the paucity of data around high frequency equity index fund flows, we choose to rely
on ETF traded volumes as a proxy. We are of course not concerned with the normal ebbs
and flows in traded volumes. In order to capture the excess ETF volume, we calculate the
ratio of the value traded in the SPY ETF relative to the value traded in all the constituents of
the SPX index. To the extent that investors are more inclined to trade the market as a whole,
this measure of normalised volume should be higher. As shown in Figure 9, this metric
steadily increased since 1998 as SPY volume steadily increased. However, since 2005 its
variation appears to be very tightly linked to equity correlation.

Figure 9: SPX Realized Correlation in recent times has been tightly linked to the volume
trade in SPY relative to SPX constituents

80% 0.4
70% 0.35
60% 0.3
50% 0.25
40% 0.2
30% 0.15
20% 0.1
10% 0.05
0% 0
April-98 April-00 April-02 April-04 April-06 April-08 April-10

SPX 3 Month Realized Correlation (LHS) Normalized SPY Volume (RHS)

Source: Barclays Capital, OptionMetrics, Bloomberg.

Mixed signals from Option markets

As discussed in Appendix A, one can use the same formula used to calculate realized
correlation to back out the correlation assumption imbedded in option prices (the so called
“implied correlation”). In fact, by using option volatilities for different expirations one can
calculate an implied correlation for different maturities to estimate the option markets
opinion on correlation over different future time horizons.

July 26, 2010 7

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

In Figure 10, we chart the trailing 3M realized correlations and compare it to the 3M and
12M implied correlations.

Figure 10: Implied Correlation trades at premium to Realized

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Realized Corr 3M Implied Corr 3M Implied Corr 12M

Source: Barclays Capital, OptionMetrics, Bloomberg

While, implied correlations trend together with realized correlations, it clear that on average,
implied correlations are higher than realized correlations. During crises periods when
realized correlation spikes, while implied correlation does increase it does not do so to the
same extent since the option market does not expect the correlation to stay high for
extended period of time (Figure 11). To some extent, this dynamic is similar to that for
implied volatility. Thus while implied volatility trades at a premium to realized volatility,
when a risk flare happens and realized volatility spikes, implied volatility does not follow
suite to the same extent and trades at a discount to realized volatility.

Figure 11: Implied Realized premium is correlated with the Implied term structure premium

0.5

0.4

0.3

0.2

0.1

-0.1

-0.2
Jan-96 Feb-97 Apr-98 Jun-99 Aug-00 Oct-01 Dec-02 Feb-04 Apr-05 May-06 Jul-07 Sep-08 Nov-09

Implied Corr 3M - Implied Corr 12M Implied Corr 3M - Realized Corr 12M

Source: Barclays Capital, OptionMetrics, Bloomberg

This behaviour has held true even during in the past few months, with the premium
between implied and realized correlation has compressed. In short, a comparison of short
dated implied correlation with trailing realized correlation indicates that the option market
does not expect the current high correlation to persist.

July 26, 2010 8

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

However, long dated implied correlation appears to provide a conflicting signal. As

highlighted in Figure 11, during the rare occasions when implied correlation has traded at a
discount to realised, the implied correlated term structure inverts (goes into backwardation)
similar to what happens to implied volatilities. In this context, it is interesting to note that
currently, the long dated correlations are trading almost flat to shorter dated ones. Clearly,
the option market believes that the current state of high realized correlation will persist for
an extended period of time.

Conclusion
To summarize, in our opinion, while equity correlation continues to be highly dependent on
volatility, the rise in indexation has led to a permanent increase in its “base” level. Thus
while we do believe that the current high levels of realized and implied correlations are
unsustainable, the eventual drop is not likely to be as high as some market participants
might expect.

July 26, 2010 9

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

Appendix A
The return of a basket of stocks is simply the total weighted average return of its
constituents. However, the volatility of an index is a function of the volatility of member as
well as how they are correlated to each other. Calculating an implied or realized correlation
number is a process of backing out the average correlation input that gets the individual
stock volatilities to aggregate to the index volatility.

The volatility of a portfolio σ p can be expressed in terms of the volatilities of its

components σ i and their weights wi .

σ p2 = ∑ wi2σ i2 + ∑∑ wi w jσ iσ j ρ ij
i i j

Here ρij is the pairwise correlation between all possible combinations of constituents.
Replacing the pair-wise correlations with a weighted average correlation , we can write:

σ p2 = ∑ wi2σ i2 + ρ ∑∑ wi w jσ iσ j
i i j

We also know
2
⎛ ⎞
⎜ ∑ wiσ i ⎟ = ∑ wi2σ i2 + ∑∑ wi w jσ iσ j
⎝ i ⎠ i i j

Hence, index variance is given by

⎛⎛ ⎞
2
⎞
σ 2p = ∑ wi2σ i2 + ρ ⎜ ⎜ ∑ wiσ i ⎟ − ∑ wi2σ i2 ⎟
⎜⎝ ⎠ ⎟
i
⎝ i i
⎠
Thus the correlation (implied or realized) is given by

σ p2 − ∑ wi2σ i2
σ p2
ρ= i
2
or ρ≈ 2
⎛ ⎞ ⎛ ⎞
⎜ ∑ wiσ i ⎟ − ∑ wi2σ i2 ⎜ ∑ wiσ i ⎟
⎝ i ⎠ i ⎝ i ⎠
The approximation works because the second term in the numerator and denominator is
quite small as compared to the first terms.

July 26, 2010 10

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

Analyst Certification

We, Maneesh S. Deshpande and Rohit Bhatia, hereby certify (1) that the views expressed in this research report accurately reflect our personal views
about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or
indirectly related to the specific recommendations or views expressed in this report.

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

Investors should consider this communication as only a single factor in making their investment decision.

The analysts responsible for preparing this report have received compensation based upon various factors including the Firm's total revenues, a portion of
which is generated by investment banking activities.

For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays
Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgi-
bin/all/disclosuresSearch.plor call 212-526-1072.

On September 20, 2008, Barclays Capital acquired Lehman Brothers' North American investment banking, capital markets, and private investment
management businesses. All ratings and price targets prior to this date relate to coverage under Lehman Brothers Inc. Barclays Capital produces a variety
of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations
contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of
differing time horizons, methodologies, or otherwise.

Risk Disclosure(s):
Options are not suitable for all investors. Please note that the trade ideas within this report do not necessarily relate to, and may directly conflict with, the
fundamental ratings applied to Barclays Capital Equity Research. The risks of options trading should be weighed against the potential rewards.
Risks
• Call or put purchasing: The risk of purchasing a call/put is that investors will lose the entire premium paid.
•Uncovered call writing: The risk of selling an uncovered call is unlimited and may result in losses significantly greater than the premium received.
•Uncovered put writing: The risk of selling an uncovered put is significant and may result in losses significantly greater than the premium received.
•Call or put vertical spread purchasing (same expiration month for both options): The basic risk of effecting a long spread transaction is limited to the
premium paid when the position is established.
•Call or put vertical spread writing/writing calls or puts (usually referred to as uncovered writing, combinations or straddles (same expiration month
for both options): The basic risk of effecting a short spread transaction is limited to the difference between the strike prices less the amount received
in premiums.
•Call or put calendar spread purchasing (different expiration months & short must expire prior to the long): The basic risk of effecting a long calendar
spread transaction is limited to the premium paid when the position is established.

Because of the importance of tax considerations to many options transactions, the investor considering options should consult with his/her tax advisor as
to how taxes affect the outcome of contemplated options transactions.
Supporting documents that form the basis of our recommendations are available on request.
The Options Clearing Corporation's publication, "Characteristics and Risks of Standardized Options", is available at
http://www.theocc.com/publications/risks/riskchap1.jsp

Barclays Capital offices involved in the production of Equity Research:

London
Barclays Capital, the investment banking division of Barclays Bank PLC (Barclays Capital, London)
New York
Barclays Capital Inc. (BCI, New York)
Tokyo
Barclays Capital Japan Limited (BCJL, Tokyo)
São Paulo
Banco Barclays S.A. (BBSA, São Paulo)
Hong Kong
Barclays Bank PLC, Hong Kong branch (BB, Hong Kong)
Toronto
Barclays Capital Canada Inc. (BCC, Toronto)
Johannesburg
Absa Capital, a division of Absa Bank Limited (Absa Capital, Johannesburg)

This publication has been prepared by Barclays Capital; the investment banking division of Barclays Bank PLC, and/or one or more of its affiliates as
provided below. This publication is provided to you for information purposes only. Prices shown in this publication are indicative and Barclays Capital is
not offering to buy or sell or soliciting offers to buy or sell any financial instrument. Other than disclosures relating to Barclays Capital, the information

July 26, 2010 11

Barclays Capital | U.S. Derivatives Strategy: Index Volatility Weekly

contained in this publication has been obtained from sources that Barclays Capital believes to be reliable, but Barclays Capital does not represent or
warrant that it is accurate or complete. The views in this publication are those of Barclays Capital and are subject to change, and Barclays Capital has no
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This information has been distributed by Barclays Bank PLC. Related financial products or services are only available to Professional Clients as defined by
the DFSA, and Business Customers as defined by the QFCRA."
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permission of Barclays Capital or any of its affiliates. Barclays Bank PLC is registered in England No. 1026167. Registered office 1 Churchill Place, London,
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