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Market Commentary
January 14, 2014
In the wake of the equity markets best year since the dot- Exhibit 1: S&P Expected Volatility Scenario Analysis
com heydays, one would think equity investors would be
gripped with euphoria. Instead, the pervasive sentiment
seems to be that of cautious optimism grateful to be at
the markets high, but wondering if we should be.
We thus enter 2014 at a potential inflection point with the
Fed poised to tap the brakes on its accommodative
monetary policy. Despite obvious macro risks, the recent
Source: Credit Suisse Equity Derivatives Strategy
shift towards a low correlation regime implies that volatility
this year will largely be defined by investors quest for
validation of current market valuations. As a result, we Exhibit 2: A Steady-State VIX Forecast at 15
expect to see increased incidences of market-beta
inversion in which sector and index volatilities are
catalyzed by single stock earnings.
Over the course of this report, we explain the rationale for
our 2014 volatility outlook: a steady state forecast of
VIX at 15, but with increased skew convexity (i.e., vol of
skew) magnifying macro shocks that could drive the VIX
in excess of 25.
4) Trade Recommendations: Finally, in section four, we Source: Credit Suisse Equity Derivatives Strategy
(212
(
EQUITY DERIVATIVES STRATEGY
Sector Volatility & Correlations: While The sample decomposition above shows two notable
correlations are determined by co-movements at developments. First, as one would expect, the premium
the single stock level, there are three sectors S&P stemming from the supply and demand for volatility
dispersion traders should focus on in particular: (skew) was significantly higher during the Fed tapering
Tech, Financials & Energy. We believe Financials sell-off in June than it was at the other two instances.
and Energy sector volatilities will move lower in Secondly, although we exit 2013 at a higher implied
2014, while Tech will see an increase in volatility. volatility level than in March, when the VIX fell to a 6-
On correlation, we expect last years low year low of 11.3, that difference is entirely due to
correlation regime to persist, favoring stock higher skew and kurtosis premiums (+0.9 pt and 1.4
selection and sector allocation to generate alpha. pts, respectively). Baseline volatility remains the same.
***Risks: The risks to buying a put, a call or a put or call spread is limited to the premium paid. The risk to selling a put can be significant. The risk of selling a
call can be unlimited. The risk to selling a variance swap or straddle could be unlimited. The risk to buying a variance swap is that variance could go to zero.
2
EQUITY DERIVATIVES STRATEGY
Baseline volatility, the type inherent in a liquid, continuous Calculate forecasted S&P return target
market, is largely a function of underlying economic Calculate daily historical returns for S&P-500 from 1928 to
fundamentals. With that in mind as we look ahead to the present (21,168 data points)
2014, there are many reasons for equity investors to
remain optimistic. Calculate rolling-window of one-year daily compounded
returns (20,916 data points)
The global economy is expected to be the most orderly in
Construct a normal density (bell-curve distribution) of the
years. A stable balance of growth, low inflation, and one-year price paths centered on the forecasted index return
accommodative policies will support a cyclical acceleration target
in activity. We expect higher household wealth to drive a
pick-up in consumer spending, and an ECB backstop to Draw 10,000 samples of the price paths from the
constructed distribution
boost the recovery in Europe.
Calculate the realized volatility of each of the 10,000 sample
While its tempting to turn cautious after a year when the paths
S&P rose 30%, history is squarely on the bulls side.
Historically, previous annual rallies of 25% or more were Baseline volatility = the mean of the sampled realized
subsequently followed with an increase in the S&P of volatilities
11%, on average.
Exhibit 6: Expected Volatility Required for S&P to Reach 2000 =12%
For 2014, our US economics team is forecasting a real
GDP growth of 3.0%, a stable inflation rate at 1.4%, and
an average unemployment rate of 6.8% (vs. 7.4% in
2013).
2014 Baseline Volatility @ 10.8%
Against this backdrop, our Global Equity Strategist,
Andrew Garthwaite, continues to see upside in equities
with a 2014 S&P target of 1960, which is an increase of
6.0% from the 2013 closing level. To arrive at this Source: Credit Suisse Equity Derivatives Strategy
number, Garthwaite probability weights three distinct Exhibit 7: Expected Volatility Required for S&P to Reach 1500 = 21%
scenarios ranging from a China slowdown which dampens
US growth to a bullish sunshine scenario where the S&P
reaches 2300 (bubble valuations).
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EQUITY DERIVATIVES STRATEGY
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EQUITY DERIVATIVES STRATEGY
1. Rising Interest Rates has evolved from whether it will occur to how it will
progress. Small changes to the scale of the program (e.g.
Interest Rate Contagion a $10bn vs. $15bn taper) may affect the VIX on the
margin, but are unlikely to cause a spike of the magnitude
With the December launch of Fed tapering, interest rate we saw in May.
risk is the most obvious candidate for a potential macro
volatility catalyst. The question for 2014 is what is the Rate Hike a Bigger Risk than Tapering
degree of sensitivity of the equity markets to interest rate
levels and interest rate volatility? Instead, the bigger risk is when the Fed will raise interest
rates. CS Economics team believes that will occur in mid-
An analysis of last years interplay between rates and 2015, which is in-line with the Feds own projections. As
equity volatility shows us that the cross-asset sensitivity of shown in Exhibit 2 below, the vast majority of the Feds
the equity markets to interest rate volatility is dependent policymakers expect the first rate hike to happen in 2015.
not merely on the magnitude of interest rate volatility, but Only 2 of the 17 members at the last December meeting
also the level of cross asset contagion. (Cross asset expected a hike in 2014.
contagion quantifies the degree to which volatility from
Exhibit 2: Fed Policymakers Projections for Fed Funds Rate
one asset class propagates to another).
As seen in Exhibit 1, volatility contagion between interest Even though an increase in the Fed Funds rate is not
rates and equities actually began increasing in the weeks likely until next year, the Fed may start preparing markets
leading up to Bernankes surprise announcement in May for it this year, especially if economic data continue to
that the Fed was considering tapering its bond purchases. surprise to the upside. However, talking about a future
Contagion steadily rose from 10% in April to 40% in early policy change can be a policy change itself and markets
May, then surging over 30 pts to a 1-year high of 71% will react as we saw with the taper talk last May.
after Bernankes announcement.
Exhibit 3: Equity & Rate Vol Reactions to Taper
Current Equity-Interest Rate Volatility Sensitivity
Volatility reaction to talk of taper: The VIX recorded its Dec14 Fed Fund futures contract, increased from 10%
biggest increase of the year from 13.4% to 20.5% in before the announcement to over 19% afterwards. Bond
the weeks after Bernanke first mentioned the possibility of yields also continued to climb, with the 10-year rate rising
scaling back QE (see Exhibit 3). This happened even from 2.83% to over 3.0%.
though Bernanke took pains to emphasize that tapering
was not imminent and would only happen after we saw Impact on Equity Volatility
evidence of a real and sustained economic recovery. Yet
investors still panicked. Interest rate implied volatility, as Core Scenario: Our core scenario is that the Fed, with
measured by the Credit Suisse Interest Rate Volatility Janet Yellen at the helm, will continue to be extremely
(CIRVE) Index, almost tripled to 114.7% in the aftermath. dovish in its forward guidance this year even as it winds
Equity implied vol-of-vol, as measured by VIX implied down QE. However, especially if economic growth picks
vol, surged over 37 vol pts to 104% in the month after. up, the market may doubt the Feds commitment to
persistent low rates and respond by taking interest rates
Volatility reaction to actual taper: In contrast, when the even higher. But we do not expect this to cause an abrupt
Fed did finally taper in December, the VIX actually fell 2.4 jump in implied volatility. Instead, we see small increases
pts while interest rate vols declined over 7 pts that day, as of 1-3 vol pts for both VIX and VSTOXX over each
markets largely shrugged off the event after having had incremental better-than-expected economic report (see
over six months to prepare for it. text box on the next page for the labor market indicators
Janet Yellen will be watching) as investors gradually refine
Will Markets Believe the Feds Dovish Guidance? their expectations for the timing of the first Fed Funds
rate hike.
Whether we see a repeat of the volatility spike we saw in
2013 will depend on how successfully the Fed can Bearish Scenario: In our bearish scenario, we see the Fed
convince markets that tapering is not tightening. In other making a surprise announcement that it is considering
words, that reducing asset purchases does not mean an raising interest rates sooner than expected, either
imminent increase in the Fed Funds rate. To accomplish because unemployment rate is falling rapidly or because
this, the Fed will need to be more dovish in its forward inflationary pressures are picking up. Even if the planned
guidance. We saw signs of this strategy at the December rate hike wont happen for some time (actual taper didnt
meeting when Bernanke coupled the taper announcement start until six months after Bernankes first mention), the
with a change in the rate guidance, saying the Fed will market reaction will be immediate and severe. In a paper
remain on hold even if the unemployment rate falls well Bernanke co-authored, he found that historically S&P sold
below its 6.5% target. Going forward, the Fed could off over 2.4% the day of an unexpected rate hike (see
conceivably move the level down to 6.0% or below. Exhibit 5). Implied volatility is also likely to jump
significantly in this case. We expect both the VIX and
Exhibit 4: Fed Policymakers Projections for Fed Funds Rate VSTOXX to rise to the 20-25% range, similar to what we
saw in May with tapering.
Bond Index). Currently, implied volatility is trading at Asian Financial Crisis Redux?
a 1-year low while skew is inverted, making call
spreads particularly attractive. We recommend The taper-induced EM sell-off last year certainly brought
buying the Jun14 85-95 call spread for $1.50 (spot back memories of the 1997 Asian Financial Crisis. Both
were fueled by hot money and large current account
ref 77.72) for a max payout ratio of over 6.5x. See
deficits. Each unraveling caused big swings in stock and
trade details on pg 34. currency prices. Yet there is one significant difference.
The 1997 Asian Financial crisis caused a more
***The risk of buying a call spread is limited to the premium pronounced reaction in global equity vol markets, with the
paid. VIX doubling from 19 to over 38 in the span of just a
week. In contrast, at the peak of the EM sell-off in 2013,
the VIX increased by just 4 pts to 20%. Other global
volatility benchmarks also showed no panic, with the
VSTOXX and VNKY rising 5-6 vol pts to 25% and 46%,
respectively.
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EQUITY DERIVATIVES STRATEGY
Why did US equity investors largely shrug off the Why 2014 Could Be Worse
Emerging Markets turmoil last year? It was not because
the US became less sensitive to EM risk. In fact, volatility While the impact of the EM sell-off on US equity volatility
contagion between EM and US markets reached similar was relatively contained in 2013, we see potential for
extremes both times: in 1997, spillover1 surged to a high higher contagion this year as US yields climb higher.
of 80% while last year it reached 77% (see Exhibit 2).
Instead, the difference lies in the magnitude of the Three potential volatility catalysts are:
shocks. At its peak in 1997, Emerging Markets volatility
increased sevenfold to a high of 42% versus 28% in Deteriorating current accounts: Many Emerging Markets
2013 (Exhibit 3). The reason for the lower volatility last countries are running significant current account deficits,
year was that EM countries have become better equipped which increases their vulnerability to Fed tightening. In
to handle financial shocks due to their increased currency particular, Turkey, India, and Indonesia are projected to
reserves. have larger deficits this year than they had even in the
run-up to the Asian Financial Crisis.
Exhibit 3: EM 1M Realized Volatility 1997 vs. 2013
Exhibit 5: EM Current Account Balances: Now vs. 1997
Since 1997, EM governments have deliberately built up Source: Credit Suisse Research
their foreign reserves, which allows them to cover short-
Increasing sensitivity to rising US yields: Worryingly, EM
term external debt when financing conditions deteriorate.
currencies have become more sensitive to rising US rates
As shown in Exhibit 4, FX reserves are now at least twice
now than at the height of the crisis last May/June (see
as large as short-term debt in these countries; that ratio
chart below). With the Fed winding down QE this year,
stood at less than one for most of them prior to the Asian
and 10-year yields projected to climb higher (CS 2014
Financial Crisis. Low coverage of short-term external debt
year-end forecast is 3.35%), EM currencies are likely to
was a key trigger for the 1997 crisis.
depreciate even further.
Exhibit 4: Reserve Coverage of Short-Term External Debt
Exhibit 6: Sensitivity of EM Currencies to US Rate Increases
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EQUITY DERIVATIVES STRATEGY
Mounting political risks: 2014 is an important election year 3. Chinas Shadow Banks: a Crisis in Waiting?
in many EM countries. Political instability could exacerbate
the capital outflow from the region. Three key countries to Opaque financial products that promise guaranteed high
watch are: returns. Lax lending standards. And an unprecedented
credit boom fueled by surging property prices. Is this the
Turkey: A corruption scandal has already created US circa 2004 or China in 2014? More importantly, is
question marks about the government. Two China about to have its own subprime meltdown and if it
contentious elections (local and parliamentary) does, will it send world markets into cardiac arrest?
this year will further test Erdogan and his party.
Since the 2008 Global Financial Crisis, Chinas economic
Thailand: It looks increasingly likely there will be engine has undergone an abrupt transformation from
judicial intervention to appoint a caretaker export-led to credit-led growth. In the last decade, China
government. This will likely lead to further street has seen a bigger credit expansion, relative to GDP, than
protests, slower growth, and more capital any other country in modern history. Total credit now
outflows. stands at 185% of GDP. However, as shown in Exhibit 1,
much of that has come from non-traditional lenders i.e.
Brazil: Loose fiscal policy is expected to help the shadow banks.
President Rousseff win reelection. This could
trigger credit downgrades. Exhibit 1: Chinas Shadow Banking Boom
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EQUITY DERIVATIVES STRATEGY
However, like the US in the 2000s, Chinas shadow Falling Property Prices: Many of these shadow lenders
banking sector suffers from poor transparency, high are highly levered to the property market, so any
leverage, and exposure to frothy property markets. We meaningful decline in price could lead to mass
see three key risks in the upcoming year that could turn bankruptcies. The resulting credit crunch wouldnt just hit
this boom into a bust and send global volatility surging. developers, but local governments too. They rely on
shadow lenders to finance infrastructure projects, and on
Rising Inflation: Our China Economics team views this as land sales to fill their coffers. Any decline in property
the greatest near-term danger as higher inflation could prices would thus strangle revenues and liquidity. They
force the PBoC to raise interest rates. They expect would likely need the central government to bail them out
headline inflation to pick-up meaningfully this year, and of some their debt, currently at 33% of GDP (including
project CPI to exceed 4.0% around the summer. If rate both direct and contingent liabilities).
hikes occur, fund inflows into shadow banks will slow as
investors would be able to get higher yields elsewhere. Exhibit 5: Local Government Debt Has Surged Since 2008
This could push some of the more leveraged lenders into
bankruptcy, setting off sector-wide redemptions.
70
NKY 1M Realized Vol
60 SPX 1M Realized Vol
50
Volatility
40
30
20
10
0
Jan-90 Mar-90 May-90 Jul-90 Sep-90 Nov-90 Jan-91
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EQUITY DERIVATIVES STRATEGY
Structural Skew Outlook Exhibit 1: Equity Index Skew Typically Downward Sloping
Evaluating Skew Opportunities in 2014
Within the equity derivatives markets, the richness or
cheapness of skew is often a major consideration in
determining how broad market directional views are
expressed. The strategy one implements to express a
bullish view in a low volatility environment with rich index
skew may completely differ from the strategy one uses to
express a comparable view with cheap
index skew. Due to recent changes in the behavior of
equity index skew in response to market conditions in
2013, however, derivatives traders may need to reassess
how to quantify the richness or cheapness of skew going Source: Credit Suisse Equity Derivatives Strategy
forward.
Skew Convexity But Has Recently Embedded More Upside Curvature
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EQUITY DERIVATIVES STRATEGY
Structural/ Transient Skew Decomposition Exhibit 3: Estimates of Volatility Contribution by Client Type
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EQUITY DERIVATIVES STRATEGY
2
The shift away from gamma towards delta has triggered a decline in option
volume as delta based strategies incur lower turnover. Exhibit 2
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EQUITY DERIVATIVES STRATEGY
Credit: Given the reduced liquidity in credit markets Exhibit 2: ... as do CDX Spreads
following the London Whale incident and responses to
Dodd-Frank, we can most easily see the impact that
Basel III requirements have had on European ITraxx IG
and US CDX IG - two credit indices widely used to
mitigate credit risk exposure at broker-dealer banks.
Credit risk capital is measured via quarter-end snapshots.
Note in Exhibits 1-2 that these two credit indices have
tended to spike at quarter-ends vs. other trading days.
Equities: Market risk capital is measured using a 60-day
rolling average; thus the incremental demand for market
risk hedges is more evenly distributed across the quarter.
Moreover, as a percentage of total capital usage within
banks, equity exposures are far smaller than
Source: Credit Suisse Equity Derivatives Strategy, Bloomberg
corresponding credit exposures. As a result, we do not
observe corresponding monthly or quarterly lumpiness Exhibit 3: but not VIX
attributed to Basel III in either S&P or VIX options.
3
Dan Rodriguez, CRO Systematic Market Making Group
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EQUITY DERIVATIVES STRATEGY
Volatility Hedge Funds relative value VIX futures and options trades are likely to
be one of the few obvious ways for volatility hedge funds
General Outlook
to source alpha within equities. More advanced strategies
In a year in which the VIX repeatedly flirted with Great in the space, particularly those related to the vol of vol
Moderation lows, volatility hedge funds had a dichotomy surface skew and term structure arbitrage have remained
of outcomes. The key factor was vol of vol. Although the mostly unexplored due to lack of appropriate instruments.
median volatility in 2013 was near 2004-2006 lows, vol
of vol realized at middling (near 50th percentile) levels. For Exhibit 1: Volatility Hedge Fund Performance vs. VIX Level
volatility carry funds that systematically sell volatility risk
premium (i.e. capturing the difference between implied
and realized volatility), a moderate vol-of-vol environment
is actually beneficial as it allows them to opportunistically
reset their short vol positions at higher levels. Exhibit 2
shows the performance of a rolling short vol strategy over
the course of last year. It maps the VIX against
subsequent 1-month realized volatility. As you can see,
with the exception of 2 weeks in March (sequester) and
again in May (taper), a systematically short vol strategy Source: Credit Suisse Equity Derivatives Strategy
would have performed very well.
Exhibit 2: PnL of a Systematic Short Vol Strategy Last Year
In contrast, volatility long-short funds typically thrive in a
higher vol-of-vol environment where arbitrage and spread
opportunities are more plentiful. This explains the
dichotomy in performance between the two groups last
year. While volatility carry funds had their second best
year since 2007 (Hedge Fund Research HFRX data),
long-short vol strategies recorded a 2.5% loss for the
year.
120
Vol of Vol: The rise in liquidity of exchange-listed volatility
1Y
100
80 6M
products such as VIX options, futures & ETFs boosted the Strike (% of Spot) 50 1M2M
3M
Maturity
growth of a variety of strategies. In addition to tactically
Source: Credit Suisse Equity Derivatives Strategy
using products to express directional views and
occasionally hedge, funds have been exploring dynamic
approaches to systematic volatility investing and potential
arbitrage opportunities arising from broad-based volatility
demand/supply. With low levels of volatility across asset
strategies, higher moment directional (vol of vol) and
16
EQUITY DERIVATIVES STRATEGY
Insurance Companies
General Outlook Exhibit 1: Insurers Continue to Temper VA Sales
2014 Derivatives Trading Implications Source: LIMRA, Bloomberg, CS Equity Drivatives Strategy
remain net buyers of short-dated (0 to 2 year) volatility but Source: Credit Suisse Locus
European Insurance Solvency Requirements Exhibit 4: Current Capital vs SCR (per country)
While the final text has not yet been made public,
Credit Suisse EMEA Structuring believes that life
insurers will be granted a 16-year transition period,
during which the Solvency Capital Requirement (SCR) Source: LIMRA, Bloomberg, CS Equity Drivatives Strategy
will be set as a pro rata temporis mix between Solvency
I and Solvency II SCRs. Although Scandinavian insurers
are ready for Solvency II and could opt for immediate
implementation if this is rendered possible by their
regulators, German insurers who have more long-term
rate guarantees in their liabilities are likely to choose
the slow path instead. Some technical adjustments
could also be defined in order to reduce the impact of
interest rate volatility, which will prove positive again for
German insurers.
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EQUITY DERIVATIVES STRATEGY
Pension Funds
General Outlook Exhibit 1: Pension Funding Deficit Below $100M
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EQUITY DERIVATIVES STRATEGY
Structured Products notes thus depresses skew across all major global
benchmarks.
General Outlook
The bulk of global structured product issuance continues Long Divs: structured trading desks are typically short
to be defined by the search for yield. However, the long-term forwards which are hedged by going long
issuance of income-bearing structures have been shorter term instruments such as futures or synthetics.
complicated by 1) the low level of interest rates, which While this trade is on average expected to generate
reduces the amount of premium available to be spent in positive carry, it also makes trading desks long implied
capital guaranteed products and limits the coupon dividends and short repo. The latter created significant
available in income-generating notes and 2) low levels of losses in 2013 due to added friction costs (in particular
volatility which reduces the premium generated by selling the financial transaction tax in Europe), unfavorable
the embedded equity option. (A 3-year down-and-in funding conditions, and dividend taxation.
equity index put option with a 30% downside barrier
Exhibit 1: Low 3-8 Year Implied Volatility Reduces Note Benefits
currently generates a coupon of only ~5% p.a., vs former +2 Std: 20.2%
levels of 7 to 9%5). In response, issuers have been 20.0%
Volatility (%)
19.0%
optics including 1) increased use of barriers and other
contingent structures and 2) shifting maturities further up 18.0%
-2 Std: 17.9%
Going into 2014, however, as equity markets extend the 31-Mar-13 30-Jun-13 30-Sep-13 30-Dec-13
global rally, we anticipate 1) a shift away from income SPX 3Y 100Pct Imp Vol Avg(SPX 3Y 100Pct Imp Vol)
2*Std(SPX 3Y 100Pct Imp Vol) SPX 3Y Hist Vol
bearing (short optionality) notes towards uncapped Source: Credit Suisse Locus
participation (long optionality) structures such as buffered Exhibit 2: 4Y SPX RTY Cert Plus (Short Correlation)
leveraged notes and 2) increased callbacks on
autocallables, many of which were issued during the
range bound markets of 2010-2012.
5
Underlyings: Eurostoxx 50, FTSE, S&P-500, Nikkei. Maturity: 2 to 3
years in Private Banking where trading is more dynamic, 5 to 8 years for
mass retail. Autocall feature knocking out the trade if an upside barrier is
breached the barrier is typically set at 100% with annual observations Source: Credit Suisse Equity Derivatives Structured Products Group
Coupon: reverse converts (5%), worst-of puts (8+%)
6
beyond a certain point however, trading desks would find themselves too
short vega, and therefore become large buyers of volatility
20
EQUITY DERIVATIVES STRATEGY
21
EQUITY DERIVATIVES STRATEGY
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EQUITY DERIVATIVES STRATEGY
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EQUITY DERIVATIVES STRATEGY
Lower volatility
Higher volatility
Source: Credit Suisse Equity Derivatives Strategy
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EQUITY DERIVATIVES STRATEGY
Energy: Shale We Dance? Despite a relatively muted outlook for underlying energy
commodities, the fundamental outlook for energy stocks
The energy sector enters 2014 with an improving is more positive.
fundamental outlook, albeit with downside oil price risk
emerging in the second half of 2014. 1-year implied Integrated Oil: CS upgraded its view on the major
volatility for the energy sector, currently at 19%, is the integrated oil companies to market weight for 2014. After
highest of all major sectors. We expect the sectors making only half of the S&Ps gains in the past five years
volatility to compress in 1H due to improving company (trailing by 60%), CS believes the integrated oil stocks are
fundamentals, with some upside risk from potential higher due for a period of outperformance and expects the key
oil supply in the second half. drivers to be the following:
Exhibit 1: Sector Scoreboard Cash Flow: After spending $250b per year (!) on
2013 Implied 2013 Realized 2014 Implied capex since 2011, the integrateds are approaching
Vol Vol Vol the sweet spot for cash flow growth in 2015-2017.
Energy Sector 21.4 14.8 19.1
Source: Credit Suisse Equity Derivatives This should pave the way for an increase in
dividends and buybacks.
Oil Outlook: 2014 is all about the potential return of oil
supply from constrained/offline international sources, Restructuring: Should the market not recognize the
particularly Libya and Iran. Potential supply increases progress the integrateds have made, we could see
wont occur until 2H14 which means CS expects Brent additional breakups (e.g. between upstream and
oil prices to remain around $110 per barrel until then. If downstream) to unlock shareholder value.
Libyan political risks subside, export production could Exploration & Production: The US onshore boom from
double from current levels by the end of the year. In Iran, shale continues and CS remains bullish on the outlook for
negotiations on sanctions are expected to be completed domestic E&P. They key drivers of performance for 2014
by the end of Q214, and exports could rise by 0.5Mb/d will be:
by year end. Taken together, CS sees about $10/barrel
of oil price risk in 2H if all goes well with returning supply. Valuation Disconnect: There is a disconnect
Depending on the path, historically falling oil prices between the strong growth outlook for US E&P
translates into a 2-4 point increase in realized volatility for companies and their inexpensive valuation. Trading
the energy sector. at 5.8x cash flow, the E&P group has the same
multiple as the major oil companies despite higher
Exhibit 2: CS Brent Oil Forecast growth and return prospects. CS believes E&P
multiples should grow to 8-14x this year depending
on the underlying assets, providing significant upside
for the group.
Efficiency: Improvements in shale technology mean
that costs keep coming down and IRR rates keep
rising. IRR rates for several regions are now through
50% with few projects generating less than 15%
returns. Improvement in efficiency, especially for oil
sensitive assets, could spur additional upside for the
group.
Source: Credit Suisse Equity Research
Exhibit 3: E&P Trade Inline with Majors, Despite Higher Growth
Natural Gas Outlook: US natural gas prices will remain
challenged as growth in supply continues at a staggering
pace from shale assets. For example, in just 4 years the
Marcellus region in the North East has grown to be the
most productive US shale asset, delivering ~13 billion
Bcf/day (from virtually zero). Gas demand wont rescue
the oversupply situation, as power and industrial
consumption remain sluggish. CS expects natural gas
prices to remain around $4/MMbtu for most of 2014.
There is however some upside to prices longer term as
Source: Credit Suisse Equity Derivatives Strategy
new export LNG terminals come online.
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EQUITY DERIVATIVES STRATEGY
Oil Field Services: The transformation from a traditional Utilities Renewed Trouble?
services industry to a technology based group continues
for the OFS companies. CS expects the stocks of the Long viewed as a low beta sector, Utilities were in fact
largest and most diversified companies to outperform in the 5th most volatile sector in 2013. The increased
2014 as increased technical capabilities lead to better volatility came as a result of cylical headwinds from
return on investment. We anticipate the shift to higher interest rates, and structural challenges from the
technology-rich products will be recognized, pushing long awaited cost competitiveness for renewable
stocks higher given that the group trades near historically energy. We expect the following factors could again
low P/B and P/E valuation multiples. make 2014 a bumpy year for this group:
Interest Rates: Utilities have one of the strongest
inverse relationships to US treasury yields. CS
Trade Recommendation expects rates to rise in 2014, which will provide a
Implied volatility for the energy sector stands at 19%. headwind for the group, especially regulated
With improving company fundamentals (especially for utilities. With high financial leverage and a
the integrateds) we expect the sector to realize vol structurally challenged operating model, utilities
levels similar to 2013 (15%). Further, with risk to oil are faced with rising costs with minimal changes in
prices later in the year, we would recommend a long revenue.
position in crude oil vol as a pair to our short energy vol Utility Sector vs. 10-Year Yield
trade. The 1Y implied vol spread between the two is 220 3.50
near a 5-year high (energy vol rich, crude vol cheap) 210 3.00
providing both a fundamental and vol opportunity. For 200
2.50
Utility Index
160 1.00
Dec-12
Jun-13
Nov-13
Dec-13
Jul-13
Oct-13
Feb-13
Apr-13
Sep-13
May-13
Aug-13
Jan-13
Mar-13
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EQUITY DERIVATIVES STRATEGY
Technology: Its a Jungle Out There networking costs by 60-70% and also allow
improved security and control of a companys data.
The Technology sector, along with Consumer Staples, While this is a longer term disruption, early adopters
was the lowest volatility sector in 2013. However, we do already include Google, Facebook, and Goldman
not expect a repeat of this in 2014. A muted IT spending Sachs.
outlook, disruptive technologies, and potential accelerating
M&A are poised to keep a bid to technology sector Software: CS maintains its overweight
volatility. recommendation for the Software sector in 2014 given
positive long term revenue expectations and attractive
Exhibit 1: Sector Scoreboard valuation. Our top things to watch this year in software
2013 Implied 2013 Realized 2014 Implied
Vol Vol Vol
include:
Tech Sector 19.0 12.0 16.5
Source: Credit Suisse Equity Derivatives
SDN #2: Hardwares loss is the software sectors
gain as both traditional virtualization companies and
IT Hardware. The outlook for IT spending is muted as new entrants provide applications to more cost-
disruptive players (e.g. Amazon) as well as changing effectively manage networks. Software-defined data
technology challenge incumbent business models and centers represent a generational paradigm shift in IT
cost of providing service. We see the following as major architecture.
catalysts for the IT sector in 2014:
Handsets: Smartphone growth is healthy but materially
Amazon.com: Amazon is quietly becoming very decelerating in 2014. We see the following factors
disruptive in the cloud market. Its entry into the affecting the outlook for global handset stocks:
storage business, originally led by price, has evolved
into a sophisticated full service provider with great White Label: Long term revenue growth is set to fall
value. Amazon has cut service prices 37 times since to 4% as the high-end is essentially saturated and
entering the IT business in 2006 and can cut growth now relies on low-end/white labels. Unit
storage cost for a customer by as much as 70%. growth in 2014 is expected to be 22%, still healthy
Further, it recently beat out IBM for a contract with but below last years increase of 43%.
the CIA despite charging higher prices, Penetration: With prices under pressure, the key to
demonstrating its degree of knowledge and growth is increased smartphone penetration.
sophistication in delivering cloud solutions. Revenue Globally we finished at 35% last year and expect
for this division is growing at 50%+ per year and as this to rise to 80% over the next few years due to
the scale increases, it becomes deflationary for falling handset prices.
traditional big cap IT vendors.
For handsets, the long term structural thesis remains, but
Exhibit 2: Cloud Storage Growing at 30% CAGR materially decelerating growth and a duopoly in high end
phones create a more challenging outlook.
Trade Recommendation
With Amazon acting as disruptive player, and new
technology threatening the incumbent hardware
players, we have an upside bias to volatility for the Tech
sector in 2014. 1Y implied vol for Tech is trading at
16.5%. We believe this is both a good outright buy and
a good hedge against our core view that vol will be low
in 2014. A key risk against this view is that correlation
Source: Credit Suisse Equity Research is very low for Technology, and has a dampening effect
on volatility.
29
EQUITY DERIVATIVES STRATEGY
Correlation Outlook Anchored by not just low levels of realized correlation, but
also volatility of correlation, implied correlation has now
also begun to fall back to its pre-crisis levels. Although on
With the dissipating influence of macro catalysts, the shift an implied-realized basis, it still appears rich. As shown on
to a lower volatility regime last year has brought about a Exhibit 2, the spread between 1-year implied and realized
corresponding shift to a lower correlation regime in both correlation has now reached a decade high of ~25
the US and Europe. Aside from two occasions, the taper- correlation points, making S&P correlation an apparent
induced sell-off in June and the debt ceiling crisis in sell into 2014.
September, 3M Top-50 S&P and Eurostoxx-50 realized
correlations remained below 15-year average levels of 38
and 49 respectively. Risks in Shorting Correlation in 2014
However, short correlation trades implemented via
dispersion could be complicated by the following two
Exhibit 1: S&P Rolling 3M Realized Correlation (Top 50) factors:
50% 1) Due to the tendency for correlation to mean
revert, the assessment of the expected
45% profitability in selling correlation via a dispersion
trade is formed not merely upon observations of
40%
the spread between implied and expected
35%
realized levels but also the absolute levels of
implied correlation, volatility, and skew. As
30% shown in Exhibit 3, the PnL of a systematically
short 1Y dispersion strategy depends on the
25% 3M Realised 1997-2013 Average absolute level of implied correlation. The optimal
2013 Average window appears to be when implied correlation
20%
Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14
levels are in excess of 60. In contrast, selling
Source: Credit Suisse Equity Derivatives Strategy correlation at current levels of ~50% typically
yields flat or negligible PnL.
Correlation and Alpha Opportunities: Low realized
correlation helped US long-short investors thrive in 2013,
since that increases dispersion among single stock Exhibit 3: PnL of S&P 1Y Dispersion Trade (100k Vega)
returns and allows better stock picking performance. It
also benefitted vol arbitrage hedge funds that still had 800
legacy short correlation or were able to go short S&P 700
correlation at over 60% at the beginning of the year, 600
300
200
50% -100
-200
40% 0.2<<0.4 0.4<<0.6 0.6<<0.8 0.8<
20%
31
EQUITY DERIVATIVES STRATEGY
Source: Credit Suisse Equity Derivatives Strategy Source: Credit Suisse Equity Derivatives Strategy
* Cumulative growth since 2010 * Cum growth since 2010
The Eurozone has passed through a period of Up until recently, markets were pricing in falling dividends
deep economic crisis, heavily impacting company for Japan as a result of the deflationary challenges facing
earnings and capacity to pay dividends. the country. See Exhibit X.
The SX5E index has been significantly That all changed in December 2012 when the BoJ
remodelled over the period, with high dividend surprised the market with an aggressive expansionary
paying sectors such as banks losing weight and monetary policy, with the stated aim of sparking inflation
being replaced with lower dividend paying sectors in Japan. Since then, the Nikkei dividend term structure
such as capital goods. has drastically changed. Dividend futures are now pricing
32
EQUITY DERIVATIVES STRATEGY
in a 35% growth in dividends over the next 4 years versus Earnings: According to CS Global Strategy, S&P
a 10% decline previously. earnings are expected to grow 7% in 2014 to $116, after
Exhibit 3: Implied Dividend Term Structure growing 11% in 2013. Growth will be strongest for the
Energy, Consumer Discretionary, and Industrial sectors;
while Consumer Staples and Financials are expected to
lag (although still positive). Growth is also expected to be
strong in the Eurozone: company earnings should grow by
11%, helped by 1) an improvement in profit margins; 2) a
weaker Euro against the dollar (a 10% decrease in the
Euro could increase earnings by 10%); and 3) continued
policy accommodation from the ECB.
Dividends: The outlook for 2014 global dividends is as
follows:
S&P: the current implied growth rate from 2013
Source: Credit Suisse Equity Derivatives Strategy (+12%) is roughly in line with the earnings
growth for 2013. Assuming a 30% payout ratio,
2014 dividend should be about $39, in line with
2014 Dividends: Stable Payouts & Higher the current dividend swap.
Earnings SX5E: 2014 dividends are expected to reach
With stable payouts and growing company earnings, 113.3 (based on a bottom up aggregation of
dividends are expected to post positive performance in analyst forecasts) or 112 on a more conservative
2014. estimate versus current dividend future of 109
(up to 4% upside). With a stable payout ratio and
Payouts: the payout ratio corresponds to the proportion
an 11% growth in earnings for 2014, we
of company earnings that are paid out to shareholders.
estimate 2015 dividends of EUR 121.5. This is
Companies are more likely to hold dividends steady as
in-line with analysts forecasts of 122, and
earnings fall, and are slow to increase dividends when
suggests 11% upside to 2015 dividends versus
profits initially rise, creating convexity in dividend
current futures prices.
payments versus earnings (Exhibit 4). Under our current
SX5E Long-Term Dividends: Credit Suisse
view of stable macroeconomic conditions, we expect
Derivatives Strategy sees up to 40% upside in
payout ratios (around 30% on the S&P and 60% on the
Eurozone earnings over the next three years,
SX5E) to remain stable in 2014. As a result, the growth
suggesting up to 40% growth between 2013 and
in dividends should reflect the growth in underlying
2017 dividends. This is in contrast to the current
earnings.
depressed SX5E dividend term structure, which
Exhibit 4: Payout Ratio vs. Earnings Growth prices SX5E dividends to fall 2% over the same
period, and would put SX5E in-line with other
global benchmarks such as S&P or Nikkei
(potential trade: SX5E 2015/2017 dividend
steepeners).
Exhibit: S&P and SX5E 2015 Dividend Scenarios
33
EQUITY DERIVATIVES STRATEGY
34
EQUITY DERIVATIVES STRATEGY
Interest Rate Hedge: Buy TBT Jun14 85-95 call spread to hedge against rising rate risk
Interest rate risk was the biggest cross-asset driver of equity volatility last year. Just mere talk of taper caused 10-year yields
to almost double and the VIX to surge over 8 pts to a 1-year high of 21%. As the Fed winds down QE in 2014 (and
potentially begins to prepare for rate hikes), we recommend equity investors hedge rising rate risk with TBT call spreads. TBT
(2x short Treasury 20+ Year Bond Index) has a 94% correlation with 10-year Treasury yields and very good option liquidity
(650k total open interest). 6M implied volatility has fallen to a 1-year low (Exhibit 1) while skew is inverted (Exhibit 2), making
call spreads particularly attractive. We recommend buying the Jun14 85-95 call spread for $1.50 (spot ref 77.72). Upside
participation starts +9.4% from current spot while the trade has a max payout ratio of over 6.5x.
*** Risks: The risk to buying a call spread is limited to the premium paid. ***
Exhibit 1. TBT 6M Implied Vol at 1-Year Low Exhibit 2: TBT 6M Skew is Inverted as Calls are Bid
36 26
TBT 6M Implied Vol
34 TBT Skew
25
32
Implied Vol (%)
Implied Vol (%)
30
24
28
26 23
TBT skew is inverted
24
22 22
Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 90% 95% 97.5% 100% 102.5% 105% 110%
Strike (%Moneyness)
Source: Credit Suisse Equity Derivatives Strategy
Emerging Markets Hedge: Buy EEM Dec14 36-30 put spread funded by the 44-strike call
Emerging market equities were the most impacted by Fed tapering last year, down over 17% from peak to trough. We
believe another meltdown is possible this year as EM countries battle slower growth, higher US yields, and mounting political
risks (see details pg 7-8). We recommend buying the EEM Dec14 36-30 put spread funded by selling the 44-strike call for
net zero premium (spot ref 39.78). Protection starts from down 9.5% until down 24.6% while the trade has a 10.6% buffer
on the upside.
*** Risks: The risk to buying a put spread is limited to the premium paid. The risk to selling an uncovered call is unlimited ***
Exhibit 3. EM Equities Most Impacted by Tapering Exhibit 4: Stock + Option Trade Payoff Diagram
105
100
95
90
85
SPX EEM
80
EWZ FXI
75
5/7 5/14 5/21 5/28 6/4 6/11 6/18
ENERGY SECTOR: Sell XLE 1Y variance swap and buy USO (oil) 1Y variance swap
Implied volatility for the energy sector currently stands at 19% and is the highest of any major S&P sector. Last year the
sector realized a volatility of 14%, and we are positive on the outlook for energy stocks this year. However, one key risk is the
timing of the return of oil supply from Libya and Iran, which could pressure Brent oil prices by $10 per barrel. As a result, we
recommend a long position in crude oil as a hedge. Currently, the vol spread is heavily in our favor for this trade, with XLE vol
trading near a 5-year high vs. crude oil vol.
*** Risks: The risks to selling a variance swap is unlimited. The risk to buying variance is that variance could go to zero***
Exhibit 1. XLE Implied Volatility is Highest Exhibit 2: XLE 1Y Implied Vol is Rich vs. USO Implied
Sector 1Y Implied Vol
Energy 19.1
Financials 17.7
Materials 17.7
Indutrials 17.6
Discretionary 16.8
Technology 16.5
S&P 500 15.3
Telecom 15.1
Healthcare 14.9
Utilities 14.9
Staples 13.3
Source: Credit Suisse Equity Derivatives Strategy
M&A IDEAS: Since the beginning of December13, there have been 8 billion dollar deals announced where the acquirers
stock jumped higher by more than 5% on the day and by a staggering average of 17% (e.g. Fiat, Avago, Sysco, Textron,
Forest Labs). We beleive this could be the needed positive reinforcement from investors to corporate management for
increased M&A after a long period muted transactions. Below we highlight 13 stocks that CS fundamental analysts view as
takeout candidates. We recommend using risk reversals to play the M&A theme, as a way to neutralize the vega exposure,
while capturing the upside on an uncapped basis. Below we show the the number of 110% calls that can be bought by
selling one 95% put. We also have delta one basket, CSUSUSMA available, which has outperformed by 10% since Q413.
*** Risks: The risks to selling a put unlimited. The risk to buying a call is limited to the premium paid. ***
Exhibit 3. CS Delta One M&A Basket vs SPX Performance Exhibit 4: M&A Risk Reversal Ideas
36
EQUITY DERIVATIVES STRATEGY
Opportunity: Capture volatility premium while positioning for equity outperformance in 2014
Global equity markets are expected to continue to outperform in 2014 for the following reasons:
o Valuation: Equities are the cheapest asset class with a US equity risk premium of 6.4% on consensus earning
vs 5.2% on Global Equity Strategy earning forecast. Equities will become expensive relative to bonds only if
yields rise above 3.5%.
o Excess liquidity: Monetary easing remains supportive for equities. Developed market central banks balance
sheets are set to grow by 19% by the end of 2014 according to CS economists estimates, including a 30-
40% increase for JGB holdings in Q1. The ECB could also ease further, including introducing a negative
deposit rate (-0.1%) and further LTROs.
o Funds flow: Long-term positioning still look supportive for equities. Inflows into equity funds are close to an 8-
month high ($80bn over the past 6 months) while bond funds are experiencing outflows ($150bn).
Steep Term Structure: Across global indices, steep term structure provides opportunity for selling longer-term volatility.
The 1Y-3M implied vol spreads are in their 66th, 66th and 73th percentile over past 5 years for SPX, SX5E and FTSE,
respectively (Exhibit 2).
Attractive Yields and Break-Evens: The straddles generate yields ranging from 13% on SPX to 21% on SX5E with
attractive break-evens. The trades are expected to generate positive PnL as long as the indices do not fall by more
than 5-6% and do not appreciate by more than 19%, 25%, and 37% for SPX, FTSE, and SX5E, respectively. For
reference, our Global Strategy team expects gains this year of of 7%, 10%, and 16% for SPX, FTSE, and SX5E,
respectively.
Exhibit 1: 2014 Year-End Price Targets Exhibit 2: Steep Term Structure (1Y-3M Spreads)
Index Spot CS Target Price % Spot
S&P 500 1837 1960 106.7% 2,5%
EURO STOXX 50 3111 3600 115.7%
FTSE 100 6722 7400 110.1% 0,0%
Volatility (%)
-5,0%
-7,5%
37
EQUITY DERIVATIVES STRATEGY
Exhibit 1: Normalized Price (From 02/01/2006) Exhibit 2: 1Y Implied Volatilities Have Fallen Significantly
125 40,0%
Volatility (%)
Price
100 30,0%
75
20,0%
Source: Credit Suisse Equity Derivatives Strategy Source: Credit Suisse Equity Derivatives Strategy
38
EQUITY DERIVATIVES STRATEGY
Exhibit 1: SX5E Div Announcements & Ex-div Calendar Exhibit 2: DEDZ4 Div Futures vs Conservative 2014
(2012) Estimate
100% 114
90% 112
80% 110
70% 108
60% 106
50% 104
40% 102
30% 100
20% 98
10% 96
0% 94
92
Oct-11
Oct-12
May-12
Dec-11
Feb-12
Jun-12
Dec-12
Jan-12
Mar-12
Aug-11
Aug-12
Jul-11
Jul-11
Nov-11
Jul-12
Nov-12
Sep-11
Apr-12
Sep-12
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: Credit Suisse Equity Derivatives Strategy Source: Credit Suisse Equity Derivatives Strategy
One risk factor to consider is Spanish banks dividend cuts: in last November, the IMF recommended that the Bank of Spain
should maintain the 25% cash dividend cap implemented in 2013. However, we believe that 1) a final decision on this is
unlikely to occur before the middle of the year, and 2) at current prices, 2014 dividends futures already assume that Spanish
banks could cut as much as 40% of their dividends in 2014.
39
EQUITY DERIVATIVES STRATEGY
*** Risks: The risk to buying a conditional call option is limited to the premium paid.***
40
EQUITY DERIVATIVES STRATEGY
Volatility (%)
USDJPY
25,0%
NKY
12500
90
20,0%
10000 15,0%
80
41
EQUITY DERIVATIVES STRATEGY
Contacts
James Masserio
Head, US Equity Derivatives
+1 212 325 5988
james.masserio@credit-suisse.com
Disclaimer:
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