LEHMAN BROTHERS | Global Equity Research Equity Derivatives Strategy December 20, 2005 yan Renicker, 1212 senicker@lehner ca 425 Devapiya Mallick 1.212.526.5429 male oh Identifying Rich and Cheap Implied Volatility | One of the primary objectives of option market participants is to identify options having relotvely high or low implied volailiy to identify potential option selling or buying candids. © In this study, we present empirical evidence of the mean reverting characterisics of the implied versus realized volalily spread for singleslock options. We also examine hwo other quaniiaive mecs: the implied versus sectorweightedoverage implied volatiliy spread and the implied versus S8P 500 implied volatility spread, | We find that the implied versus seciorwaighled-average implied volatility spread hos been the single mast reliable indicator for predicting @ stock’s future realized volatility | We establish thal a scieening process combining each of these three indicators in unison improves option todes' dotiy io prolit by ientlying oplions that indeed are tnly rch or cheap. Although our screening process tends to work ccross business cycles over the backs! period (1996 - 2005), we observe that identifying rich or cheop options has become more difficult in recent years, particularly for options identified as being "cheap". We believe the largest focior conkibuing to tis phenomenon is the persisent downward trend in. mackst volatility since the beginning of 2003. Another factor could be thai the volatility market has become more efficient, with increasing usage of similar quantitative rich/cheap screens by option marke! poticipants, © In cddtion, we find that, on average, one-month implied volatility spreads tend to. more accurately identfy overpriced options, whereas three-month implied wolalily spreads cre generally o more reliable predictor for identifying options that are truly cheap. | We also find that using @ hwe-yeer lookback history when analyzing each of hese spreads resuls in 6 more accurate determination of whether on option is pricing in unreasonably high or low implied voll. | Ourrich and cheap matics have been consistent in identifying stocks with excessively high or low risk expectations enbedded in their options, regardless of which sector the stocks belonged to. Lehr Bathos doo ar seks fo do busines wth componiecovtedin We rotacch par. aval esto shuld be awote hal helm may have. cone of ints fal could alt the cbjectivy of i rept ‘Cuvomer of aha Brothers inthe Untied Stes can resiveIndoendent,thckpety research on he compny ar compan covered in thi report ot ao hem, har sich esearch sacle, Coders xn aati Indapercrtvseach ww lean. com cn cal SOD 2IEHAMAN ko veges apy lth vase Invests shoul cone is repr at arya snl acto in making he oyestmat decor PLEASE SEE ANALYST(S) CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 12,Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility Introduction One of the primary objectives of option market partcipans is to identity opiions having relatively low/high implied volalily to identify potential option buying seling candidates. Sines the tendency of volatility in equity markels to revert fo a longer term mean has been well esiablished, option Koders in the long run can profit if they con identify options hat hove unreasonably high or low implied volatilities hat are likely 1 reven Srudies have also demenstoted that implied volatility s a relatively reliable inclcoter cf wht the fuure level of reckized voailiy is expected to be, Moreover, implied volatility at the market level shows the existence of a volallty risk premium, as evidenced by the tendency of implied volaty to ade at premium to what the undetlying index had recenlly realized (realized volailiyl, This is the Compensation an eplion seller demands for taking on volaliy risk ‘Alter idenifying petential option buying or selling candidboles, options taders attempl to copiure prefis by dela hedging agains heir long or short option postion. Tha i, an opens irader who belioves the maket is pricing in relaively lowhigh isk expectotions for a stock can toke a long//short gomma. postion and delizhedge dynamically io lock in the difference between the volatility implied by the makei cl incopfion of the trode, and the stock's volaiilly thai is actualy redized over the corresponding period. A similar siategy is also available using everthecounter (CTC) pracuets such {5 variance oF volatility swops, whereby invests earn & poyoll dependent on future retin variability ‘and would not need to acively poticipate inthe dynamic hedging process. In oddition, investors con combine & view on futre volatlity wih their directional opinion of the underlying itso efficiently sructure a desired payof (Figure I], For instance, # Investors expecting © siock to cally in the near term might choose to buy calls if they are trading ‘cheap’, but sell pusif hey ore trading “ich” «A bearish forecast! of the underlying ceuld leed one to sel calls if implied volatley is high ane buy pusif it istading relavely low. Figure |: Positioning for Rich/Cheap Volatility Buy Calls Sell Puts ] i j i ‘Voit ew Buy Puts Sell Calls, Sauce lima Bots ‘While the foto return of on unhedged strctegy would likely be affected more by the movement in the undetying than by the level ofthe option premium, the relative magnitide of implied volatility would be an addliiond focter diving he yield, pariculanly ever shorter holding periods LEHMAN BROTHERS December 20, 2005 2Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility Identifying “Rich” and “Cheap” Implied Volatility In this study, we present empirical evidence of the mean evering characteristic ofthe implied versus tedized volatilily spread. We obo examine olher quantitaive metics, such as the implied verws sectorweighladaverage implied volailty spread and the implied versus S&P 500 Index implied volatlky spread. We onalyze each of these metrics separately, and in unison, in an effort to improve ‘our abiliy to idertéy options heving, unreasonably high/tich or lowi/cheep implied velatliy levels, Opticns tnly heve “rich” implied volotliies i their underlying stock's fuure realized velatity |"expost redized voletiiy’) turns cut to be lower than what was orginally implied by the options mentet’. On the other hand, we say cptions tuly have “cheap” implied velatites if their undeying stock's expost tedized volatilly is higher than what was criginelly implied by the epiions marke. Our universe consiss of socks tha! have been constivenls of the SBP 500 or the Nessaq 100 since Januery 1996 cand hove had eplions reding on them over his peri. We find that an oplion’s implisdealized spread indeed has a tendency to revett io is nearerm mean. However, we determine that the impliod versis sectorweighedaverage implied velliliy spread has been the single most reliable indicator for prediciing @ siock’s expeat realized volaliy We do find that an opiion's implied versus S&P 500 impli volailly spread is not © very 1obusi indicator for estimating a stock's expost realized volaiilly. However, combining all of these metrics Jogether provides the best reais, and has the highes predictive ability for identiying options having Lumeasonably rich or cheop implied volatiles. Thus, a screening process combining each of hese three indicaiors in unison should improve option traders’ ability fo prof by identifying options that indeed are tly rich of cheap, and delta hedge agains! a sher! or lang eplion position. In addition, the scieering mehodclogy can assis! in identfying instances when it mokes sense to express directional viewpoints in a stock by ether buying or selling options. The improvemert is found to be consisent across sectors and market cyeles over the sample period considered We find thot using T-month implied volatliy spreads tends io werk best when attempting to identify ‘options having rich implied veletities. On the other hand, 3merth implied volatility spreads tend to be «a mote relcble indicator when screening for cheap implied velatilties. In addtion, comparing current spread levels agains! their lnngertem histories |12 or 24 months) ~ rather then shetterterm periods (1 (or 3 months) — leads 0 beter resus for each of he thee implied volatliy spread menies cnalzed However, we oso emphosize that each of cur “ich” and “cheap” indicators must be analyzed in contex! with the unigue circumstances surrounding eoch potential volatliy rade, since ~ even though the average performance one would obtain by combining each of our thiee indicators in unison is the highest - the voriabiliy of returns temoins at high levels. On the other hond, despite the slaisical limitations an empitical screening process inhereny has, one should be oble to improve thar ability to idonify potential long or shot! volaiity candidates by using our volaily screening mehodology as & staring point for he sich versus chop vollily selection process The expo teaized spread isthe dflorence between he hte vlaltyteozed over he fem cfihe option, and tha implied at inceplon ofthe tack. Fer 2 hil cheap apie, the expos! teized sper! should by pave hemp valli tick, we would expect he expos! ealzed spread io be negate LEHMAN BROTHERS December 20, 2005 3Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility Indicators of Rich/Cheap Implied Volatility Implied - Realized Volatility Spread ‘he spread of implied to teclized volatility is © populor measure of he valailty isk premium, Since this spread is widely used by option investors fo identify the relaive richness or cheapness of an option, ‘we fits! lest his spread’'s power in forecasting expos! realized volaily. Figure 2: Expos Realized Spread versus Implied Realized Spread Figure 3: Diswibution of lnpiedReclized Spread z scores ‘etrkalon Skewed oo 7 Towsed “ 2 ° 2 + a a a 2.8m Range fn plessReaized Spread) 2-ore Range impled-Reazed Spread) Sov: lbman Bote, QptonMete ‘Saxe laran Bros, Cptetaties For ou bate cose, we group he ascere of the spied of the Smenth impled volailty lo 66 rading day realized volatility, relative to its 12-menih history, info bins cf 0.1 sanded deviations each, The 2 score for & given spread over a given time period is simaly equal to the number of standord devictions the cument sprecd level is fom its mean. I is similar 1, and highly correlated with, « percentile ranking. This leads to two key Frings © Ploting the zscore range ogains! the expos! recized spread in Figure 2 demonsttes the, con average, options hoving relatively low implied realized volat ly sprecds flower zscores) tend to have future realized volatiy higher than was originally priced into their eplions * Options having tlatively high implied ~ realized volailily sprecds |higher z scores) tend to have fulure reaized volatility thal & lower than whai was originaly priced into their options, Thus, i appears investors tend to underestimate the expected fue realized valatlty of & stock when curent implied ~ realized volalty spreads ote relatively low relative to the spread's | 2month history and overesiimate expacted lite realized volatliy when this spread is relatively high Fique 3 ilistates hat the zscore of Smonth implied minus 66 trading’ day redlized volatility tends to trade rich relive 1o its history mere clien than its tendency to trade cheap, similar to the distibution of the impliedzealized volatliy spread itself (negatvely skewed]. One possible explanation for this is that investors geing long velatity cre willing 16 pay premium, on average, fer the possibly of paticipating spikes in realized volatily, which have a tendency to occur whenever there i on unforeseen market “shock”. Alematively, investors selling voliliy will demand « premium for seling polentilly unlimied downside risk in the event of a surge in realized volatility ("gap risk’) We believe the relatively high frequency of very negative zscores might be explained by one of he key pilfols of the reclized velatility calculation isell. Specifically, it hos been wall established that redized volatility, which by definition incorporates historical returns, can be subject fo disconinuous jumps if 0 company’s stock price has an unusually large or highly negative reiun on & given doy. LEHMAN BROTHERS December 20, 2005 4Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility ‘When large moves such os this oxcur, realized volailily spikes os well ond will tend 0 remain of cbnermelly high levels unl the relum that coused the ini spike in recized volatily is no longer included in the realized volatilty colalation somple period fin ow study, 66 trading days afer the inilicl spike). implied volatity, on the cther hand, would probably rise os well immediately following the event, bui may revert lower in the days or weeks following the inti spike if the fuure risk ‘expeciations for the stock decline, and the dramatic move thal had recently occured is no likely to repect isin the near future, The combination of hese two factors likely undestetes options’ imolied = redized velailiy spreads during the 6 wading dys ater such realized volatliy spikes ccear, which would lead to a dispreporionately higher number cf highly negative 2xcores included in the analysis Implied Volatility Relative to the S&P 500 and the GICS Sector The impliedvedized spread, however, is no! & perfect mecsure of isk expectations since it compares «a forwarcHooking corsensus estimate of expected futre volailty (implied volailiy) with backwate looking standard deviation oF retuns (edlized velafly). In cdiion, «stock's retens and risk ere impacted by foctors reloted to the morket [systematic factors) as well 0s sector factors, apart fom its ‘own unique characlrisis (idiosyncratic component). We surmise that the sprecd of on option’s implied volatlity relative to the SAP 500 implied volaliy and the spread relative to the average sector volatility’ will allow us to mere completely isolate the idiosyneratie component of its total risk. We ‘examine the power of each cf these spreads in signaling the direction of future realized voli, Figure 4: Expoe Realized Spread Based on Implied vs S&P 500 Figure S: Expos! Realized Spread Based on Implied ve Seclor exrest Resized rad gaesuege 4 2 ° 2 « 2 Seere Range mes SEP S00 implies Spread) Score Range (npled-capVeghted Secor Ag implied) Soe: hmm Beha, Qptehtais Saves: linen Br, Optic Figue 4 ond Figue 5 digloy the zsccres of impliod volatlly spreads relative fo SBP 500 impliod volaliy and each companys weighed average sector implied valtilty, plated agains the slocks' ox pos! ture realized volatty spread relative to what had been criginally implied. We fird that ‘options’ implied volt relive 'o S&P 500 implied volatty hos rlcively low predictive power in estimating their futre realized volatility. Cn the other herd, options’ implied versus average sector volatlly spreads have the highest explanatory power for estimating future realized volality ‘Apo ftom the three spreads above, we also consider iF an option’s curtent absolute level oF implied velatlly relative to ts history can be @ relable indicator of richness or cheapness. We deline on ‘option as having “tich* abseluie implied velaliy if its curent implied volatlty level is ot leat 1 standard deviation above ils average implied velotility level forthe pas! yect. An oplicn is deemed to have “cheap” cbsolite implied volathly # is cunent implied voltilty is ct least 1 standerd deviation below ils average implied volatility level for the post yeer. As Figure 6 on the following page “The aveiage sec volatly is he mae! capioizatonveighled average implied velaiity of all docks in cut une tht bolo to the sce GICS sector. Ts les am fhe implied voltly la hypattatial ETF ex ancl index containing the same socks, which contains an edetonal implied conelaion componert LEHMAN BROTHERS December 20,2005 SEquity Derivatives Strategy | identifying Rich and Cheap Implied Volatility ilshtes, using en option's absolute implied volalily level by itself is « poor indator for conselly forecasting a sleck’s expos! eal.zed volalily. Thus, we will nol consider this metic when atlempting to identify options having rich or cheap implied volatlites, Incorporating All Three Implied Volatility Spreads Figuie 6 oso demonstiates tha! the predicicbiliy of the expos! realized volatliy is improved as we successively incorporate additenel volailily spread screening eleva’. That is, he expos! walzed spteod for gplions deemed to be “cheap” is highest and lends to increase more frequently when the 2 scares for implied minus realized, implied minus secior and implied minus SAP 500 wlailiy spreads ‘are all ass thon -1. Likewise, the expos! 1ealized spread for options labeled os “rich” is lowes! and Tends fo dectease more frequenily when the 2score for each of these spreads is greater than 1. We dlso find thot “ich” signals ore usually more reliable than “cheap” signds, possibly indicating the tendency ofthe matket to overprice downside risk expectations Figure 6: Bener Predictailily of Fuure Realized Volatility Using AllIndicotors Options with “Cheap” Voltity Options with Rich" Volasity 0% m% OH aK 0% 0% 2 40% mM % 10% 20% pe ox 20% % Som, 1% 10% 0% 2% o% m% 70% 2% InpledVol nplod Inplod- pice mp Fol AL Irplcs Vol pics: plod impibe- impel Al Fontes SPK np SX edcators 9% Carrel @ Avg epost Redzed Spread Sector Fooled SPR Sector Mp-SPK ndeator: Sax: ltinen Bh, O (2 Correct @ Avgex-pent Reed Send However, the impact of ouller returns is relatively large for each of these indicators, paticukaly when used fo identify options hoving sich implied volatlties. Thot is, the standard deviation of expos! tedized spreads itself (fr right column in Figure 7 on the following page) ionds fo be much larger thon both the average ond median expest realized - current implied volaility spreads for each of the indicators in isolation or togelher. Thus, an opiion identified as “cheap” or “rich” coud actually have much higher or lower fure realized volatily then what was originally implied, and a single long or shor! volaility posiion could make or lose substanidly mare money han whot is made, on average, for loige number of siilar postions across & wide range of options in the long tun Yin Fgne 6, "Coren is delnedat he propation cl cases whore seine vole med inthe dracon predied The cveoge ecpos alzed spreads he awrage difence between Live tedized volatily ond curert impled vet fr socks hat dear each screen Rich stocks cre expected io have lower lve realized vlaly ard @suocesh indole shuld maul in mere regetive expen! raczed spreads. Fer cheap socks, expos relied speed shoud be Higher fhe indicators meaning LEHMAN BROTHERS ———— December 20,2005 6Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility Figure 7: Performance of Screen for Rich and Cheap Implied Volatility "ease “watand’ tovaed™ carentingied Curetingied ‘Sead “Sprand More Ths One Std Devinion Lens Than One Venr Maan [Cheap Vola] ‘Abed mpled Valathy 195595 654g 40% —~OZTE Tae a Ip Reatued re pin Px 449426 68.308 © 46% ORTH OTR aI. wei Toms 8% seam 108% 27600 34.812 208% —«O6T% Bab yaw otra 27m te ozs fan OF Ireped vali 2986) ome ioe 15 75% Ipod Reateod soa. 0% 06% «= 2am 12K Inpia SPX 26447 srk zm tsam ga pin Sector seaaas es as ode IS az Ipod Rested, Impies Px soe om 2m 2am tS a0 Implod Reatod,ImolasSPX, plod Soca | 22.209 o% = 28% 38% wT Sexe: labman Bes, Optonehice However, itis wothwtile to nole that the percenlage of correc rich end cheap signals does tend to improve os we successively incorporate addiional voailly spread screening citerc. In addition, he average ard medion expos! realized ~ current implied volatiliy spreads lend to move “in the right direction” a5 we include adaitional screening cri Moreover, we do not aier ou universe to exclude special stuoiors such as MBA ct unique event faks, which lovestor would cevainly take inlo accaun! prict ta initating © singlestock ycletty pasion, even fa quantiaive screening process signals that the sock’ options ere rich or cheap ‘elaive to histvical spread metres. In other weds, an option could be “chee” ot “ich fer a reason, ‘and the expected rikadiusled tun of initting a Jeng cr shor veatlily trode might no! make sense given the unique tks exsocioted wth a sack. Finally, at noled earler, the discontinuous nate of ‘edized land implied) velatlty Ukely bicses the exppost realized ~ cument implied velathty spreads standd deviation higher These factors indicate thet our analysis likely ents on the side of consewetism ord — despite the staisticel limitations an empirical screening process inhererily has ~ invesiors should be able to improve their abilly to idenify potential Long or short vololly candidles by using our velatliy screening methodology 6s a stating point forthe ich versus cheap selection process LEHMAN BROTHERS December 20, 2005Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility Rich and Cheap Volatility Signals Across Business Cycles Next, we excmine whether these sich or cheap sgnols heve been « reliable predictor of fuure tedized volatlty across business eycles |1997 — 2005). Figure 8 and Figure 9 show tha! expast tedized volatlly for “ich” optons hos tended to be lower than whet wos originally eslimeled by ‘options marke! participants (implied volatity) throughout mos! of he sample period. In eddiion, expos! tedized volalily for “cheap” opliens tended to be higher than wha! was originally forecast throughout mast of the period and yzed However, we also observe that identifying tich or chop oplions has became mote dificult in recent yeuts, partculaly for options hoving “cheap” implied volutes. Tho is, flue wedized vokatiity for ‘options orginally idenified as having cheap implied volailiy did noi tend to exhib signficantly higher expos realized volailiy han what hed inaly been implied eoized volatility tended to dit lower throughout 2004 ond 2005). We believe the lorgest factor contibuting to this phenomenon relates to the persistent downward ttend in market voltiliy since the beginning of 2003, which made it clic to idenily options thot were tly trading “cheap”. On the other hand, the recent dectining volatlly regime likely made it easier to identify options that were tly “ich. Another factor ccontibuting 10 tis resub coud be that the velatlly market has become much more eficien!, with inetecsing wage of similer quantitative rich/cheap screens incorporated by option market participants, Figure 8: Monbly Performance of “Cheap* Signal Figure 9: Monty Performance of Rc” Signal cay Sgt A ne Se ser ten sit hg Pn Md Sp ee ‘Correct Cheap Signal — 0% 20 i tom De 10% Tom j wo 8 i a 2 ox i ic * © on 0% t 5 som PPP POP PLL PPPOE I PPES Sov: lbman Brea, QptonMetie Saves: laron Bros, Optetaties Are Near-Term Implied Volatility Spreads Better Indicators? In this section, we les! the predicive power of forecasing fuure realized velailiy (expos! realized) using zscores based an T:month and 3month implied volutes. Similar tothe fem suclue of interest tales, nearterm implied valaility responds more fo shorbteim catalysts and tends to be subjed to wilder ‘swings than longer dated implied volailiy. For exomple, Imorth implied volality can change asiicall, depending on whether or not @ material colokst, such as an eamings anrouncement, FDA lug approval or shareholder vote, is expected io ccour prior fo option expiration. f here is a colclys! forthcoming, Imorth implied volarity should reflect it and nade relatively high; fn, implied velatiy should trade low. On the other hard, 3monh implied volaility = which always includes of least one ‘earings period ~ tends to be much more stable LEHMAN BROTHERS December 20, 2005Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility 1-Month vs. 3-Month Implied Volatility Spreads The fist chart in Figute 10 compares the implied minus expes! realized volatlity spread for options having “cheap” |-morth volatliy versus options having “cheop” 3month implied volatilities. An eption is considered to hove cheap I-monh implied velotiliy # ts month implied volatility spread versus 22 tadngdoy realized, its Imonth sector weightedaverage voloilty spreod and Timon SP 500 implied volatliy spread ore at leas! 1 standard deviction below the average of where each of hese spteods had taded during the prior yeor (2scores <1). The same cfleic: apply for 3merth implied! volatiles, except he realized vdlailly sprecd encompasses 66 trading days and the average sector implied volatility ond the SEP 500 implied volailily correspond io 3 month forms. Semon impliod ‘olailily oppears fo be a beer metric for identifying stocks with rekavely low risk expectations. This is ‘also apparent in Figure 11, which shows the average diference between fuiuie reclized volaity and the volatility originally implied is higher using mcnth volilily, while the standard deviation of the metic is lower Figure 10: Relative Performance of Rich/Cheap Metrics Using One-Month ard ThreeMoath Implied Volatlily Matures = = eon rs is 7 i= is is is pet LLLP PPL SS PPP PPL LSS However, os the second chatt in Figue 10 istotes, I-month implied voloilly predicted fue tedized volaiity for opiions classified as “rich’ more accurately (athough the standard deviation is higher). One possible explanatin far this could be thal heighloned risk expectations offen coincide ‘with earrings announcements or other shortierm everts, ond investors lend fo express these concems using the front month cencet. Thus, shorHerm velailty would be more likly to revert sharply ence the catalyst has possed. invesiors purchasing unhedged options wah the front month maturity cose ko catalyst such as earnings would also tend to be willing 16 pay « larger premium to compenscte for the laiger expected swings in the underlying. On average, ‘his “incerainty premium” tends 1o elssipate ‘once the event has passed Figure 11: Dependence on Maturity of lmpliad Volatility smotnavoastyitstity | Toth #Comeer_—toGormeet "Rea Reine ested Spread "Cheap™ Options: T Meri imploa Tez46 TTT SE ae Tas S.Month imped, 4790117457 273% 125% 2.76% *Rich” Options. T-Nonth implies ipa ess 78% eae 0 S:Mont imped 2225914808 7B 8 8. 16.1% Sate: etna Bt, Options LEHMAN BROTHERS December 20, 2005Eauily Derivat 25 Strategy | Identifying Rich and Cheap Implied Volatility Optimal Look-Back Window for Calculating Average Spreads Lt this point, we have compared each of the implied volatly spreads i their respective 12-month histories and calculated the ascores based on the deviation fom their mean ever thet petiod. Is his the best lookback window over which to caleulate the longieim average of each spread er can we ‘empirically demonstrate beter prediction ef fulxe realized volalily using a ciferent ime period? Shorter peticds are more likely 1o coplure shortterm momentum elfecs while longer periods tend to smeoh out the impoct of random spikes inthe implied volattly history. We compare the accuracy of ‘our metics using 24monih, 12month, Jrmonth and I-month lookback historias for each of the tree implied volatility spreads onalyzed lusing 3morth constant maturiy implied volte) Figuie 12: Dependence of Predicibiityon Look back Histor for “Cheop” Implied Volsites, fe mate Ue tok ee (2mante| 12755 Gas 5 Bem Hom rma [42.003 189 10h Om RM PP PKS Sac ltmen Bers, Opto Figue 12 displays the impaci of changing the time peticd used for calculating the history of zscores for each of the sereods, for instances whon the three metics signaled volaility was “cheap”. I is lect thot the precietabilty of realized velailly increased as the lookback window agoins! which the spreads were compared was increased. in addiion, there were progressivaly fewer inslances when implied voldily wes considered cheap when measured agains! longer histories, and when using 'woryecrt look-back period, uiue ‘edlized volatily exceeded implied volatility about 58% of the ie. In addition, the average expost realized - implied spread was, on average, the highest when incorporating a 2-year lookback history Figure 13: Dependence of Predictably on lookback History for “Rich” Implied Votasities e e ‘tats | at acomet ees “Ries “AS Rata wher anette Cepid ‘See Tomante| 2017 1388 Gh BBR AON He teat [4228 deo ak Seam ff ££ A Soe: lbman Bros, QptonMete Figure 13 ilustates thet there is no significant diference in predictcbily for options signaled as having “rich” implied volatiies as the camparisen history is increased. While the longer history allows for more eceurate identification of the longterm mean ofthe volatlity spreed, it resuls in a weaker sigral when volatility has been cliven up in the near past because of upcoming catalysts. However, the average expost realized - current implied spread wos, on average, the mast negalive when incorporating a Zyeer lookback history. LEHMAN BROTHERS ————— December 20,2005 10Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility Volatility Mean Reversion Across GICS Sectors ‘An option’s implied volatliy, which measures the total risk expectation in the undertying stock, is naturally impaded by faders spectic lo « company’s sector. Figute 14 shows our rich and cheap matics hove, for he most part, been very successful in identifying stocks which have excessively high cr lows risk expectations embedded in their opions, regardless of which sector the slocks belonged to ‘Over a nine year history, options in the Consumer Staples sector that had eriginally been characterized by our sctgen as having cheap volatlty tended to have higherthan-oxiginallyantcspated tedized volatily over the next thee months in twarhitds of the cases. In addition, options in the Industrials end Consumer Discretionary sectors originally identified as having relatively sich implied volollly tended to have lowertheroriginallyaniicipated reclized velatilty over the following three months on more than 7 cut of 10 aceasiens. Figuie 14: Dependence of Indicators on GICS Sector ‘Cheap implod Votatity leh implied Voltiy be ANBEx post Ste Dev of Ex 4% AVOB post Std Dev oF Exe Sector Total cohect conect Realized postRRealized | Total oo". covect _ Realzed- post Realized Current impiod "Implied Current impiod "implied Coy Teas Eran [Toe e261 Dae atenats 2S 1295 58h 28S esse 2s nese we tS eae reais 2163 1557 6% 18 vase [598 2393 7% 459% weave Consumer Discretionary | 3.510 1962 56% «2a 2% |4m3 3360 mm 474% wane Consumer tapos sit 1068 66% 280% roux | 20% i372 orm Asa rene Heath care 2ori 1028 Sm 20m teszy [2005 Haas mR 70H. ye20% Fails ase 4177 ime 3.55% 7ea% [237 1523 om © _aso% ta Information Technology — | 1751 953 5th 5 ssie [a7 43s se tan seam Telecommunion Services | 202 28 42m 191%, risy | m1 dee Bom 22 897% Unites mi 402 eB gam [vi 7m we “16 waite Soven! lb Betas, Opto Conclusion We hove proposed three metics: zacores of he spread cf 1) implied vaoiliy to realized 2) implied ‘olatlily elove to the SBP 500 implied and 3) implied volatility relaive to sector weightecaverage implied volailty |GICS secir| fer identing options having ich or checp volatily. We have demonsraied thot, on average, using a screening criterion oF | score for each of these spreads results in mote accuiate prediction of fulue realized volatilly than ery single spread in iscesicn, although the standard deviation of the future realized ~ eurent implied volatty spread remains very high. We also fourd that, on average, one month implied volatlty sprecdls tend to mere accurately ideniily overpriced options, whereas three-month implied volatility spreads are genetally a mere teliable predictor for cheap options. In eddlion, we found that using @ two year lookback history ‘when analyzing ecch of these spreads results in & more eccurale detesmination of whether an option is pricing in unvecsonably high or low implied vai We believe - despite the statsicd limitations on empivical screening process inherenly has ~ one should be able 1o improve their ability to identify potential long or shot volatlity candidates by using ‘ou volilily screening methodology as 0 stating point in the tich/cheap volality selection process. ———— LEHMAN BROTHERS December 20,2005 11Equity Derivatives Strategy | identifying Rich and Cheap Implied Volatility ‘Analyst Cortifcation: 1 ya Raia, barby erly (1) he the views exprewed in his reteorch acl accu alc my parva views about any orl al the bat secu ot ‘were ralered n tis eal ond [2 no part my compensation wo, iF wilbe diel or nda eae tothe pac ecommendains or aw apron ints emo Options are not cultablo for all Investors and the risks of option trading should be weighed against the potential rowards. Supporting documente that form tho basis of the recommendations are avallable on roquoct. Please moto that the trade i this report in no way relate to the fundamental ratings applied to European stocks by Lehman Brothers" Equity Research. FOR CURRENT IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS RESEARCH REPORT, PLEASE SEND A WRITTEN REQUEST TO. Lehman Brothers Control Reem, 745 Seventh vera, 130 floor, New York NY 10019 cr efer tothe fms inclu ‘website at www Jehman.com /disclosures Important Disclosures The aaa espeniefor preparing his report have resined compensation boved upon various acters inlaing the Firms tbl ven, o portion of which is greta by verre barking aces ‘Thi mater has bean prepared and/or ied by ehnan Brot nc, aber SIPC, and/or one of ts oftloies Clehon Brahe) ar hos been approved by Lahan Brothers Ifrnatona top), aubonzad and vested by he Branca Sonica Aur, n eannacon wih dtcbton the European Ezronie ‘saa. This oil louie in ope by Lebron thr Japan Ie, at in Hong Kona by ltron Bicthars Ado Lied, This malls diisated in Avaia ty Lehnan Biter. Aus Py ited, end in Sngapere by Lean Beater Inc, Srgapere Bare (AIS) Where hs moter dished by LIS plane ‘ate tat tis tended or gonerdcclcton only and the rscommandations conta ned ern does notale i account he specie ivesner objectives, tronca ‘iui or partclar needs al any parce ptton-An vest shoud canst hs Linen chen’ presence vegardng he ttbly of he produc! and tke ine excount hi speceeser objec, nail stuaion a partly read: balove ha males cornet atcha th vaste ede. Temata i daibvad a Kaa by Liman Broa Ieratnal [Evtops)Seou! ranch. This document iso ilamationpurpets oy a shoud nat be vegaded a an (arf wl ere 2 sllation of orcs la buy the scares orca ncments meena ini Na prt fir cocard nay be eprckced i any area ‘nthow the writen pernision of ehen Brhas, Wik the exeypion of dicloruenreaing to lshwan Brother, his tsearch repo based en caret public Inman tha’ kar Brathrs consi rll, but we mate no apesentan ha acute or compl, and shoud nal be eld on atch I the 20 fan cele tthe aliet ha! han Biches ne. cs alias bowel own 75 a mate lay das ol commen eau sacurties ofthe abject conan. the computation of benelicial ownrsia cf euros based upon the mahodology wed to corp awnarshio under Secon 1 othe United Sits’ Sectites Exchange Af 1994 Inthe cone af orydileure tote aie tLe Brother nda llates hold a thor pon ata of can shore opin! ca parsulr canpany, wich diclware tle oly te od ary sre coptl of he company. Accordingly, whie uch coelon represen lahman Brother! holdings ne of ary lang euton Inthe onary share asic he company, such calan exlees ry righ a abgaans hat Laka Bator may cere hae, a which may aztue inh ute wh resect 1s sch acinar sare capi. Smithy sch caleston dees nat ilude ny share hald or cured lamon Soto's har sich sates areal under ewer aaieoment ct avangean! Bo Hw adie or = eautrpy eotearning the sates lauch company eg prime broking ond/or tack kndng octviy Any such cinco repre he potion o laine Broers os he ot burns ay af the ‘aeedar month preting tba ste of hit epar. Ths ails provided wth tbe undertonding Ye ler Braars i nt clog ina fiduciary capaci ‘Opinion exprenied hate sla he epnin af ahman Biches ard ow able 6 change haut natce. Th presets mantoned ie hs docu may at be lib fr sale in ome saa or coun, and hey mayo! be sutabl lar al pas of ests. an ivesor has ery daubt abeut sted! abit he shoul owl is Lekman Bren repetitive. Th vl lard ha income posiced by prods may Hate so ha an investor may gel back lots han ha esi aloe ond income may be adhere lected by achange rab ine ies, of cer fio, Ps prance b net necssrly lcci ot hire vette Fe prodvct is income pradvng, por he captives ray be ved to pay tht incre © 2005 aha Broher Al igh etaed. Aden inlomation i ‘vob on eet Please canaco Lehn Brchersexy'm yout hoe orien lehran Bote policy or managing cance nkted in comecon wih inven! reach somal a! yoeishman.smZnaicsadlicply. Bangs, ‘mings ger thore”Krecoss and. pice ‘orgel cantned. inthe Fam equty research repors coweing US. compones ore cccble ot ‘re lehoa. com dels, Compe clue information on companies covered by Lehan Brother Ent Resecch fs ovolable ct ww nan com aloes es LEHMAN BROTHERS December 20,2005 12