Strategic Research for Equities & Derivatives

19 January 2005

US Index Option Strategies
Options Research – USA

S&P 500 – volatility term structure

How to trade correlation and dispersion
n Volatility remains low despite the market pullback. Volatility returned to midDecember levels after an early-January uptick. n 2005 outlook: several potential catalysts for a rise in volatility, but timing is uncertain. Volatility may remain low for some time, but earnings, M&A activity, the dollar, oil prices, an Asian crisis or a significant event may signal the next uptrend. n Contrasting correlation and dispersion. The implied-realized correlation spread is attractive but difficult to capture. Dispersion is easier to trade, but the expected payoff is lower and influenced by long volatility exposure. n Four ways to trade dispersion and correlation. We review and contrast the traditional dispersion trade, synthetic dispersion trade with variance swaps, correlation proxy with variance swaps and custom basket correlation swap. n Buy dispersion to capitalize on earnings surprises and stable or rising volatility. We believe this trade should in 2005 benefit from its long volatility exposure and a discriminatory environment for individual companies. n Capture the correlation spread with a variance-neutral dispersion trade underweighting stock components vs. the index. We recommend using variance swaps with a min/max weighting scheme. The trade is easy to implement, hedged against the volatility trend, and is an efficient way to capture most of the impliedrealized correlation spread.
Dow Jones Industrials – 1Y and 2Y implied and realized correlation, 2003-04

20% 18% 16% 14% 12% 10% 1M 6M

1/18/05 1/11/05 12/16/04

1Y

2Y

5Y

SPX Implied Realized Impl Corr. Rlz Corr.

1M 11.5 9.5 23.0 28.6

3M 12.0 10.2 27.7 23.7

1Y

1Wk Chg

13.6 Dn 0.9 11.1 Up 0.2 34.5 Dn 4.3 26.1 Up 1.3

NASDAQ 100 – volatility term structure

25% 23% 21% 19% 17% 1M 6M

1/18/05 1/11/05 12/16/04

65% 60%
1Y 2Y 5Y

ImpCorr1Y RlzCorr1Y

ImpCorr2Y RlzCorr2Y

55% 50% 45% 40% 35% 30% 25%

NDX Implied Realized Impl Corr. Rlz Corr.

1M 18.1 12.9 29.5 26.0

3M 18.6 15.3 35.6 25.0

1Y

1Wk Chg

20.2 Dn 1.5 18.4 Up 0.3 44.1 Dn 5.5 33.6 Up 1.4

Source – Bloomberg and BNP Paribas

Emmanuel Baror, CFA BNP Paribas Securities Corp. emmanuel.baror@bnpparibas.com +1-212-841 3126

12/31/02

3/31/03

6/30/03

9/30/03

12/31/03

3/31/04

6/30/04

9/30/04

12/31/04

Source – Bloomberg, Mergent and BNP Paribas – graph reflects former DJI composition before 4/8/2004

eqd.bnpparibas.com

Please refer to important disclosures at the end of this report.

US Index Option Strategies

19 January 2005

Volatility remains low despite the market pullback
S&P 500 – implied and realized volatility

20% 18% 16% 14% 12% 10% 8% 6% 9/23 10/14 11/4 11/2512/16 1/6 Imp1M Imp6M Imp2Y Rlz1M
Source – Bloomberg and BNP Paribas

After a few days of increased volatility in early January, volatility markets have moved back to the low levels of mid-December. The trend we saw in the last few months of 2004 is not yet broken and may indeed extend for a longer period of time: Short-term implied volatility remains close to its lowest levels, with the S&P 500 1M around 11.5%, the VIX at 12.5% and Nasdaq-100 1M around 18% versus respective lows of 10.9%, 11.2% and 14.9%.
n n Realized volatility remains low at 9.5% (S&P 500 1M) and 12.9% (Nasdaq-100). Intraday volatility is declining again, indicating that the uptick of the first few days of January has subsided. n The implied-realized spread has gradually increased from its low December levels to reach average levels by historical standards. Skews are stable, with the S&P 500 1M skew around 8.7 %. These stable conditions indicate that the low implied volatility levels are sustainable.

Nasdaq-100 – implied and realized volatility

2005 outlook: potential catalysts for rising volatility
Our volatility scenario for 2005 recognizes that volatility may remain low for some time. Our economic scenario points to a moderate rise in equity markets worldwide, which should favor low volatility. A historical comparison with the 1994-96 period shows that rising interest rates, strong economic growth and a weak dollar can produce a sustained phase of low volatility. In our view, the timing of a new volatility uptrend is unclear, but it may hinge on possible triggering events such as:
n a reassessment of corporate earnings following the switch to international accounting standards in Europe, or negative company or sector news in the US. n n n n

26% 24% 22% 20% 18% 16% 14% 12% 10% 9/23 10/14 11/4 11/2512/16 1/6 Imp1M Imp6M Imp2Y Rlz1M
Source – Bloomberg and BNP Paribas

renewed concerns about the dollar a financial crisis in Asia (China or India) rising oil prices a significant event such as a major terrorist attack an increase in M&A activity signaling rising and riskier equity markets.

S&P 500 – implied and realized spread

n

5% 4% 3% 2% 1% 0% -1% 9/23 10/14 11/4 11/25 12/16 1/6 Sprd1M Sprd2Y
Source – Bloomberg and BNP Paribas

Equity markets focusing on inflation and earnings
Financial markets expect the Fed to continue raising rates throughout 2005. The strong domestic demand, evidenced by rising retail sales and a record trade deficit in November, raises the risk of the Fed accelerating its tightening pace beyond 25 basis points at each meeting. In this context, inflation news will be watched closely, for instance the CPI and the Beige Book today. Equity markets are also watching earnings announcements, with the majority of companies reporting this week and next. While double-digit growth is expected for 2005 overall, investors will also be looking for greater contrasts between winners and losers, which may lead to increases in single stock volatility.

Sprd6M

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US Index Option Strategies

19 January 2005

Correlation and dispersion: basic concepts
Correlation trading attempts to capture inefficiencies in the pricing of options on indices compared to options on their component stocks. Implied correlation, as inferred from option prices, has generally been higher than realized correlation computed from actual returns. This is especially true for longer maturities, as displayed below using the example of S&P 500 1Y–2Y correlations.
S&P 500 – 1Y and 2Y implied and realized correlation

S&P 500 – 1Y correlation analysis

Volatility Average stock Correlation 34.5% Correlation 26.1% 22.9 21.6

55% 50% 45%

ImpCorr1Y RlzCorr1Y

ImpCorr2Y RlzCorr2Y

13.6 Index 11.1 Implied Realized

40% 35% 30% 25% 12/31/2002 3/31/2003 6/30/2003 9/30/2003 12/31/2003 3/31/2004 6/30/2004 9/30/2004 12/31/2004
Source – Bloomberg, Mergent and BNP Paribas

Source – Bloomberg, Mergent and BNP Paribas

Computing correlation in the context of an index works as follows:
n We compute the average correlation coefficient of the portfolio of component stocks given their individual volatilities and the volatility of the index. Correlation ( ρ ) measures the diversification effect by which relatively higher stock volatility at the stock component level diversifies away into lower index volatility.

S&P 500 – 1Y dispersion analysis
Variance Average stock Dispersion (19.7%)² Dispersion (20.2%)² (24.0)² (23.1)²

We solve for ρ in Where

σ I2 = å ωi2σ i2 + 2 ρ å ωiω jσ iσ j
i =1 j >i

N

σ I = index volatility, σ i = stock i volatility, ω i = index weight

(13.6)² Index (11.1)² Implied Realized

n Two sets of calculations can be done using either implied or realized volatilities. For instance, the current S&P 500 1Y stock components implied volatility (average 22.9%) diversifies away into an index implied volatility of 13.6%, which is consistent with a correlation level of about 34%, as displayed in the margin. The relatively larger gap for realized volatility (21.6% vs. 11.1%) yields a lower realized correlation of 26%. n The 8.4% correlation spread indicates that selling S&P 500 1Y implied correlation versus buying realized correlation might be profitable. However, since correlation is not a traded instrument, investors are faced with the issue of finding proxy instruments to capture the positive spread as closely as possible. n

Source – Bloomberg, Mergent and BNP Paribas

The S&P 500 and Nasdaq-100 correlation spreads are moderately attractive, currently in the 4-9% range for S&P 500 3M-2Y maturities and 9-11% range for Nasdaq-100. Please turn to our dispersion analysis on page 11 for more details. The implementation gap leads to the concept of dispersion. The mathematical concept of dispersion is closely related to correlation, but with the added advantage

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US Index Option Strategies

19 January 2005

that dispersion is easy to replicate and trade with derivative instruments such as vanilla options or variance swaps:
n Dispersion is the square root of the difference between the weighted average variance of component stocks and the index variance. Dispersion is expressed in units of volatility: N Dispersion = ω iσ i2 − σ I2

å
i =1

Implied dispersion and realized dispersion are computed through two separate sets of calculations. For the S&P 500 1Y maturity (as displayed on page 3), implied dispersion is currently equal to 19.7% and realized dispersion is 20.2%.
n

Dispersion vs. Correlation payoffs - S&P 500 3M swaps, 2003-04

4 Buy Dispersion Spread Payoff (%) R2 = 0.27 2 0 -5 -2 -4 -6 -8 0 5 10 15 20

The dispersion spread works in the opposite way to the correlation spread. Implied dispersion is generally lower than realized dispersion, as we can see in the graph below for S&P 500 1Y and 2Y maturities. The typical dispersion trade is therefore to buy implied dispersion and to sell realized dispersion.
n

S&P 500 – 1Y and 2Y implied and realized dispersion

38% 36% 34% 32% 30% 28% 26% 24% 22% 20% 18% 12/31/02 3/31/03 6/30/03 9/30/03 12/31/03 3/31/04 6/30/04

-15 -10

ImpDisp1Y ImpDisp2Y RlzDisp1Y RlzDisp2Y

Sell Correlation Spread Payoff (%)
Source – Bloomberg, Mergent and BNP Paribas

-10

9/30/04

12/31/04

Source – Bloomberg, Mergent and BNP Paribas

S&P 500 3M swaps – Correlation between strategy payoffs, 2003-04

As we can see by comparing the two graphs for the S&P 500, there are major differences between correlation and dispersion:
n They respond differently to changes in volatility. The value of dispersion, either implied or realized, partly reflects the market’s volatility and notably stock component average volatility. This is why dispersion curves declined over the 200304 period, in response to the general decline in volatility. n In contrast, correlation displays more independent variations. Correlation tends to respond to short-term changes in volatility, but its long-term variations are much less affected.

Strategy

Correlation 52.1% 34.0% -53.3%

Sell Correlation - Buy Dispersion Sell Correlation - Sell Index Variance Buy Dispersion - Sell Index Variance
Source – Bloomberg, Mergent and BNP Paribas

S&P 500 3M swaps – Average strategy payoffs, 2003-04

Strategy Sell Correlation Buy Dispersion

Average Payoff 6.6% -1.7%

As a result, correlation and dispersion swap payoffs (e.g. sell implied correlation, buy realized correlation over the selected maturity) reflect a positive but weak linkage. As shown in the margin for the S&P 500 3M maturity over 2003-04, the Rsquare of the regression between the two daily payoff series is only 27%. The correlation coefficient is only 52%. The buy dispersion strategy is also significantly negatively correlated to the variance swap selling strategy (-53.3% correlation). This confirms the significant exposure to variance gained from the dispersion strategy.
n n The 3M correlation swap strategy showed a comfortable profit level of 6.6% over 2003-04. However, the dispersion strategy showed a loss of 1.7%, mostly due to the

Source – Bloomberg, Mergent and BNP Paribas

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US Index Option Strategies

19 January 2005

adverse effect of long volatility exposure. The dispersion strategy appears weaker than the correlation strategy due to both unwanted volatility exposure and lower average profitability. We refer readers to BNP Paribas’ European research paper “Arbitraging component correlation” dated 1 July 2004 for a more theoretical analysis of correlation and dispersion. In the sections below, we present four main types of trades available to capture the dispersion and correlation spreads and provide recommendations for the current volatility markets.

The traditional dispersion trade
The traditional dispersion trade is to sell vanilla index options against a basket of component stock options. The main characteristics are summarized below.
Traditional dispersion trade with vanilla options – summary of characteristics

Characteristics Sell Buy

Index Replication Weighting Scheme
Payoff Type Trading Costs Maintenance Pros Cons
Source – BNP Paribas

Description An index options straddle, strangle or a combination of strikes in a set %ATM range to achieve the target vega N Straddles, strangles or combinations for each name in index replicating basket, depending on liquidity/strikes available 10-50 of the largest weights in the index for best representation Index weights (e.g. SPX, NDX) or equal weights (small sample) Realized dispersion - implied dispersion Initial options 1/2 bid-ask cost & commissions. Delta hedging costs and rollover costs for each option book. Delta hedge each instrument (index or stocks) separately until maturity and roll over options strikes to maintain vega after large spot moves Flexibility, for instance timing of buys vs. sells and selection of strikes given differing skews between index and stocks Requires significant maintenance, time and expertise. Requires risk management system to manage greeks' exposures.

The traditional trade offers ample flexibility for experienced volatility traders, but its high trading costs and delta-hedging requirements are difficult for the average investor to implement.

Synthetic dispersion trade with variance swaps: easy to implement and a good bet for rising volatility
Selling an index variance swap against a basket of component stock variance swaps is an easier way to replicate the dispersion payoff without incurring the burden of options trading and delta hedging. The dispersion payoff will be accurately replicated provided the investor applies the index weighting scheme at the level of the swaps’ variance units (and not the vega notional). In other words, the investor should:
n

Select the vega notional for the index and compute the variance units as vega notional / (2 x volatility strike)

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US Index Option Strategies

19 January 2005

n Compute the variance units for each stock by applying the stock’s weight to the index variance units. Compute the equivalent vega notional for each stock. n

The replicating basket may use the index weighting or an equally-weighted scheme. In practice, index weights seem better suited to a large replication basket (e.g. 50 stocks for the S&P 500) and equal weighting may work just as well for a smaller basket when tracking matters less.
Synthetic dispersion trade with variance swaps – summary of characteristics

Characteristics Sell Buy

Index Replication
Weighting Scheme Payoff Type Trading Costs Maintenance Pros Cons
Source – BNP Paribas

Description Index variance swap with desired maturity and vega notional N variance swaps on stock components Same as traditional trade (10-50 stocks) Index weights (SPX, NDX) or equal weights (small sample). Select variance units for stocks as index variance units times weight. Realized dispersion - implied dispersion, adjusted for the variance strike premiums over implied volatility 1/2 bid-ask spread on index and components variance swaps No position adjustment until maturity Easy to implement, no maintenance May want to hedge the delta exposure from variance swaps

The main drawback of this trade stems from weaknesses in the dispersion spread payoff. As discussed before, the true dispersion strategy has not been profitable in the declining volatility environment of the last 2 years. However, we believe that the strategy may do better in the current environment as the volatility downside is limited:
n The dispersion strategy with a maturity within the 1Y-2Y range would position the investor for an increase in volatility with unspecified timing, while in the meantime providing a small but positive return in a stable environment.

We forecast an increase in the dispersion of individual stock performances in the slow-growing but discriminating environment expected in 2005.
n

We therefore cautiously recommend this strategy for the next few months, provided investors are aware of the inherent long volatility exposure in the dispersion formula.

Tracking the correlation spread with lower stock component weights
Investors can replicate the correlation spread payoff more closely by underweighting the stock variance swap component in the dispersion trade. The intuition is simple: for every 1% increase in index volatility, stock components’ volatility probably increases by more than 1%, in proportion to their higher initial value. We can define new weighting schemes ( α i ) to both neutralize the long volatility exposure and better track the correlation spread, as follows:
n

The most intuitive response is to make the trade volatility (vega) neutral overall.

This method uses weights components å α i σ i
1≤ i ≤ N

α i = ωi σ I σ i

. The weighted sum of volatilities of

is equal to the index volatility

σ I , which results in the same

total vega notional for stock components and for the index.

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US Index Option Strategies

19 January 2005

n

Another method is the min/max weighting scheme suggested in our 1 July 2004

research paper “Arbitraging component correlation” (pg. 25). The suggested weighting scheme is variance-neutral and is designed to2 minimize the strategy’s worst payout ratio. The min/max weights are
n

α i = ωi

Investors may also select theta- or gamma-neutral weighting schemes.

σI σ i å ωiσ i

Our research paper “Arbitraging component correlation” includes a back-testing analysis of the payoff of the min/max strategy and concludes that the results come much closer to the correlation spread payoff than the original dispersion trade. The min/max scheme neutralizes the long exposure to components volatility and captures much of the positive correlation spread over time. The trade’s characteristics are summarized below.
Min/max weighting scheme for correlation spread approximation– summary of characteristics

Characteristics Sell Buy

Index Replication
Weighting Scheme Payoff Type Trading Costs Maintenance Pros Cons
Source – BNP Paribas

Description Variance swap on index N variance swaps on stock components Same as traditional trade (10-50 stocks) Lower stock weights to achieve overall variance neutrality and to minimize worst payout ratio Replicates approximately implied - realized correlation payoff 1/2 bid-ask spread on index and components variance swaps No position adjustment until maturity Easy to implement. Expect higher payoff than dispersion. Close, but not exact proxy for correlation spread payoff

The example of the Dow Jones Industrial Average may help investors understand the various weighting schemes available. Let us assume a dispersion trade using variance swaps for a vega notional (index part) of $1 million, a volatility strike (index) of 15%, resulting in variance units of 1,000,000 / (2*15) = $33,333. The average volatility strike of the 30 DJI stock components is 23.5%. The various weighting schemes are illustrated below for stock component Pfizer (PFE – volatility strike 25% and index weight 1.83%).
Weighting alternatives for the PFE variance swap in a DJ Industrial dispersion/correlation trade

Dispersion trade weighting scheme Index weights Equal weighted Volatility neutral Min/max weights

PFE Variance Units

PFE Vega Total Stocks Notional ($) Vega Notional ($) 30,500 55,555 18,300 11,681 1,516,129 1,516,129 1,000,000 656,736

610 = 33,333 * 0.0183 1,111 = 33,333 * 0.0333 366 = 33,333 * 0.0183 * (15/25) 233.6 = 33,333 * 0.0183 * (15*15) / (25*23.5)

Source – BNP Paribas and Bloomberg

In this example, we would advise investors to select a vega notional for PFE variance swaps of between $11,681 and $18,300. The PFE weight is lower than the $30,500 or even $55,000 vega notional in the straight dispersion trade. The lower weights result in a total vega notional for stock components that is below the $1 million vega notional of the index.

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US Index Option Strategies

19 January 2005

Correlation swap on custom stock basket
The correlation swap is the only instrument in our list whose payoff is directly based on correlation. The swap is initially set at the correlation strike and the investor receives the average correlation between all stocks in the underlying basket. The list of stocks in the basket, usually 20-30 names, is very flexible. It is not tied to membership in an index and can even include stocks trading in different global markets.
Correlation swap on custom basket of stocks – summary of characteristics

Description Correlation swap on custom basket (N stocks) None Basket Construction Investor selects names in basket from any market/country Weighting Equal weighted. Compute straight average of the N(N-1)/2 correlations Scheme between pairs of stocks using daily returns. Payoff Type Correlation. Strike price derived from historical (realized) analysis. Trading Costs OTC product, high trading costs imbedded in swap's strike price. Maintenance No position adjustment until maturity Pros Complete freedom in basket selection, easy to implement, no maintenance, pure correlation payoff. Cons Custom basket is difficult to price efficiently and hedge. Notional may be limited due to unique risks. Pricing does not allow to arbitrage implied-realized correlation spread.
Source – BNP Paribas

Characteristics Sell Buy

The correlation swap has several drawbacks that make it difficult to use in the context of correlation arbitrage:
n Since there is no market for implied volatility for the custom basket, pricing tends to reflect realized volatility computed from historical analysis. It is not practical to price or hedge the swap based on market indices (e.g. S&P 500, STOXX) due to the unique characteristics of the stocks in the basket. n Without a strike price based on implied volatility, the swap can hardly be used for implied-realized correlation arbitrage. This instrument is better suited for directional views on realized correlation or for hedging purposes. n

From a dealer standpoint, hedging is difficult and risks are significant. These costs are passed on to the investor in the form of a wide bid-ask spread. The size may be limited due to the dealer’s reluctance to carry unique correlation risk on his books. The correlation swap is an interesting instrument due to its high flexibility and direct linkage to realized correlation. While it will probably not help capture the impliedrealized correlation spread, it can be useful to implement views on correlation or to hedge correlation exposure.

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Strategic Research for Equities & Derivatives

US Index Option Strategies

19 January 2005

S&P 500 volatility
1M implied vs. 1M close/close and index level

As of 01/18/05 close

SPX = 1195.98

3M implied vs. 3M close/close volatility

22% 18% 14% 10% 6%

Imp1M

Rlz1M

VIX Index

S&P 500 1250 1200 1150 1100 1050 17-Dec

20% 18% 16% 14% 12% 10% 8%

Imp3M

Rlz3M

17-Jun

17-Oct

17-Aug

17-Sep

17-Jan

17-Jul

17-Dec

17-Aug

17-Sep

17-Jun

17-Oct

17-Jul

17-May

17-Nov

Implied and realized volatility statistics

Implied spread, skew and term structure

17-May

Implied Volat 1 Wk Change 1 Mo Change Pctile Rank Realized Volat Pctile Rank

1M 11.49 -0.9 -0.3 3.8 9.52 14.3

3M 11.99 -1.0 -0.3 1.4 10.25 4.4

6M 12.62 -0.9 -0.4 1.0 10.83 8.2

1Y 13.64 -0.9 -0.4 0.0 11.13 3.2

2Y 15.03 -0.7 -0.4 2.8 14.04 0.2

5Y 17.41 -0.6 -0.3 10.7 20.09 0.0

Sprd Impl-Rlz 1 Wk Change 1 Mo Change Pctile Rank Skew Pctile Rank
Volatility cone

1M 1.97 -1.7 -0.3 29.4 8.7 16.5

3M 1.74 -0.9 0.3 20.9 7.1 32.2

6M 1.80 -1.0 -0.6 32.0 5.8 45.5

1Y 2.51 -0.9 -0.4 58.4 4.6 62.0

17-Nov

2Y 0.99 -0.7 0.0 88.1

5Y -2.68 -0.6 -0.2 13.7

12M implied vs. 12M close/close volatility

20% 18% 16% 14% 12% 10%

Imp1Y Rlz1Y

35% 30% 25% 20% 15% 10%

Implied 5% Rlz High

Realized 5% Rlz Low

17-Dec

17-Aug

17-Sep

17-Jun

17-Oct

17-Jan

17-Jul

17-May

17-Nov

5% 1M 3M 6M 9M 1Y 1.5Y 2Y 3Y 5Y

Implied volatility term structure

Skew (percent of ATM)

20% 18% 16% 14% 12% 10% 1M 3M 6M 9M 1Y 1.5Y 2Y 3Y 5Y 1/18/05 1/11/05 12/16/04

35% 30% 25% 20% 15% 10% 5% 80% 90%

1M

3M

1Y

100%

110%

120%

130%

Source – Bloomberg and BNP Paribas

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17-Jan

US Index Option Strategies

19 January 2005

NASDAQ 100 volatility
1M implied vs. 1M close/close and index level

As of 01/18/05 close

NDX = 1573.49

3M implied vs. 3M close/close volatility

Imp1M 31% 27% 23% 19% 15% 11%

Rlz1M

VXN Index

Nasdaq 100 1675 1600 1525 1450 1375 1300 17-Dec

27% 24% 21% 18% 15%

Imp3M Rlz3M

17-Dec 96.2

17-Oct

17-Oct

17-Jun

17-Jan

17-Jun

17-Aug

17-Aug

17-Sep

17-Sep

17-Nov

Implied and realized volatility statistics

Implied spread, skew and term structure

17-May

17-May

Implied Volat 1 Wk Change 1 Mo Change Pctile Rank Realized Volat Pctile Rank

1M 18.09 -1.3 -0.2 7.6 12.91 1.8

3M 18.63 -1.6 -0.1 5.0 15.27 1.0

6M 19.36 -1.5 0.0 4.2 17.68 0.0

1Y 20.19 -1.4 -0.2 2.0 18.37 0.4

2Y 21.38 -1.0 -0.4 1.4 21.82 0.0

5Y 23.24 -0.6 -0.6 0.0 42.28 0.0

Sprd Impl-Rlz 1 Wk Change 1 Mo Change Pctile Rank Skew Pctile Rank
Volatility cone

1M 5.17 -2.5 2.9 70.8 7.7 56.7

3M 3.36 -1.6 1.4 51.1 5.7 59.2

6M 1.68 -1.4 0.6 41.7 4.6 71.8

1Y 1.82 -1.4 0.0 60.2 3.5 94.8

17-Nov

2Y 5Y -0.45 -19.04 -1.0 -0.4 0.2 -0.1 11.5

12M implied vs. 12M close/close volatility

30% 27% 24% 21% 18%

Imp1Y

Rlz1Y

80% 70% 60% 50% 40% 30% 20% Implied 5% Rlz High Realized 5% Rlz Low

17-Dec

17-Jun

17-Oct

17-Aug

17-Sep

17-May

17-Nov

17-Jan

17-Jul

10% 1M 3M 6M 9M 1Y 1.5Y 2Y 3Y 5Y

Implied volatility term structure

Skew (percent of ATM)

26% 24% 22% 20% 18% 16% 1M 3M 6M 9M 1Y 1.5Y 2Y 3Y 5Y 1/18/05 1/11/05 12/16/04

35% 30% 25% 20% 15% 10% 80% 90% 100% 110% 120% 130% 1M 3M 1Y

Source – Bloomberg and BNP Paribas

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Strategic Research for Equities & Derivatives

17-Jan

17-Jul

17-Jul

US Index Option Strategies

19 January 2005

Dispersion analysis
S&P 500
Correlation summary 1M implied vs. realized correlations and dispersion

18-Dec
18-Dec

18-Jun

18-Oct

18-Aug

18-Sep

3M implied vs. realized correlations

1Y and 2Y implied vs. 1Y realized correlations

50% 45% 40% 35% 30% 25% 20%

RlzCorr3M ImpCorr3M

18-May

18-Nov

55% 50% 45% 40% 35% 30% 25%

RlzCorr1Y ImpCorr1Y ImpCorr2Y

18-Dec

18-Oct

18-Jun

18-Aug

18-Sep

18-Jan

18-Aug

18-Sep

18-Jun

18-Oct

18-Jul

18-Jan
17-Jan

18-Jul

Implied Correlation 1 Wk Change Realized Correlation 1Wk Change Dispersion 1Wk Change Realized Volatility 1Wk Change

1M 23.0 -4.4 28.6 4.0 17.8 -0.5 9.5 1.1

3M 27.7 -4.3 23.7 0.5 19.8 -0.5 10.2 0.1

6M 31.1 -4.3 25.6 0.5 19.9 -0.1 10.8 0.1

1Y 34.5 -4.1 26.1 0.1 20.2 0.0 11.1 0.0

2Y 39.6 -4.0 32.1 0.0 21.6 0.0 14.0 0.0

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

1M Rlz Dispersion 1M Rlz Correlation

1M Rlz Volatility 1M Imp Correlation

18-May

18-Nov

NASDAQ 100
Correlation summary 1M Implied vs. realized correlations and dispersion

17-Dec

17-Aug

17-Sep

17-Jun

17-Oct

3M implied vs. realized correlations

1Y and 2Y implied vs. 1Y realized correlations

17-May

60% 50% 40% 30% 20%

RlzCorr3M ImpCorr3M

65% 60% 55% 50% 45% 40% 35% 30% 17-Jun 17-May

RlzCorr1Y

ImpCorr1Y

17-Nov

ImpCorr2Y

17-Dec

17-Jun

17-Oct

17-Aug

17-Sep

17-Jan

17-Oct

17-Jul

17-May

17-Nov

Source – Bloomberg, Mergent and BNP Paribas

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Strategic Research for Equities & Derivatives

17-Nov

17-Dec

17-Jul

17-Aug

17-Sep

17-Jan

17-Jul

Implied Correlation 1 Wk Change Realized Correlation 1Wk Change Dispersion 1Wk Change Realized Volatility 1Wk Change

1M 29.5 -4.9 26.0 5.0 27.8 -1.5 12.9 1.3

3M 35.6 -6.0 25.0 0.7 28.6 -0.5 15.3 0.1

6M 40.9 -5.9 30.9 -0.2 28.1 -0.1 17.7 -0.1

1Y 44.1 -5.3 33.6 0.1 27.1 -0.1 18.4 0.0

2Y 47.9 -4.5 38.6 0.0 28.6 -0.1 21.8 0.0

18-May

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

1M Rlz Dispersion 1M Rlz Correlation

1M Rlz Volatility 1M Imp Correlation

18-Nov

18-Jan

18-Jul

US Index Option Strategies

19 January 2005

Dow Jones Industrials and ETF/sector indices
Dow Jones Industrials
Volatility summary

As of 01/18/05 close
1M implied vs. realized volatilities

DJI 30 = 10628.79

17-Oct

17-Aug

17-Sep

17-Dec

17-Jul

17-Jun

Implied volatility term structure

1M implied vs. realized correlations and dispersion

17-May

20% 18% 16% 14% 12% 10% 1M 3M 6M 9M 1Y 1.5Y 2Y 3Y 5Y 1/18/05 1/11/05 12/16/04

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

1M Rlz Dispersion 1M Rlz Correlation

1M Rlz Volatility 1M Imp Correlation

17-Nov

17-Dec
27.3 -0.8 28.4 0.0 -1.0 4.0
SMH

17-Aug

17-Sep

17-Jun

17-Oct

17-Jul

17-Jan
RTH Retail 15.5 -1.7 14.2 0.0 1.3 6.1
1/11

Implied Volatility 1 Wk Change Pctile Rank Realized Volatility Spread Implied-Rlz Pctile Rank Implied Correlation Realized Correlation Dispersion

1M 11.13 -0.7 8.0 8.78 2.35 38.6 25.9 30.9 13.7

3M 11.99 -0.8 4.8 9.85 2.15 17.1 34.9 26.4 16.0

6M 13.03 -0.8 2.8 10.57 2.47 2.8 42.4 27.9 17.1

1Y 14.34 -0.8 2.8 10.77 3.57 20.7 48.1 28.4 16.7

2Y 15.54 -0.7 10.0 13.65 1.89 83.7 52.9 34.2 18.4

22% 19% 16% 13% 10% 7%

Imp1M

Rlz1M

DJI 30

10900 10650 10400 10150 9900 9650

ETF/sector indices’ volatilities
1M volatility summary 3M volatility summary

Base Index 1M Implied Volat. 1 Wk Change 1M Realized Volat. 1 Wk Change 1M Sprd Impl-Rlz 1M Skew
1M implied volatility
40% 35% 30% 25% 20% 15% 10% 8/11 IWM 9/11

IWM SMH Ru 2000 Semicon 19.9 0.0 16.0 0.1 3.9 7.5 29.1 -3.2 20.8 1.5 8.3 5.3

BBH Biotech. 21.1 -0.2 16.5 3.3 4.6 6.3

OIH Oil Serv . 27.9 -0.4 24.3 0.4 3.6 4.9

RTH Retail 15.7 -1.9 12.1 1.7 3.6 9.7

17-May

Base Index 3M Implied Volat. 1 Wk Change 3M Realized Volat. 1 Wk Change 3M Sprd Impl-Rlz 3M Skew
1M realized volatility
43% 38% 33% 28% 23% 18% 13% 8%

IWM SMH Ru 2000 Semicon 19.6 -0.3 14.5 0.0 5.1 5.7 28.5 -2.3 25.2 -0.2 3.3 4.1

BBH Biotech. 21.7 -0.1 20.9 -0.4 0.7 4.8

10/11 BBH OIH

11/11

12/11 RTH

1/11 SMH

8/11 IWM

9/11 BBH

10/11 OIH

11/11

12/11 RTH

Source – Bloomberg, Mergent and BNP Paribas

12

Strategic Research for Equities & Derivatives

17-Nov

OIH Oil Serv .

17-Jan

US Index Option Strategies

19 January 2005

Intraday volatility, credit spreads and historical skew
S&P 500
Futures intraday volatility and DJ CDX credit spread statistics
Intraday 5 day average 24 hrs Mkt hrs Current 1 Wk Change 1 Mo Change 11.1 0.4 1.6 18.7 0.3 2.4 Gap 5.4 0.3 0.9 1M realised 9.3 -1.0 -0.6 Intraday last 3 days 1/18 1/14 1/13 10.6 8.8 11.1

S&P 500 futures intraday volatility vs. 1M realized volatility

17-May

17-Nov

Current 1 Wk Change

DJ CDX Master and Hvol indices vs. 3M and 1Y implied volatility

Historical skew – 1M implied volatility vs. index level
22% Post Iraq w ar 29 Dec 03 to 24 Aug 04 25 Aug 04 to present Skew of 18 Jan 05 R2 = 0.45 R2 = 0.79

22% 20% 18% 16% 14% 12% 10% 6/16 8/31

Imp3M Imp1Y CDX (rhs)

70 65 60 55 50 45 40

22% 20% 18% 16% 14% 12% 10% 6/16

Imp3M Imp1Y CDX Hv ol

130 120 110 100 90 80 70

20% 18% 16% 14% 12% 10% 925

17-Aug

R2 = 0.41 975 1025 1075 1125 1175 1225

11/15

8/31

11/15

NASDAQ 100
Futures intraday volatility and DJ CDX spread statistics
Intraday 5 day average 24 hrs Mkt hrs Current 1 Wk Change 1 Mo Change 16.1 -1.9 2.6 26.7 -4.5 3.8 Gap 8.7 0.5 1.6
CDX Hvol 98.75 3.25

NASDAQ 100 futures intraday vol. vs. 1M realized volatility

1M realised 11.8 -1.1 1.3
3M Implied 18.6 -1.6

Intraday last 3 days 1/18 1/14 1/13 14.8 12.7 16.9

17-Jun

17-Jul

17-May

17-Nov

DJ CDX Master and Hvol indices vs. 3M and 1Y implied volatility

Historical skew – 1M implied volatility vs. index level
32% 30% 28% 26% 24% 22% 20% 18% 16% 14% 1050 1150 1250 1350 R2 = 0.44 R2 = 0.82 R2 = 0.74 Post Iraq w ar 22 Jun 04 to 09 Sep 04 10 Sep 04 to present Skew of 18 Jan 05

30% 28% 26% 24% 22% 20% 18% 16% 6/16

Imp3M Imp1Y CDX (rhs)

70 65 60 55 50 45 40 35

30% 28% 26% 24% 22% 20% 18% 16% 6/16 8/31

Imp3M Imp1Y CDX Hv ol

130 120 110 100 90 80 70 60

8/31

11/15

11/15

17-Aug

Current 1 Wk Change

1450

1550

17-Dec

17-Sep

Source – Bloomberg and BNP Paribas

13

Strategic Research for Equities & Derivatives

17-Jan
1650

17-Oct

CDX Master 48.50 1.25

1Y Implied 20.2 -1.4

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

Intraday (24hrs) Non-market hrs

Market hrs 1M realised vol

17-Dec

17-Sep

CDX Master 48.50 1.25

CDX Hvol 98.75 3.25

3M Implied 12.0 -1.0

1Y Implied 13.6 -0.9

35% 30% 25% 20% 15% 10% 5% 0% 17-Jun

Intraday (24 hrs) Non-mkt hrs

Mkt hrs 1M realised vol

17-Jul

17-Jan

17-Oct

US Index Option Strategies

19 January 2005

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