2014 Volatility Outlook Final PDF

EQUITY DERIVATIVES STRATEGY
Market Commentary
January 14, 2014
2014 U.S. Equity Volatility Outlook

Braking Bad?
Equity Derivatives Strategy
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.
Our report is divided into four parts:

1) Volatility: In the first section, we define our level for
baseline realized volatility by analyzing relevant underlying
Exhibit 3: Sector Volatility Outlook for 2014
economic fundamentals. We then examine potential
macro catalysts such as a spike in US interest rates, EM
Weight in 1Y Impl Volatility
contagion, and a meltdown in Chinas shadow banking
S&P Volatlity Sector Outlook
sector all of which are likely to inflate the premium
19% 16.1 Technology
accorded to implied volatility over baseline volatility. 16% 17.3 Financials
2) Skew & Term-Structure: In the second segment, we 13% 15.0 Healthcare
discuss investment trends in the derivatives markets to 13% 16.5 Consumer Discretionary
determine how the supply and demand for volatility from 11% 17.4 Industrials
hedge funds, banks, institutions, insurance companies, 10% 18.4 Energy
pension funds, and retail investors shape our views for 10% 13.1 Consumer Staples
3% 14.6 Utilities
index volatility skew and term structure.
3% 17.4 Basic Materials
3) Sector Volatility & Correlations: In the third part, we 2% 14.3 Telecom Services
discuss developing themes within the specific sectors that
are likely to influence volatility at the single-stock level and Lower volatility
how these changes could affect inter-stock correlations. Higher volatility
4) Trade Recommendations: Finally, in section four, we Source: Credit Suisse Equity Derivatives Strategy
wrap up by proposing trades that best reflect our views.
Edward K. Tom Stanislas Bourgois Terry Wilson Mandy Xu

ed.tom@credit-suisse.com Stanislas.bourgois@credit-suisse.com terry.wilson@credit-suisse.com mandy.xu@credit-suisse.com
(212) 325 3584 +44 20 7888 0459 (212) 325 4511 (212) 325 9628
(212
(
Executive Summary Framework for Analyzing Volatility

Baseline Volatility: The new normal is squarely Our discussion will utilize a framework that decomposes
upon as we exit 2013 with the lowest realized implied volatility into 3 components:
volatility since 2006. Accommodative global
1. Baseline volatility Our expectations for realized
monetary policies, accelerating economic growth,
volatility driven by economic fundamentals;
and record corporate earnings combine to provide
a constructive backdrop for equities. Looking 2. Kurtosis - The excess premium volatility traders
ahead, our Global Equity Strategy team has a charge to account for the uncertainty of tail-events;
2014 S&P target of 1960. Using that target price,
3. Skew The excess premium implied volatilities
we forecast a baseline S&P realized volatility of
trade above realized owing to the supply and
10.8% for 2014.
demand for volatility as an asset class.
Potential Volatility Shocks: From surging US
yields to a collapse in Chinas shadow banking
Illustration of Volatility Framework
sector, there remain a number of macro catalysts To illustrate this technique, we apply the methodology
that could drive implied volatility up to 30%. On the to the VIX at three instances in 2013: Mar 14th (lowest
other hand, accelerating economic growth reduces VIX reading), Jun 20th (height of tapering fear), and
the kurtosis premium currently embedded in Dec 31st (year-end).
implied volatility. Exhibit 4: Example Decomposition of VIX in 2013
Volatility Supply & Demand: Anticipated macro
shocks will likely manifest via skew and increase its Skew Premium
shock sensitivity. Against this backdrop, a 25 Kurtosis Premium

Baseline Volatility
forecasted decline in institutional & pension fund 20

overwriting, increased hedge funds' use of options
to express directional views, and the shortened
15
VIX
duration of insurance hedges should increase skew 10
convexity. Absent a liquidity event, the declining 5

inventory of legacy variable annuity exposures will
result in an increasingly illiquid and sticky back- 0
Lowest Vol Fed Tapering Dec 31st
end term structure. Source: Credit Suisse 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.
2014 Trade Recommendations
Top Macro Ideas Top Thematic Ideas

EEM zero premium hedge Short energy volatility, long USO (oil) volatility
Europe vs. US Outperformance M&A basket and risk reversal ideas
Long TBT call spreads Long European dividends
Bullish Japan (vanilla & exotic)
Long SX5E/Euro Hybrid Call
Short Index Straddles
***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
Establishing Baseline Volatility Bootstrapped Monte-Carlo
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).
Accordingly, to develop our estimate for baseline volatility,

we analyze the volatility of the price paths (via a boot-
strapped Monte-Carlo) required for the S&P to reach
Garthwaites S&P year-end target of 1960. As shown in
Exhibit 5, the average of the required volatility is 10.8% -
our expected baseline for 2013.
Exhibit 5: Expected Volatility Required for S&P to Reach 1350 Exhibit 8: Expected Volatility Required for S&P to Reach 2300 =13%
S&P level at 2014

2014 Scenarios Probability S&P return
year-end
Core Scenario 60% 2000 8.2%
Downside Scenario 20% 1500 -18.8%
Sunshine Scenario 20% 2300 24.5%
Baseline Vol = 10.8% 1960 6.1%
3
Potential Tail Catalysts (Kurtosis)

While we forecast baseline volatility at a benign 11%,
there are a number of macro catalysts that may
precipitate volatility shocks in the coming year. In the
following section, we explore in detail the top 3 macro
catalysts that we believe could have a significant impact
on equity volatility over the next 12 months:
Potential Catalysts That Could Drive VIX Higher

A Spike in US Rates: Last year volatility surged to a
1-year high at the mere suggestion of tapering. This
year, we believe a bigger risk is the Fed unexpectedly
raising (or talking about raising) interest rates. If that
were to happen, we could see the VIX jump 5-8 vol
pts higher.
Turmoil in the Emerging Markets: With slowing

growth, rising US yields, and mounting political risks,
the Emerging Markets could face a bigger crisis this
year than last years taper-induced sell-off. Potential
contagion could send the VIX up 5 vol pts.
China Shadow Banking Meltdown: China has seen a

bigger credit expansion, relative to GDP, than any
other country in modern history. However, its credit-
driven growth looks increasingly unsustainable. We
explore three key risks in the upcoming year that
could turn this boom into a bust and send global
volatility surging.
Exhibit 9: 2014 Steady-State VIX Forecast of 15%
4
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).
Exhibit 1: Interest Rate Equity Volatility Contagion
Source: Credit Suisse Research Source: Credit Suisse Research
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
What is the current degree of equity-interest rate

sensitivity? As shown in Exhibit 1, while contagion risk
remained elevated for most of 2013, it has declined
meaningfully since the Fed embarked on tapering.
Volatility spillover between interest rates and equities more
than halved after the Fed announced it was reducing its
asset purchases by $10bn in December.
Because Bernanke left open the pace of future

reductions, we expect tapering to continue to dominate
headlines this year. However, because of the decline in
volatility contagion, we do not expect it to be a significant
driver of equity implied volatility. Uncertainty over tapering
5
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.
Exhibit 5: Historical Market Performance on Rate Hike
Source: Bernanke & Kuttner 2004 ; European Central Bank, 2007
But will markets believe the Fed? Exhibit 4 suggests

maybe not. After the December FOMC meeting, interest
rate investors actually priced in a higher likelihood of an
early rate hike, despite the dovish guidance. The
probability of a rate hike in 2014, as implied by the
6
2. Turmoil in the Emerging Markets

The Yellen Indicators
Since the start of QE in late 2008, Emerging Markets
In a March 2013 speech, then Federal Reserve Vice have been the beneficiary of increased foreign capital
Chair Janet Yellen highlighted the five labor market inflows, as negative real yields in the US have forced
indicators she considered most informative. As she investors to look elsewhere for returns. CS Global Equity
takes over at the Fed, the announcement of these Strategy team estimates that Emerging Markets have
statistics could become volatility catalysts, as the seen total net portfolio inflows of ~3% of GDP. Thus, its
market tries to guess when the Fed may start raising not surprising that when the Fed began its taper talk in
interest rates. May, EM countries took the biggest hit. EM equities and
currencies tumbled 10-25% in the months after (see
Janet Yellens Favorite Labor Market Indicators: Exhibit 1).
1. Unemployment rate
2. Payroll employment Exhibit 1: Emerging Markets Sold Off Across the Board
3. Hiring rate (JOLTS survey)

4. Quit rate (JOLTS survey)
5. Real GDP growth
Top Interest Rate Hedge
For equity investors looking to hedge the risk of

rising interest rates, we recommend buying call
spreads on TBT (Ultrashort US Treasury 20+ Year Source: Credit Suisse Equity Derivatives Strategy
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.
Exhibit 2: Volatility Contagion Between EM vs. US Equities
7
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
8
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
Top Emerging Markets Hedge
Emerging Markets 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. As a hedge,
we like buying the Dec14 36-30 put spread funded
by selling the 44-strike call for net zero premium (spot
ref 39.78). See trade details on pg 34.
Source: Credit Suisse Research
*** The risk to buying a put spread is limited to the premium
paid. The risk to selling an uncovered call is unlimited. These unregulated lenders include trusts, wealth
management products, underground lenders, as well as
traditional banks off-balance-sheet lending arms (see
Exhibit 2). Credit Suisse China Economics team estimates
that shadow banking activity has surged in recent years to
a total size of RMB 22.8T, or 44% of GDP. It now
1
Volatility spillover measures the degree of co-movement between accounts for 25% of all outstanding credit and over half of
equity volatility and another asset classs volatility. For example, a new credit issued in the past year.
spillover number of 80% between the VIX and EM volatility in this
case means that whenever EM vol rises, 80% of the time the VIX Exhibit 2: Major Players in Chinas Shadow Banking System
will also increase.
9
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.
Exhibit 3: Inflation is Forecast to Rise Meaningfully This Year
Preemptive Deleveraging: The central government has Impact on Equity Volatility

been trying to rein in the explosive credit growth. It let
SHIBOR rates spike twice last year (the overnight rate We believe that a 2008-style unraveling in Chinas
almost tripled in June), in order to teach the market a shadow banking system is, for the moment, unlikely. The
lesson and weed out the most leveraged of the central government will almost certainly bail out the state-
unregulated lenders. But this concern about moral hazard owned companies to prevent an all-out panic. Even if
could be misplaced. Whenever governments try to teach there were a financial meltdown, contagion would likely be
markets a lesson, it almost never ends well. Case in point, limited because Chinas banking sector isnt that tightly
Lehman Brothers. Its too easy for the government to integrated into the global financial system.
misjudge how severe a credit crunch can be and how
expensive it can be to fix. When it comes to China, the Instead, we believe any turmoil in the shadow banking
PBoC could semi-deliberately create a crunch in the system would reverberate as an economic, and not a
shadow banking sector that quickly spills over into the financial, crisis. In the worst case, where the central
traditional one. government has to bail out state-owned banks and
companies, there would still probably be a lingering credit
Exhibit 4: SHIBOR Rates Almost Tripled Last June crunch. Chinas investment-led growth would take a
significant hit and so would its trading partners,
especially ones that supply it with raw materials. These
ripple effects on global growth could sink markets and
send volatility surging. Indeed, a recent IMF study
estimates that China accounted for a quarter of global
growth in 2013.
As the USs second largest trading partner, a slowdown in

China could potentially pull the US back into a recession.
In fact, CS Global Equity Strategy team believes China to
10
be the biggest risk to US growth in 2014. Recessions

typically result in some of the largest increases in equity
volatility. Over the past 70 years, US recessions have
produced on average a 19 pt surge in S&P realized
volatility.
We believe a good historical parallel is the collapse of

Japans credit-fueled asset bubble in the early 90s. At the
time, Japan was also the USs second largest trading
partner. During the first phase of the correction, NKY 1M
realized volatility surged over seven times to a high of
47%, yet S&P volatility barely reacted. It wasnt until US
economic growth slowed in response and eventually
slipped into a recession that we saw a significant spike in
US equity volatility (+13 pts to 26%; see Exhibit 6). We
believe a shadow banking crisis in China this year could
cause a similar jump in the VIX, up 12-15 pts to a high of
30%.
Exhibit 6: NKY vs. SPX Volatility at Peak of Japans Crisis
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
11
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
Of the three primary aspects of the volatility surface, skew

is the one that is most inconsistently defined. Even within
the same firm, the precise definition of skew may vary
from trader to trader and can refer to one of the following:
1) a volatility differential by moneyness (e.g.: 90%-110%
strikes); 2) a volatility ratio (e.g.: 90%/110%); or 3) a
volatility differential by delta (e.g.: 25 delta put 25 delta
call).
The common feature among these definitions is that they
all involve taking the difference of 2 points along the skew
surface. Although in relatively stable volatility
environments (i.e., low to moderate vol-of-vol and a VIX Source: Credit Suisse Equity Derivatives Strategy
level close to its historical average of 20), relative

Quantifying Skew Convexity
differences in the determination of richness or cheapness
of skew between the varying definitions is negligible, they We believe the effects of skew convexity will be especially
are all based upon a common assumption: that equity acute in 2013. Recall that in our framework, skew
index skew is downward sloping. 1 includes the probability of 2-standard deviation moves
(daily returns), whereas 3+ standard deviation moves
Recent developments regarding the likelihood of an manifest themselves within the tails (kurtosis). We
upside tail-event and the current low volatility regime hypothesize that if the market has built-in expectations for
may challenge this assumption going forward. Specifically: shocks arising from the previously mentioned macro
1) last years decisive market rally, a 3-standard catalysts, shocks that would normally precipitate a fat-
deviation event with the VIX averaging 14 tailed market move in excess of 3-standard deviations
2) lack of interest in selling calls given the low vol and would now have a more muted impact upon the
levels and opportunity cost of missing a rally market, resulting in smaller, 2-standard deviation moves
As a result, skew has become increasingly convex (more instead. We therefore expect volatility markets will
bowed), especially in recent months. experience higher rates of change in skew convexity (high
vol of skew) than in years past.
In these situations, measures of skew that reply upon
simple put-call volatility difference calculations can differ
vastly from measures that take into account its curvature.
1
Recall that downward sloping equity index skew has held sway since the
If this effect persists in 2014 we suggest supplementing
Crash of 87 to compensate for the empiricism that 1) large 3+ standard traditional measure of skew with a probability distilled from
deviation market moves are usually associated with market declines rather the implied distribution which represents likelihood of
than increases 2) portfolio managers are willing to pay a premium for
decline below a certain level.
downside protection 3) investors tend to harvest yield by selling calls.
12
Structural/ Transient Skew Decomposition Exhibit 3: Estimates of Volatility Contribution by Client Type
In order to discuss the time series of skew across Structured

different (high vs. low) volatility regimes, we reference a Retail, 10%
Pensions, 5%
definition of skew that is relatively insensitive to spot
volatility and takes into account the curvature of skew. Vol Funds,
30%
Specifically, we define skew using a modified form of the Insurance,
15%
variance swap calculation in which skew refers to the
premium of weighted volatilities across a range of strikes
over at-the-money implied volatility. Long Only/HF,
30%
In this framework, the time series of skew is subdivided
into two components: 1) a structural component
representing the volatility premium attributable to implied
Source: Credit Suisse Equity Derivatives Trading
volatility through investors desire to hedge or generate
yield under normal market conditions and 2) a transient
component of skew referring to the volatility attributable to
implied volatility via the desire to hedge in times of market
duress (see Exhibit 2).
Exhibit 2: Structural Skew ~ 1.0% in 2013
While admitting that the process of translating structural

demand to volatility requires a combination of art and
science, we attempt to do so by surveying each of our
major client groups in the following sections: hedge funds,
asset managers, insurance funds, structured retail, and
pension funds. We conclude by extrapolating implications
of emerging derivatives trends.
Our survey reveals that as volatility is likely to remain low
in 2014, institutions and fundamental long-short hedge
funds will likely rein in call-overwriting and other skew-
suppressing yield-enhancement strategies. Furthermore,
we expect to see an increase in option use to express
directional views. These activities should reinforce the
effects of increased skew convexity discussed earlier,
resulting in increased skew beta sensitivity relative to
spot vol.
.
13
Institutional/ Fundamental Long-Shorts Additionally, as investors become more confident in their

global equity investments, we would expect to see a
General Outlook
return in interest for European underlyings, in particular
Since the post-Crisis recovery in 2009, the primary long delta/long vol trades such as outperformance options
derivatives strategies employed by institutional and long- or simply outright long vanilla call options which have
short equity PMs have been premised upon 1) a become increasingly popular in the last months of 2013.
structurally elevated correlation regime and 2) a At current low implied volatilities, such structures offer
leptokurtotic drift (rising markets likely to be subdued but cheap participation in European outperformance in 2014.
falling markets likely to be abrupt). Thus, leading up to
2013, volatility savvy accounts generally focused on index
hedges or index level volatility/skew based yield Exhibit 1: Alpha Availability Increases as Correlation Declines
enhancement strategies that typically returned 200 to
300bps p.a.
To Heck with Hedging: Needless to say, after last years
decisive 30% market rally and the disappointing
performance of hedges in 2012, the vast majority of
institutional hedgers have now capitulated. Although a
number of catalysts (sequester, tapering, debt ceiling) did
in fact cause volatility spikes in 2013, they were too
muted and too short-lived for hedgers to effectively
monetize. Accordingly, hedging-related flow heading into
2014 was generally either unwinds or implemented with Source: Credit Suisse Equity Derivatives
the purpose of hedging the hedge.
Levered Delta: The more relevant dynamic for 2014, Exhibit 2: Options Turnover Declines as Delta Bets Increase
however, has been investors response to the decline of
equity correlation. As shown in Exhibit 1 which maps
correlation against the CS Alpha Availability Index, as
correlation declines to post-Crisis lows, the return
differential between the highest and lowest decile
performers in the S&P widens increasing the rewards
for superior stock-picking. As such, the exceptionally
strong market conditions amidst a backdrop of declining
correlation last year shifted investors away from index
level volatility arbitrage strategies towards the use of
options (mostly calls) primarily as levered delta
Source: Credit Suisse Equity Derivatives Strategy, Bloomberg
(directional) single stocks bets. 2
2014 Derivatives Trading Implications Exhibit 3: Opportunities for Skew Based Stock Replacement
Given our forecast for modestly higher equity markets and
low correlation, we anticipate 1) a re-emphasis on volatility
premium capture as a 200-300bps return is more
meaningful when market performance is modest and 2) a
focus on single stocks. This is likely to culminate in
increase in 1) sector level dirty dispersion (selling sector
straddles to buy calls on single stocks) and 2) skew based
overlay strategies to establish long delta positions (e.g.
selling puts to enter into long positions when put skew
steepens and buying calls to replace stock positions when Source: Credit Suisse Equity Derivatives Strategy
call skew flattens).
2
The shift away from gamma towards delta has triggered a decline in option
volume as delta based strategies incur lower turnover. Exhibit 2
14
Investment Bank Trading Desks

General Outlook Exhibit 1: iTraxx 5Y Spread Widens at Quarter-End
Basel III Credit and Equity Hedging Requirements3

New capital rules for global broker dealer banks under
Basel III have systematically increased the aggregate
market demand for credit risk protection and tail risk
protection for equity indices, particularly in the most liquid
indices such as the S&P500. In calculating risk weighted
assets (RWA) under Basel III, market-risk stress VaR and
the new credit valuation adjustment (CVA) require
significantly higher capital from banks. To partially off-set
some of the increased capital requirements for market
and counterparty credit risks in market-making portfolios,
banks have been incentivized to purchase and carry
greater levels of credit risk and tail risk protection. Source: Credit Suisse Equity Derivatives
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
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.
2014 Derivatives Trading Implications

Although many banks are relatively far along in adapting
to Basel III capital requirements, others are still at the
beginning of this transition. Thus, its possible that credit
indices experience even more outsized hedging demand
at quarter-end this year as more banks adopt the new
capital requirements. This could force some banks to
consider using equity index put options to hedge their
credit exposures. This dynamic suggests the possibility of
intermittent liquidity-induced increases in volatility near
quarter end for equity indices such S&P.
3
Dan Rodriguez, CRO Systematic Market Making Group
15
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.

Correlation: Earnings period may provide vol funds Source: Credit Suisse Equity Derivatives Strategy
opportunities to conduct sector correlation trades.
However at the broad index level, vol funds generally
consider the selling of correlation levels below 60 to be Exhibit 3: VIX Vol Surface a Potential Source of 2014 Alpha
statistically unattractive, we expect correlation to be an
opportunistic rather than systematic trade for vol funds in
2014.
120
Relative Value: With increased illiquidity in long-dated 100
volatility, term structure opportunities will likely be driven 80

Volatility
by term structure inversion. If our view of higher skew 60
sensitivity bears out, vol funds will likely focus on 40
exploiting dislocations in skew & skew term structure. 20

150
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
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
Insurance Companies
General Outlook Exhibit 1: Insurers Continue to Temper VA Sales
Against a backdrop of stringent solvency requirements

and a diminished supply of long-dated vega, the insurance
industry witnessed a significant retrenchment in variable
annuity (VA) activity. Two major carriers Hartford and
Sun Life completely withdrew from the variable annuity
arena last year, while ING and John Hancock both greatly
reduced the size of their VA books.
Even insurers who nonetheless remain committed to the

VA business continue to de-emphasize variable annuities
in their product mix and have gravitated towards equity
index annuities and other products with a more benign risk Source: LIMRA
profile. Thus, although VA sales have only trended down
by an average of 4% per annum over the last two years
as shown in Exhibit 1, the potential vega footprint of VAs
have decreased (the current product mix embodies less Exhibit 2: Variable Annuities Sold Post-Crisis are Deep OTM4
convexity risk as insurers continue to charge more for
products with comparatively less optionality). Compared
to the variable annuities sold pre-Crisis, current equity
variables annuities 1) are sold at a higher premium to
compensate for the excess costs of hedging required and
2) embed additional risk control features to obviate the
need for long-dated protection. From a volatility
perspective, the upshot of this two-pronged approach
coupled with the outright sale of some legacy VA blocks is
that insurers have been able to steadily reduce their
potential vega footprint.
2014 Derivatives Trading Implications Source: LIMRA, Bloomberg, CS Equity Drivatives Strategy
Because of the abovementioned product redesigns, the

bulk of the need for long-dated vega in 2014 arises not
from new sales but from the need to hedge legacy GMxB Exhibit 3: Declining Demand: S&P Long Dated Skew At 5Yr Lows
structures. The extent of this demand in turn hinges upon
the moneyness of legacy guarantees.
+2 Std: 1.7%
With the market at record highs, however, the vast 1.7%
majority of the implicit index put options underwritten by
Volatility (%)
insurers are currently deep out-of-the-money. As shown 1.6%

in Exhibit 2, which gives an estimation of the moneyness Avg: 1.5%
of the implicit index puts embedded into the guarantees,
1.5%
most GMxB written over the last five years currently range
from 10% to 50% out-of-the-money.
1.4% -2 Std: 1.4%
Moreover, as interest rates rise, the present value of VA
liabilities will be further reduced. As a result, barring a 31-Mar-13 30-Jun-13 30-Sep-13 30-Dec-13
steep market sell-off of 30 to 50%, insurers will likely .SPX Skew Avg(.SPX Skew) 2*Std(.SPX Skew)
remain net buyers of short-dated (0 to 2 year) volatility but Source: Credit Suisse Locus
will be relatively elastic with respect to long-dated (7 to 10

year) vega.
4
To quantify the moneyness of recent guarantees, we used the median level of the S&P for each
quarter weighted by that quarters new sales percentage contribution to produce the current average
moneyness of post-Crisis guarantees by vintage.
17
European Insurance Solvency Requirements Exhibit 4: Current Capital vs SCR (per country)
In Europe, insurance companies news flow continues

to center around the application of the Solvency II
directive. Omnibus II (the update of the 2009 Solvency
II European Directive) was agreed on by European
policy-makers on November 13, confirming that
Solvency II will be implemented starting January 2016.
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.
Overall, a more stringent SCR is likely to keep equity

allocations close to their current record low levels of 5
to 10% of assets across Europe (with anecdotal
evidence that allocations in Italy or Germany could be
as low as 3%). Additionally, the new regulatory
framework is expected to put a larger emphasis on
diversification and dynamic hedging strategies,
generally reducing the overall long-term vega footprint
of the Insurance sector in Europe.
Over the last couple of years, hedging activities by

European insurers have only been fractions of their pre-
crisis levels, and as such, are only a marginal driver of
volatility. We do not expect the volatility footprint of
European insurers to increase in 2014, mainly because
as discussed above, allocations to Equity
continues to be at historical lows with little
scope for increase (with the exception of Great
Britain and Scandinavian countries)
an even lower portion of this Equity exposure is
actually systematically hedged, and
more capital has been allocated to alternative
strategies, which are typically net short equity
volatility.
18
Pension Funds
General Outlook Exhibit 1: Pension Funding Deficit Below $100M
Back in Blackalmost. Following the Credit Crisis, US

corporates defined benefits (DB) pension plans spent
years quagmired in an industry-wide funding shortfall in
excess of $350 billion. Over the last year however,
funding levels were buoyed by two elements:
1) Stock market: the 32% S&P rally increased the
38% of plan assets linked to equities
2) Interest rates: the 84 bps increase in high-grade Source: Millliman
corporate bond yields from 3.96% to 4.8%,
coupled with legislative reform via the Moving
Exhibit 2: Corporate Pensions are Currently 93% Funded
Ahead for Progress in the 21st Century Act
reduced the present value of liabilities.
As a result, a recent Towers Watson study finds that the
funding status of Fortune 1000 DB plans has in
aggregate risen $285 billion, increasing funding levels
from 77% in 2012 to 93% at 2013 year end. Based
upon earlier precedents, as the funding levels improve, we
are likely to see corporate plans begin to de-risk by either
1) shifting their exposures away from equities into bonds
or 2) initiate buybacks via lump sum offers and annuity
purchases for formerly vested participants.
Source: Towers Waston
Similarly, the increase in rates and strong equity
performance has improved pension funding levels in
Exhibit 3: Pension Deficit Forecasted to be Erased By 2014 YE
Europe and notably in the UK, which traditionally has a
strong proportion of assets invested in equities (45%).
The aggregate UK funding gap based on IS19
calculations has fallen to circa 100bn despite adverse
implied inflation moves (most UK benefits are inflation-
linked). Because European pension funds tend to be
more geographically diversified than US, most of the
performance in 2013 was linked to overseas equity Source: Millliman
investments, with a clear overweight in US equities.
2014 Derivatives Trading Implications Exhibit 4: Allocation Away from Equities Capped Returns
Although pension plans pulled back on hedging during last

years equity market rally, with the market currently at
record highs, we expect the abovementioned de-risking
as a catalyst for a pick-up in pension hedging activity in
2014. Although pensions have traditionally been open to
hedging via a range of strategies, an increasing sensitivity
to premium expenditure will probably induce pensions to
focus on short-duration, zero-premium strategies such
put-spread collars. However, given that 1) only about 1%
of pension plans actually hedge and 2) the typical put-
spread collar strategies utilized by pensions usually have
low vega, we expect minimal vega impact at the market
level on behalf of US/Euro pensions in 2014. Source: Towers Watson, Milliman
19
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%
incorporating a number of innovations to improve the Avg: 19.1%
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%
the term structure.

17.0%
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.

Given the subdued outlook for rates in 2014, we expect
the bulk of the impact of notes upon the volatility markets
to stem from the inventory of income notes. In general
the risk profile tends to make structured trading desks
long volatility, short skew, short repo, long implied
dividends and short correlation.
Volatility: as shown in Exhibit 3, issuers are short volatility
as the underlying underperforms, as long as it stays
reasonably far from the down-and-in barrier, driving
(rolling) at-the-money volatility down6. In strong equity
Source: Credit Suisse Equity Derivatives Structured Products Group
markets, issuers become long volatility and are exposed to
implied-realized volatility decay.
Exhibit 3: Vega Profile of a 1Y DOI SX5E Put (Barrier 2,000)
Skew: Income notes push down implied volatilities for
strikes lower than spot, and push up implied volatilities for
strikes higher than spot. The large footprint of income
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
Systematic Investment Strategies Tail Hedging

Long the bane of every nervous portfolio manager, tail
General Outlook
hedging has also been addressed by the growing realm of
The use of systematic indices continued to grow rapidly in
systematic investment strategies. Amongst the greatest
2013, as investors sought to package various strategies
challenges of installing a systematic tail hedging program
into index format, and achieve the transparency, liquidity
is paying for decay when purchasing options that is to
and lower costs associated with these products. The
say, option premium is expensive, options often expire
evolution of index products took an accelerated turn post
worthlessly, and the net cost impairs performance to the
financial crisis, when investors went beyond better stock
point where not hedging is often the path chosen.
picking methods (also referred to as smart beta or
intelligent indices) to embed actual systematic strategies
Investment banks, exchanges, and asset managers have
within indices. Today, these tools have found applications
all assumed the challenge and over the past few years,
across a wide swath of users from pension funds, to asset
tail risk indices have proliferated with various profiles and
managers, and even retail investors.
characteristics. As the US market rose over 30% in
2013, predictably, these indices exhibited negative
Prevailing Themes
performance some severe.8
Based on recent flows and inquiries, we expect that the 3
areas of focus in 2014 will be:
Cross-Asset Portfolio Investments
risk premia capture
As investors sensed the end of the Feds QE program,
tail-hedging, and
conversations about rotating out of bonds and into
cross-asset portfolio investment strategies.
equities and other asset classes became more prevalent
throughout 2013. Moreover, there has been a growing
Risk Premia desire by institutions and private investors alike, to find
The concept of capturing risk premia today includes the systematic and disciplined approaches to managing cross-
realm of structured derivatives. Once the domain of hedge asset portfolios, by using either index swaps or ETFs as
fund traders, sophisticated derivative ideas can now be components of a balanced investment strategy.
found embedded into indices which have distilled those
strategies into its essential elements, via systematic rules- In many of these indices, the size of each constituent
based trades. Examples of these systematic strategies exposure is determined using the core disciplines of
for capturing risk premia include: modern portfolio theory, and this dynamic portfolio also
volatility risk premium, has an overall volatility target to control the cost of the
dividend yield curve, and options linked to it.
mean-reversion
Packaging these portfolio strategies into a single index
Volatility Risk Premium: attempts to capture the volatility product enables the investor to have a systematic, yet
risk premium of the equity markets. Derivatives traders active, approach to its assets, and reap the benefits of
have long held the belief that the implied volatility used in the convenience of what is traditionally considered a
equity option pricing typically often trades at a premium to passive instrument (i.e. an index). The appeal to
its realized volatility. This is typically explained by the investors of cross-asset portfolio indices remains
natural and persistent imbalance of investors seeking to unabated, and we anticipate further growth of AUM in
buy protection, and the general overpricing of future such products this year.9
expected risk. 7
Dividend Yield Curve Arbitrage: takes advantage of the
structural imbalances in the dividend yield curves of global 8
In order to combat the drag of decay, Credit Suisse launched its Advanced
indices. Defensive Volatility Index (Bloomberg Ticker: CSEAADVL) in 2012 which
Mean Reversion: captures mean reversion properties of takes positions along the VIX futures curve where the futures roll carry is
the market. minimized, and based on proprietary signals, the investor rapidly becomes
long volatility in times of market distress. Since its inception, this risk
hedging index remains our most talked about, and most traded index
product.
7
In 2009, Credit Suisse launched its Global Carry Selector Index
9
(Bloomberg Ticker: GCSCS), which utilizes equity index variance swaps to Credit Suisse launched its TEMPO (Tactical Efficient Markowitz Portfolio
capture this view, and given its strong performance, AUM in this product Optimizer) index (Bloomberg Ticker: CSEATMPE) in 2013, to address the
increased five-fold in 2011-2012. Despite more turbulent performance in growing desire of investors to not only achieve a dynamic cross-asset
2013, the index still experienced net inflows as investors maintained their portfolio, but also obtain exposure to the VIX an asset that provides a
confidence in the strategy. built-in tail hedge in times of market stress.
21
Summary: VIX Forecast For 2014

Given our underlying positive economic outlook, our 2014
VIX forecast reflects what we see as a continuing trend
towards a low volatility regime. Our core scenario uses the
framework detailed on page 2 of this report, which
decomposes implied volatility into 3 components: baseline
volatility (see pg 3), kurtosis premium (pg 4-11), and
skew premium (pg 12-17). We then analyze the possible
range the VIX could trade in over the next year by
overlaying potential shock scenarios.
Our steady-state scenario evaluates the case where no
major macro catalysts occur and the current economic
recovery continues unimpeded. In three other scenarios,
we estimate the increase to kurtosis and skew if one of
our top 3 macro catalysts rising US yields, EM
contagion, and China shadow banking meltdown were
to happen.
Our findings are summarized below. In our steady-

state scenario, we estimate the VIX will trade at an
average of 15 over the next year, representing a
marginal increase from the 2013 average. However, if
any of the negative macro shocks we outlined were to
occur, we estimate the VIX could trade in the 20-30
range.
Exhibit 1: Steady-State VIX Forecast of 15%
22
2014 Equity Sector Volatility Outlook

Exhibit 1: 2013 Performance Up to May 1st
As we enter the 6th year of a bull market, its hard to
believe that the current streak has lasted almost as long
as the run in the mid 2000s. Since its March 2009 low,
the S&P has returned over 170% and is 17% above its
pre-financial crisis high. Yet, not everyone is in on the
party. Only 5 out of 10 sectors have regained the grounds
once lost, with Financial, Utilities, and Telecom still a ways
away. But with correlation having (finally!) broken down in
2013, the environment is geared for sector/stock
selection and fundamentally driven alpha generation.
Catching the shift from defensives into cyclicals last year,
for example, would have added 15% alpha vs. the S&P.
In this section we identify the key performance drivers for
the S&P and the major sectors that will help frame the
fundamental outlook and our resulting sector volatility Source: Credit Suisse Equity Derivatives Strategy
views.
With rising interest rates and an accelerating economy,
Economic Outlook: CS expects the global economy to we expect sector divergences to continue. We see the
be the most orderly in many years. A stable balance of Financial sector as one of the key beneficiaries of the
modest growth, low inflation, and accommodative policies positive macro environment, especially banks (high net
will help global GDP growth accelerate to 3.7% in 2014 interest margins) and life insurance companies (better
after rising 2.9% in 2013. In the US, growth should portfolio returns). We also expect the Industrial sector
increase at a steady pace of 3%, driven by improvements the best performing group in 2H13 to continue to do
in housing and consumer spending. The key uncertainty is well as it has one of the highest correlations to US
the timing and magnitude of Fed taper. CS base case is Treasury yields. In contrast, industries with high financial
for a reduction of $10b per meeting but in reality the path leverage and low operating leverage will underperform
will be bumpier. Much stronger economic growth could, (rising costs and minimal sensitivity to economy). These
ironically, be the catalyst that pushes the VIX higher as it groups include Utilities, Telecom, Tobacco, Beverages,
brings forward the Feds tightening timeline. and Food.
Earnings Growth: CS expects S&P earnings to grow Exhibit 2: 2013 Performance After May 1st
7% in 2014 to $116. Growth will be strongest for the
Energy, Consumer Discretionary, and Industrial sectors;
while Consumer Staples and Financials are expected to
lag (although still positive). We have a year-end S&P
index target of 1960 which would put the market at 17x
earnings a level we believe is reasonable given low
interest rates, strong corporate balance sheets, and
accelerating economic momentum. With margins already
at record levels, companies will need to demonstrate
topline growth in order to meet consensus expectations.
Interest Rates: CS expects 10-year Treasury yields to
increase to 3.35% by year-end. Rising interest rates was
a key reason for sector differentiation last year. Up until
May when Bernanke first hinted at tapering, the defensive
sectors such as Utilities, Staples, and Healthcare were
leading the market with YTD gains of 15% or more (see
Exhibit 1). Following the taper talk, relative performances In general, we expect cyclical sector volatility to drift
reversed with cyclical sectors drastically outperforming lower, while the outlook for the defensives is more
defensives. In fact, most of the defensive sectors challenged. We detail our key sector volatility views in the
recorded negative returns for the rest of the year (see next few pages.
Exhibit 2).
23
Key Sector Volatility Views 2014: The Year of the Buyout?

Financials: We expect Financials volatility to move
Since the beginning of December 2013, there have
lower given improving fundamentals and lower
been 9 billion-dollar deals where the acquirers stock
earnings variability. It has the potential to approach its
price jumped higher by more than 5% on the day of
2004-2006 lows this year.
the announced (e.g. Fiat, Avago, Sysco, Textron,
Energy: We see an opportunity to pair a short Energy Forest Labs, etc). The average increase is a
sector vol position against a long crude oil vol hedge. staggering 17%. This could be the much needed
The outlook for energy companies is constructive, positive reinforcement from investors to corporate
despite the fact that we see downside risks to oil management for increased M&A after a long period of
prices in 2H 2014. muted transactions.
Utilities: With rising interest rates and competition
from renewable power sources, the utility sector could
experience more volatility than its traditional low beta
status would imply.
Technology: Disruptive technology along with the
impact of Amazons expansion in the cloud storage
business should keep a bid to tech sector volatility in
2014. We also see increase M&A as a vol catalyst.
Exhibit 3: 2014 Sector Volatility Outlooks
Weight in 1Y Impl Volatility

S&P Volatlity Sector Outlook While IPOs had a banner year in 2013, M&A deals are
19% 16.1 Technology still running more than 50% below normal levels.
16% 17.3 Financials Leading indicators of M&A including higher equity
13% 15.0 Healthcare markets and increasing CEO business confidence are
13% 16.5 Consumer Discretionary decidedly positive. Recent surveys indicate CEO
11% 17.4 Industrials willingness to increase M&A in 2014. Further, FCF
10% 18.4 Energy yield remains significantly above corporate bond yields,
10% 13.1 Consumer Staples suggesting M&A should be cash EPS accretive. We
3% 14.6 Utilities expect the recent performance of M&A stocks to help
3% 17.4 Basic Materials
drive an acceleration in corporate activity.
2% 14.3 Telecom Services
Lower volatility
Higher volatility
CS has a Delta One basket comprised of top analyst

picks for potential M&A targets: CSUSUSMA Index.
This index outperformed the broader market by 10
points in 2H13.
24
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
new export LNG terminals come online.
25
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
details, please see pg 35. 190

2.00
***The risk to selling a variance swap is unlimited. The risk to 180
buying a variance swap is that variance could go to zero. 170 1.50
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
Renewable Energy: The long awaited

competitiveness from renewable energy is finally
upon us. While still small vs. traditional power
generation, improvements in technology have
made solar and wind energy cost competitive.
Generally, only natural gas generation is cheaper
now than wind and solar. As a result, CS
estimates that renewable energy could meet
~85% of future utility demand growth. This is
likely to hurt the earnings outlook for the
competitive power generators.
Exhibit: Solar and Wind Are Cost Competitive
Source: CS Equity Research

26
Financials: Yielding to Regulation 2014. Recent performance of M&A deals should

fuel investor enthusiasm.
The impact of regulatory reform is now evident for the
financial sector. Increased capital, along with tighter risk Regulations: Key headwinds from enacted
controls, are reducing the variability of corporate results regulations (Dodd-Frank, Volcker), as well as
and creating a system better able to withstand downside litigation risks (mortgages), are largely in the rear
shocks. As we forecasted last year, the financial sector view mirror. This should allow investors to refocus on
broke a streak of 6 consecutive years as the most volatile improving trading and banking results and reduce
major S&P group. We expect this trend to continue, and the regulatory risk premium. The Fed stress test in
argue that volatility could approach something closer to March is a central driver for the brokers as it could
the 2004-2006 lows when the sectors vol realized an pave the way for a significant increase in return of
average of 12%. capital (dividends or buybacks) for shareholders.
Exhibit 1: Sector Scoreboard Valuations are supportive with the brokers trading at 1.2x
2013 Implied 2013 Realized 2014 Implied tangible book value.
Vol Vol Vol
Financial Sector 19.9 14.6 17.7 US Insurance. Following a 47% return in 2013, CS
Source: Credit Suisse Equity Derivatives believes we are in the late innings of the re-rating trade.
US Banks. CS remains constructive on the outlook for However we still believe the sector is moderately attractive
banks, although the bullishness is tempered versus last given cheapish valuation and favorable macro conditions.
year following a 38% rally for the group. We view the We see the following as the key drivers for the sector:
following factors as drivers of 2014 bank performance: Rising Yield Play: The insurance sector is positively
Capital: Five years post credit-crisis, banks have met levered to rising bond yields as it increases the
Basel I standards and are making progress towards return on the investment portfolio and reduces the
meeting stricter Basel III capital requirements. The present value of liabilities.
Fed stress test in March should again provide Non-Bank SIFI Rules: In mid-to-late 2014, clarity on
additional clarity for the banks and allow them to the new capital rules for non-bank SIFI companies
continue returning capital to shareholders. will begin to emerge. We expect the rules will favor
Revenue: Our tempered bullishness stems from a the P&C group over the Life companies given they
muted revenue outlook, as banks are facing have lower leverage and less VA exposure.
headwinds from slowing mortgage refinancing, and
sluggish loan growth. Exhibit 3: Strong Correlation Between Insurance and Yields
Expense control will again a focus, and should help drive

10% EPS growth in 2014. Valuations remain supportive,
with the group trading at 10.8x 2014 estimated earnings
and 1.4x tangible book value. The key upside surprise
could come from faster than expected economic growth,
as bank results are highly levered to loan growth and
higher net-interest margins.
Exhibit 2: Large Cap Banks- Fundamentals Continue to Improve
2012 2013E 2014E
Capital (B1 Tier Comm) 10.6% 11.0% 11.8%
Capital (B3 Tier Comm) 8.7% 9.6% 10.5% Source: Credit Suisse Equity Research, Thompson Reuters
Profitability (ROE) 10.9% 9.7% 10.8%
Credit Quality (NCO)
Valuation (P/E)
1.2%
14.4 x
0.7%
11.9 x
0.6%
10.8 x
Trade Idea Recommendation
Source: Credit Suisse estimates. Peer group includes BAC, C, JPM, PNC, USB, WFC.
We recommend a long delta and short vol position for
the Financial sector. 1Y implied vol is currently at 18%,
Brokers/Capital Markets Outlook: The outlook for the and we expect the sector to realize below 15% this
brokers this year is bullish for the following reasons: year, with a chance of falling below 13%. Note that
Banking activity: Banking transactions have due to new regulations, there are few natural sellers of
increased and CS forecasts 10% growth in M&A Financial sector vol, providing an edge for those who
deals next year. IPO volumes last year were the are able to execute the trade.
second best post crisis and should stay strong in
27
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.
SDN: Software Defined Networking is a relatively

new technology that allows for better optimization of
network traffic (which carries internet traffic, mobile
data, etc). SDN allows users to decouple the
software (which directs traffic) from the router
(which pushes it to users). This process can reduce
28
European Sector Outlook

The Return of Earnings Growth Exhibit 1: Sector Liquidity Profile
Call OI Put OI
Notional Notional Total
With Europe finally emerging from its recession, Credit Code Name Last (EURmio (EURmio) (EURmio)
Suisse expects the region to perform well in 2014. Our SX7E ESTX Bnk Pr 147.6 3,365 4,343 7,708
Global Equity Strategy team forecasts a 2014 return of SXPP
SX6E
STXE 600 BsRs Pr
ESTX Util Pr
390.4
248.7
1,080
164
445
92
1,525
256
16% for the SX5E (year-end target of 3,600). We see SX7P STXE 600 Bnk Pr 200.3 104 113 216
three main drivers of this rally: SXEP
SXEE
STXE 600 Oil&G Pr
ESTX Oil&G Pr
337.1
323.4
126
98
32
30
158
129
SXAP STXE 600 Au&Pt Pr 480.7 12 107 119
Growth: CS economists forecast GDP growth of 1.3% in SXKP STXE 600 Tel Pr 299.9 31 84 115
2014, mainly on the back of reduced fiscal tightening. For Source: CS Derivatives Strategy.
the first time since the beginning of the Euro-crisis, lead

indicators (e.g. manufacturing PMI new orders) are having
Exhibit 2: Sector Volatility Profile
a sustained recovery. Moreover, house prices are 3M Imp 3M 90- 1Y-3M
beginning to stabilize in markets where previously they Code Name Vol Pct'l 110 Skew Pct'l TermStru Pct'l
had been falling (for example, in Dublin and the SX7E ESTX Bnk
SXPP STXE 600
23.4%
22.4%
6%
17%
4.5%
3.3%
30%
4%
1%
2%
64%
80%
Netherlands) and bank lending conditions have eased SX6E ESTX Util 17.4% 17% 4.9% 63% 1% 45%
SX7P STXE 600 Bnk 18.2% 5% 3.6% 9% 1% 51%
considerably over the past year, especially for mortgages. SXEP STXE 600 Oil&Gas 13.8% 14% 5.2% 82% 1% 18%
CS also sees scope for a rebound in consumer SXEE ESTX Oil&Gas
SXAP STXE 600 Au&Pt
15.7%
20.2%
13%
11%
4.1%
5.3%
13%
86%
1%
1%
33%
51%
discretionary spending. SXKP STXE 600 Tel 14.2% 0% 2.8% 22% 2% 99%
Source: CS Derivatives Strategy.
Monetary Policy: As a result of deflation concerns
European Banks (overweight): According to CS Research,
(Credit Suisse economists forecast an average inflation
European banks are expected to outperform in 2014, in
of 1.1% in 2014 vs. ECB target of about 2%), the ECB
particular French banks. This is primarily due to a sizeable
could ease further, including conducting another round of
lag in performance vs. European indices, and also
LTRO, cutting the deposit rate, and reducing repo
because the ECB could surprise in 2014 with measures
requirements.
expected to boost banks profitability, such as a UK-style
Earnings: CS forecasts Euro-area earnings to grow by funding-for-landing scheme or a further easing of
11.1% in 2014, driven primarily by margin expansion. collateral requirements for SME loans. Over the last 2
European margins are currently only half of USs levels. years, Banks implied volatility has consistently been a
Earnings should also benefit from an expected weakening good short, with negative P&L occurring only 16% of the
in the Euro against the dollar (Credit Suisse FX Strategy time. At 22.2%, SX7E 3-month implied volatility is high
has a year-end forecast of 1.24). Specifically, we versus other European sectors, and only 3% of all realized
estimate that a 10% fall in the Euro would increase observations for the last 3 years fall under this level.
earnings by 10%.
Basic Resources (underweight): Miners, a key
Overall, the 2014 European equity outlook favors cyclicals underweight according to CS Research, represent over
and financials, while mining, oil and utilities are still 70% of the SXPP index. Miners suffer from a large
expected to underperform the rest of the market. exposure to Chinese tail risk, stretched valuations, and
low capital discipline. Falling commodity prices or a
stronger dollar could magnify the above issues. At 22.3%,
3-month implied volatility is cheap relative to history (17th
Key European Sector Views percentile versus last years observations, see Exhibit 2),
As shown in the Exhibit 1, European sector options have and more than 20 points lower than 2008 pre-Lehman
relatively low liquidity compared to their US equivalents. levels).
Only two sectors have a total listed open interest notional
Utilities (benchmark): with the exception of UK power
exceeding EUR1bn: SX7E (Eurozone Banks) and SXPP
generation, European utilities suffer from high financial
(Europe Basic Resources). There is, however, much
leverage at a time when interest rates are expected to
deeper liquidity in the OTC market. Generally, five years
rise, falling power prices in a context of over-capacity and
after the financial crisis, volatility has fallen back to pre-
high political and regulatory risk after a decade of rising
crisis levels across European sectors. Volatility term
electricity prices. This defensive sector ranks high in
structure is steep across the board, except in the case of
implied skew (50% percentile over the last year), although
Oil & Gas, while skew remains slightly elevated (Exhibit
reasonably cheap in implied volatilities.
2).
29
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
potentially landing a profit of 2.5 vega in a vega-flat 500
dispersion trade. 400

PnL
300
200
Exhibit 2: S&P 1Y Implied-Realized Correlation Spread 100

0
50% -100
-200
40% 0.2<<0.4 0.4<<0.6 0.6<<0.8 0.8<
30% Source: Credit Suisse Equity Derivatives Strategy
20%
10% 2) Typically, transaction costs for trading the index

0%
and single stock legs in dispersion trades (around
0.5 vega for the index and 1 vega for the single
-10%
stocks) mean that the effective level at which
-20% correlation is shorted is much lower than mid
-30% estimates. In times of low volatility and (still)
1997 1999 2001 2003 2005 2007 2009 2011 2013 elevated correlation such as now, this impact is
Source: Credit Suisse Equity Derivatives Strategy magnified. We calculate that transaction costs
30
knock out up to 15 correlation points in a Exhibit 4: Strength of Information Read-Through

dispersion trade, implying an effective correlation
level of slightly under 40. Only in 2011/2012
were transaction costs higher, but that was also
during a time when correlation itself was also up
to 20 points higher.

Correlation-Induced Market Beta Inversion
Typically the level of correlation follows as a response to
overall index level trends and volatility. For example, when Correlation Forecast for 2014
the market falls and volatility rises, correlations tend to
Our implied correlation forecast is constructed using our
increase. With the market now at record highs, equity
index implied volatility forecast (VIX at 15, see pg 21) and
investors will be seeking to validate current levels. With
our sector level implied volatility forecasts (see pg 23). In
the dissipation of most major macro overhangs and
contrast, our realized correlation forecast is based upon
correlation remaining at low levels, the source of that
the Monte-Carlo scenario analysis described on page 3.
validation will come from company earnings. Individual
Based on these two techniques, our 1Y median implied
company earnings releases from industry leaders will likely
and realized correlation forecast for the S&P-500 is 38%
become mini-volatility catalysts. As a result, we are likely
and 33%, respectively.
to experience a market beta inversion in which rather than
stocks moving in response to the S&P, the S&P (and by
extension S&P vol) will move in response to individual As a result, dispersion trading activity in 2014 is thus
stocks. likely to be either 1) opportunistic: selling dispersion on
market events such as the ones discussed in the Volatility
With fundamental drivers in focus, the market will
Catalysts section on page 4, or 2) selective: going short
extrapolate new information onto applicable market,
index versus going long a cherry-picked basket of single
industry, and company views. The magnitude of the
stock volatilities.
response will depend on several intersecting factors.
First, the information can be characterized as having a

broad market impact, an industry specific importance, or a
company specific read-through. The more powerful the
micro data point, the higher the volatility risk for the
broader market. For example if a company such as Alcoa
reports better than expected results, the broader market
could rally on the potential for an accelerating economic
backdrop.
Second, the source of the read-through can come from a

company peer or from a vertical supply chain partner.
News from a peer can be a powerful read through for
certain industries such as Financials, Energy, and
Materials, where sectors tend to trade as a group. Recall
recently when Lennar reported better results, the entire
homebuilding sector rallied by 3%.
Supply chain analysis can also catalyze stock specific

stories, especially in sectors such as Technology, where
correlation is low. The intersecting factors can be
summarized in the following response matrix.
31
Dividend Outlook Historically, the SX5E has been the underlying

The dividend swap and futures markets provide investors index for an active structured product market.
with a quantifiable measure of dividend expectations for Because most of the products offered to
the S&P, SX5E, FTSE and Nikkei. It also allows investors institutional or retail clients (continuous flow from
to monetize their views regarding the certainty of a future retail to sell downside risk through knock-in puts,
dividend cash flow stream: sell the dividend swap (future) large trades from US investors going short long-
to lock-in the desired dividend stream for the S&P for a term vanilla puts) incorporate a long equity
desired time horizon. Buy the dividend swap if the current exposure, European banks have developed a
implied dividend appears too low as a result of muted systematic short SX5E forward axe. This axe was
expectations of futures earnings growth and payout ratios. historically hedged through liquid, shorter-term
Imbalances can also stem from structural supply and instruments like SX5E futures, which left banks
demand for dividends (for a more complete guide on trading desks with a structural long SX5E
dividend trading, please refer to The Dividend Risk dividend axe. The size of this SX5E dividend
Premium). overhang is manifesting itself through a
depressed SX5E dividend term structure, adding
alpha to systematic long dividend positions. With
The Ever-Depressed SX5E Dividend earnings expected to grow 11% in Eurozone, we
Although in 2013, dividends paid by the S&P, FTSE or expect upside in the dividend curve.
Nikkei grew by at least 7% versus their 2012 levels,
Exhibit 2: Realized and Implied Dividends (2007-2020)
SX5E dividends remain materially below 2009 levels.
Dividends paid by the S&P have seen a cumulative growth
of 25% since 2008, while FTSE and Nikkei dividends
have grown by 33% and 28%, respectively since 2010.
By contrast, SX5E dividends have fallen by 31%
Exhibit 1: Global 2012 and 2013 Realized Dividends
Source: Credit Suisse Equity Derivatives Strategy Source: Credit Suisse Equity Derivatives Strategy
* Cumulative growth since 2010 * Cum growth since 2010
Looking at dividend expectations priced-in by dividend

futures or swaps, this unique SX5E situation will likely
continue, with SX5E dividends expected to fall by another
Japanese Inflation and the Nikkei Dividend
5% by 2020 (compare to S&P and Nikkei dividends Boom
which are priced to rebound by 55% and 45%, Dividends are often referred to as an inflation hedge, and
respectively). We see the following reasons for the SX5E the recent dynamics of Nikkei dividend futures market
divergence: perfectly exemplifies this point.
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
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
Trade Recommendations for 2014
34
Top Macro Hedges

Rising Rates: Buy TBT Upside
Zero Premium Emerging Markets Hedge
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)
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

35
Top Thematic Ideas

Sell Energy Volatility; Buy Crude Oil Volatility
Sell Risk Reversals on Potential M&A Candidates
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
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
Yield Play: Short Index Straddles

Sell Dec14 Straddles on Global Indices
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 (%)
Source: Credit Suisse Global Equity Strategy

-2,5%
-5,0%
-7,5%
30-dc.-08 30-dc.-09 30-dc.-10 31-dc.-11 30-dc.-12

SX5E SPX FTSE
Derivatives Strategy Idea

Trade: Sell Dec14 SPX 1960 Straddle, SX5E 3600 Straddle, FTSE 7400 straddle
We suggest selling Dec14 straddles centered on Credit Suisses price targets for the three indices. The premium generated
ranges from 13% on the SPX to 21% on the SX5E (Exhibit 3). The trades are expected to yield positive P&L as long as the
indices do not decrease by more than 5-6% and do not appreciate by more than 19%, 25% and 37% for SPX, FTSE and
SX5E respectively.
*** Risks: The risk to selling a straddle is unlimited.***
Exhibit 3: Short Straddles Summary

Index Spot Strike Strike % Premium Premium % Implied Vol Breakeven % Spot Delta
S&P 500 1837 1960 106.7% 231 12.6% 13.0% 93.9.% / 119,5% 43.1%
EURO STOXX 50 3111 3600 115.7% 642 20.6% 15.7% 94.1% / 137.4% 71.2%
FTSE 100 6722 7400 110.1% 1001 14.9% 12.2% 94.9% / 125.3% 66.4%
37
Top Macro Idea: Europe vs. US Outperformance

Buy Dec14 SX5E/SPX Outperformance Call Options
Opportunity: Get leveraged exposure to SX5E via outperformance call options

Credit Suisse Global Equity Strategy team believes that the SX5E will outperform the SPX in 2014 (forecast return of
16% for SX5E vs. only 7% for SPX) and overweights Continental Europe relative to the US:
o Monetary policy: While the US has started tapering its bond purchases, monetary policy is likely to surprise on
the dovish side in Europe. Because of deflation concerns, the ECB could ease further, including introducing a
negative deposit rate (-0.1%) and further LTROs.
o Rising bond yields have historically been associated with US equities underperforming global markets.
o Stronger dollar: The US Dollar is expected to strengthen against the Euro which will likely be a drag on US
earnings and favour Continental Europe export companies.
o SX5E has lagged SPX significantly: While SPX has rebounded over 165% in the past 5 years and made
new all-time highs, SX5E has only gained 72% from its 2009 lows and is still trailing more than 30% from its
pre-crisis levels. (Exhibit 1).
Attractive pricing: Low implied volatilities and high implied correlation provide attractive pricings for the outperformance
options. As shown in Exhibit 2, implied vols for both indices have fallen back to their 2007 lows, while implied
correlation is still elevated at 85%.
Outperformance overlay for long SPX: SX5E/SPX outperformance options can be a compelling overlay to an existing
long SPX position, making the investor long the best of both the SPX and SX5E at year-end.
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%
04-Dec-06 03-Dec-08 03-Dec-10 02-Dec-12 30-dc.-04 01-juil.-07 30-dc.-09 30-juin-12

SX5E S&P SX5E S&P

Trade: Buy Dec14 USD quanto SX5E vs. SPX outperformance conditional on SPX above 1800 at expiry for 1.89%
The payoff of the outperformance call at maturity is:
SX 5E1 SPX 1 if SPX trades above the 1800 barrier at expiry, 0 otherwise.
Notional Amount x max ,0
Out
C1
SX 5E0 SPX 0
The trade is long 46% delta on the SX5E, short 45% delta on the SPX for the vanilla outperformance, while the conditionality
reduces the long SX5E delta to 27% or 21% depending on the barrier level, and the SPX delta to under -16%.
*** Risks: The risk to buying an outperformance option is limited to the premium paid.***
Exhibit 3: Indicative prices for conditional outperformance

Option Premium Delta SX5E Delta SPX Vega SX5E Vega SPX
Vanilla Outperformance 3.85% 45.58% -45.22% 0.21% 0.06%
Conditional SPX > 1800 1.89% 26.69% -16.47% 0.29% -0.17%
Conditional SPX > 1900 1.48% 20.80% -10.29% 0.26% -0.15%
38
Dividend Trade: Long Euro Dividends with Catalyst

Go Long SX5E Dividends Futures in Q1
Opportunity: Up to 3.5% upside left in 2014 dividends

As discussed in our report The Dividend Risk Premium, SX5E dividend futures are priced conservatively versus dividend
expectations, pricing-in a relatively large risk premium which erodes away as uncertainties around dividend policies are
lifted through dividend-related newsflow (earnings, announcements, payments).
The announcement calendar for SX5E dividends is highly concentrated with close to 50% of dividends being
announced between January and February (Exhibit 1). By the end of February, a significant portion of the dividend
futures risk premium will have therefore dissipated.
January is the best month to be long the Credit Suisse Dividend Alpha Index, up 3.4% on average since 2010 and with
continued performance in February (up 1.5% on average).
4% upside in 2014 dividends: Although the 2014 dividend future rallied 9.5% from July and mid September last year,
it has been stuck in a narrow range since then, trading between 108 and 109.5 ips. An aggregation of MarkIT dividend
forecasts shows a 113.3 ips estimate for SX5E 2014 dividends, leaving 3.5% upside versus current offer of 109.5
or 2.2% upside versus a more conservative estimate of 112 (Exhibit 2). A significant portion of the upside is expected
to be captured following the dividends annoucements in Jan and February.
13% upside in 2015 dividends: alternatively, investors looking for potentially more upside could go long 2015
dividends, currently priced conservatively at 109.8. Based on MarkIt estimate for 2014 and applying a 10% growth rate
(consistent with Credit Suisse Equity Strategys forecast of 11% growth in Eurozone earnings in 2014, assuming a
constant payout ratio), 2015 dividends could realise as high as 124ips, for up to 13% upside versus current bid.
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
SX5E 2014 Dividend Futures 2014 Dividend Estimate

Announced Ex-div

Trade: Long SX5E Dec14 Dividend futures (DEDZ4) in Q1
We recommend going long SX5E Dec14 dividend futures in Q1 as we believe the majority of the upside left will be captured in
the early months of 2014. SX5E dividend is currenlty offered at $109.5 and we see 4 points of upside over the next two
months.
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.
*** Risks: The risk to going long futures is significant.***
39
Top Cross-Asset Idea: Long SX5E/Euro Hybrid Call

Go Long Dec14 SX5E Call Conditional on Weaker Euro
Opportunity: Capitalize on weakening Euro to get leveraged exposure to SX5E
Credit Suisse Global Equity Strategy expects the SX5E to perform strongly in 2014 with a target price of 3600, an
increase of 16% from current levels.
Weaker Euro: The combined effect of the Fed tapering and a dovish ECB should result in a weakening of the Euro
against the US dollar - our FX Strategy team forecasts 1.24/$ by 2014 year-end. A weaker Euro will further help
European companies to outperform, as every 10% decline in the Euro is expected to increase earnings by 10%.
Negative SX5E/Euro correlation: As shown in Exhibit 1, the typical (pre-2007) correlation between SX5E and the Euro
is negative (a strong Euro implying a weaker SX5E and vice versa). While the Global Financial Crisis and the ensuing
European Sovereign Debt crisis (2008-2012) induced a temporary dislocation in this relationship, correlation has since
fallen significantly. We expect the old-normal regime of negative correlation to come back in 2014. In contrast, the
market is currently pricing in a zero implied correlation for SX5E/Euro.
Exhibit 1: Rolling 3M FX/Equity Correlation (Smoothed) Exhibit 2: Rolling 3M FX/Equity Correlation

100% 100%
NKY/JPY
80%
SPX/EUR 80%
60% SX5E/EUR 60%
40% FTSE/GBP
40%
20%
20%
0%
0%
-20% NKY/JPY
-20% SPX/EUR
-40%
SX5E/EUR
-40%
-60% FTSE/GBP
-60%
-80%
Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13
Oct-00 Apr-02 Oct-03 Apr-05 Oct-06 Apr-08 Oct-09 Apr-11 Oct-12

Trade: Buy SX5E calls conditional to EUR/USD trading below 1.35 at expiry
The payoff of the strategy at maturity is:

SX 5E1
C1 Notional Amount x max 1,0 if EUR/USD trades below the 1.35 barrier at expiry, zero otherwise.
SX 5 E 0
The trade is long 21% delta on the SX5E, short 24% delta on EUR/USD, short SX5E/EUR correlation, long vega on the SX5E
and slightly short vega on EUR/USD. The major risk of the trade compared to a vanilla call would be a strengthening of the Euro
against the US dollar, which would cancel any profit even if the SX5E increase sharply during the year.
*** Risks: The risk to buying a conditional call option is limited to the premium paid.***
Exhibit 3: Trade Summary

Option Premium Delta SX5E Delta EUR/USD Vega SX5E Vega EUR/USD
Vanilla Call 5.78% 47.40% 0.38%
Conditional EUR/USD < 1.35 2.78% 20.73% -23.78% 0.18% -0.05%
40
Japan: Bullish with up to 8X Payoff

Nikkei Upside Through Vanilla and Exotic Structures
Opportunity: Go Long Nikkei on the back of further QE and cheap valuation

Despite a strong run in 2013 (+57%), we expect the Nikkei rally to continue this year. Credit Suisse Global Equity
Strategy has a 2014 year-end target price of 18,400, up 14% from current level, driven by the following factors:
o Weaker yen: CS economists believe that to meet its inflation target of 2%, the BoJ will have to devalue the Yen
by 10-15% by the middle of next year and will thus accelerate QE in Q1 2014. The weaker Yen and expanded
QE should help equities to outperform (see correlation between NKY and USD/JPY in Exhibit 1).
o Allocation to equity: While Japanese investors remain positioned for a deflationary environment (over 60% of
financial assets in cash and bond), rising inflation could spark a meaningful asset allocation shift to equities.
o Valuation: Japanese valuations are reasonable and earnings revisions are the strongest of any region
Dislocated Volatility Surface: Nikkei implied volatility is expensive compared to other global indices (1Y implied vol at
~22.3% vs 15% for SPX and 17.5% for SX5E). We suggest buying a call spread on NKY to limit vega exposure, but
also benefit from flat upside skew. Bullish expectations and idiosyncratic market dynamics (Uridashi knockouts) have
combined to push implied vol for higher strikes to levels at odds vs. other global benchmarks (Ex. 2).
Exhibit 1: NKY and USD/JPY Performance Exhibit 2: NKY Upside Skew is Flat
35,0%
15000 100
30,0%
Volatility (%)
USDJPY
25,0%
NKY
12500
90
20,0%
10000 15,0%
80
50Pct 75Pct 100Pct 125Pct 150Pct

31-dc.-11 30-juin-12 30-dc.-12 30-juin-13 NKY SX5E SPX
NKY USD/JPY Source: Credit Suisse Equity Derivatives Strategy

Trade #1: Buy Nikkei Dec14 17,000/18,500 call spread
We suggest going long Nikkei Dec14 17,000/18,500 call spreads for 410 (or 2.5% of spot, ref 16,121) for a maximum
payout ratio of 3.7x at maturity. The upside strike is set roughly in line with the CS 2014 year-end target price of 18,400.
*** Risks: The risk to buying a call spread is limited to the premium paid.***
Index NKY Spot 16121
Strike 1 17000 Strike 1 % 105.4%
Strike 2 18500 Strike 2 % 114.8%
Premium 410 Premium % 2.5%
Breakeven % 108.0% Delta 15.4%
Trade #2: Buy EWJ Dec14 12-strike call with knock-out barrier at 14.50
For US investors who dont want to actively manage Yen exposure, we suggest going long EWJ Dec14 12-strike call with a
continuously observed knock-out barrier at 14.50 for $0.30 (or 2.49% of spot, ref 12.04), representing over 63% in cost
savings versus the vanilla 12-strike call (at $0.82). Upside participation starts immediately with a max payout ratio of over 8x.
Meanwhile, the knock-out barrier is set at over 20% over the current spot level.
*** Risks: The risk to buying a call with a knock-out barrier is limited to the premium paid.***
ETF EWJ Spot 12.04
Strike 12.00 Strike % 99.7%
KO Barrier 14.50 KO Barrier %120.4%
Premium $ 0.30 Premium % 2.49%
Breakeven $12.30 Breakeven %102.16%
41
Contacts
James Masserio
Head, US Equity Derivatives
+1 212 325 5988
james.masserio@credit-suisse.com
Credit Suisse Equity Derivatives Strategy and Structuring
Grace Koo Edward K. Tom

Head, Equity Product Strategies Head, Equity Derivatives Strategy
+1 212 325 4755 +1 212 325 3584
grace.koo@credit-suisse.com ed.tom@credit-suisse.com
Credit Suisse Derivatives Sales
Tim Scanlon Michael Clark

Head, Equity Derivatives Sales Head, Structured Retail Products
+1 212 325 4755 +1 212 325 5909
tim.scanlon@credit-suisse.com michael.g.clark@credit-suisse.com
Credit Suisse Derivatives Trading
Khoa Le Robert Sowler

Head, Equity Derivatives Flow Trading Head, Equity Derivatives Structured Trading
+1 212 325 5988 +1 212 325 7281
james.masserio@credit-suisse.com robert.sowler@credit-suisse.com
Disclaimer:
Please follow the attached hyperlink to an important disclosure: http://www.credit-suisse.com/legal_terms/market_commentary_disclaimer.shtml.
Structured securities, derivatives and options are complex instruments that are not suitable for every investor, may involve a high degree of risk, and may be
appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Supporting documentation for
any claims, comparisons, recommendations, statistics or other technical data will be supplied upon request. Any trade information is preliminary
and not intended as an official transaction confirmation. Use the following links to read the Options Clearing Corporations disclosure document:
http://www.cboe.com/LearnCenter/pdf/characteristicsandrisks.pdf
Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how
taxes affect the outcome of contemplated options transactions.
This material has been prepared by individual traders or sales personnel of Credit Suisse Securities Limited and not by the Credit Suisse research department.
It is provided for informational purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the
products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. It is intended
only to provide observations and views of individual traders or sales personnel, which may be different from, or inconsistent with, the observations and views of
Credit Suisse research department analysts, other Credit Suisse traders or sales personnel, or the proprietary positions of Credit Suisse. Observations and
views expressed herein may be changed by the trader or sales personnel at any time without notice. Past performance should not be taken as an indication or
guarantee of future performance, and no representation or warranty, expressed or implied is made regarding future performance. The information set forth
above has been obtained from or based upon sources believed by the trader or sales personnel to be reliable, but each of the trader or sales personnel and
Credit Suisse does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising out of errors, omissions or
changes in market factors. This material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a
limited view of a particular market. Credit Suisse may, from time to time, participate or invest in transactions with issuers of securities that participate in the
markets referred to herein, perform services for or solicit business from such issuers, and/or have a position or effect transactions in the securities or
derivatives thereof. The most recent Credit Suisse research on any company mentioned is at http://creditsuisse.com/researchandanalytics/
2010, CREDIT SUISSE
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EQUITY DERIVATIVES STRATEGY

2014 U.S. Equity Volatility Outlook

Our report is divided into four parts:

wrap up by proposing trades that best reflect our views.

Edward K. Tom Stanislas Bourgois Terry Wilson Mandy Xu

Executive Summary Framework for Analyzing Volatility

shock sensitivity. Against this backdrop, a 25 Kurtosis Premium

forecasted decline in institutional & pension fund 20

duration of insurance hedges should increase skew 10

convexity. Absent a liquidity event, the declining 5

2014 Trade Recommendations

Top Macro Ideas Top Thematic Ideas

Establishing Baseline Volatility Bootstrapped Monte-Carlo

Accordingly, to develop our estimate for baseline volatility,

S&P level at 2014

Source: Credit Suisse Equity Derivatives Strategy

Potential Tail Catalysts (Kurtosis)

Potential Catalysts That Could Drive VIX Higher

Turmoil in the Emerging Markets: With slowing

China Shadow Banking Meltdown: China has seen a

Exhibit 9: 2014 Steady-State VIX Forecast of 15%

Source: Credit Suisse Equity Derivatives Strategy

Exhibit 1: Interest Rate Equity Volatility Contagion

Source: Credit Suisse Research Source: Credit Suisse Research

What is the current degree of equity-interest rate

Because Bernanke left open the pace of future

Exhibit 5: Historical Market Performance on Rate Hike

Source: Bernanke & Kuttner 2004 ; European Central Bank, 2007

Source: Credit Suisse Equity Derivatives Strategy

But will markets believe the Fed? Exhibit 4 suggests

2. Turmoil in the Emerging Markets

3. Hiring rate (JOLTS survey)

Top Interest Rate Hedge

For equity investors looking to hedge the risk of

Exhibit 2: Volatility Contagion Between EM vs. US Equities

Source: Credit Suisse Equity Derivatives Strategy

Source: Credit Suisse Equity Derivatives Strategy

Source: Credit Suisse Equity Derivatives Strategy

Source: Credit Suisse Equity Derivatives Strategy

Top Emerging Markets Hedge

Emerging Markets equities were the most impacted

Source: Credit Suisse Research

Exhibit 3: Inflation is Forecast to Rise Meaningfully This Year

Source: Credit Suisse Research

Source: Credit Suisse Research

Preemptive Deleveraging: The central government has Impact on Equity Volatility

As the USs second largest trading partner, a slowdown in

be the biggest risk to US growth in 2014. Recessions

We believe a good historical parallel is the collapse of

Exhibit 6: NKY vs. SPX Volatility at Peak of Japans Crisis

Source: Credit Suisse Equity Derivatives Strategy

Of the three primary aspects of the volatility surface, skew

level close to its historical average of 20), relative

In order to discuss the time series of skew across Structured

Source: Credit Suisse Equity Derivatives Strategy

While admitting that the process of translating structural

Institutional/ Fundamental Long-Shorts Additionally, as investors become more confident in their

Investment Bank Trading Desks

Basel III Credit and Equity Hedging Requirements3

2014 Derivatives Trading Implications

2014 Derivatives Trading Implications

Relative Value: With increased illiquidity in long-dated 100

volatility, term structure opportunities will likely be driven 80

* Risks: The risk to going long futures is significant.*