Derivatives-2012

www.morganmarkets.com

Global Equity Derivatives & Delta One Strategy08 December 2011

Global Derivatives Themes2012 Outlook for Equity Derivatives

Global Equity Derivatives & Delta One Strategy

Marko Kolanovic AC

(1-212) 272-1438

[email protected]

J.P. Morgan Securities LLC

Davide Silvestrini AC

(44-20) 7777-1018

[email protected]

J.P. Morgan Securities Ltd.

Tony SK Lee AC

(852) 2800-8857

[email protected]

J.P. Morgan Securities (Asia Pacific) Limited

Michiro Naito AC

(81-3) 6736-1352

[email protected]

JPMorgan Securities Japan Co., Ltd.

See page 41 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. In the United States, this information is available only to persons who have received the proper option risk disclosure documents. Please contact your J.P. Morgan representative or visit http://www.optionsclearing.com/publications/risks/riskstoc.pdf.

Summary

In 2011 we witnessed two distinct market regimes: very low volatility in H1, and extreme correlation, poor liquidity and high volatility in H2. Escalation of European sovereign credit crisis in August caught investors by surprise, triggering a series of large risk on/off flows. The record drop in equity liquidity and the rise of cross-asset correlations effectively shut off equity markets for fundamental stock investors. In addition, derivative hedging flows at times overwhelmed liquidity, further adding to market volatility and correlation.

Political risk is currently the main driver of market volatility. Uncertainty related to the European monetary and fiscal policies has disadvantaged holders of risky assets. In addition, the capacity of the financial system to store risk has been diminished by ongoing deleveraging and by regulatory changes that have eliminated proprietary desks and increased the cost of capital. The diminished risk-taking capacity has resulted in large dislocations in implied correlation, skew, convexity, long-dated volatility, and dividend markets.

In 2012, we expect a decline in volatility relative to H2 2011. Despite lingering macroeconomic, political and geopolitical risks, we believe that cyclical forces will likely reduce what we believe are unsustainable levels of correlation and risk premium. We recommend that investors implement trades that have a short skew, short correlation and short convexity bias, as these metrics are all currently expensive, in our view.

In the second part of this report, we recommend a number of trade ideas that incorporate our market and volatility views. In particular, we suggest the following: Risk Premium Trades – sell index skew through put ladders, put ratios and barrier options; sell convexity on the Nikkei 225 and Hang Seng; sell correlation on the ASX 200, FTSE 100 and S&P 500; sell long-term variance on the S&P 500; long protected upside on 2013 Euro STOXX 50 dividend futures; Downside Protection Trades – hedge risk-off events with selected global index puts; hedge geopolitical risk with “Iran puts” (S&P 500 puts contingent on oil prices rising); hedge volatility risk with May-12 VIX call spreads; hedge Hong Kong bank risk with a best-of put; Relative Value Trades – sell S&P 500 variance, buy KOSPI variance; EM vs. DM outperformance; and European single-name credit-equity trades; Upside ParticipationTrades – buy OTM calls on derated names in Europe; bullish Japan calendar spreads.

Marko Kolanovic AC (Global Head)

(1-212) 272-1438

[email protected]

J.P. Morgan Securities LLC

Davide Silvestrini AC (EMEA)

(44-20) 7777-1018

[email protected]

J.P. Morgan Securities Ltd.

Tony SK Lee AC (Asia Pacific)

(852) 2800-8857

[email protected]

J.P. Morgan Securities (Asia Pacific) Limited

Michiro NaitoAC (Japan)

(81-3) 6736-1352

[email protected]

JPMorgan Securities Japan Co., Ltd.

Equity Derivatives Strategy Team

US

Marko Kolanovic [email protected]

Adam Rudd [email protected]

Amyn Bharwani [email protected]

Kapil Dhingra [email protected]

Min Moon [email protected]

EMEA

Davide Silvestrini [email protected]

Bram Kaplan [email protected]

Peng Cheng [email protected]

Rahil Iqbal [email protected]

Asia Pacific

Tony Lee [email protected]

Sue Lee [email protected]

Clara Law [email protected]

Japan

Michiro Naito [email protected]

Hayato Ono [email protected]

2


Marko Kolanovic(1-212) [email protected]

Table of ContentsEquity Derivatives Outlook......................................................3

2012 Global Volatility Outlook ...............................................................................3

Skew and Convexity................................................................................................8

Term Structure ......................................................................................................11

Correlation............................................................................................................13

Dividends..............................................................................................................16

Systematic Strategies Update.................................................................................20

Derivative Trade Ideas ...........................................................23

Risk Premium Trades ............................................................................................23

Monetize High Index Skews..................................................................................23

Sell S&P 500 Skew via Dec12 1250-1150-1050 Put Ladder...................................24

Correlation Trade Ideas: Sell ASX 200, FTSE and S&P 500 ..................................25

Sell Convexity on Nikkei 225 and Hang Seng........................................................26

Dividends: 12s Risk/Reward Balanced, Buy Protected Upside on 13s ....................27

Downside Protection Trades..................................................................................29

Identifying Cheapest Index Put Hedges..................................................................29

Buy “Iran Puts”: S&P 500 Puts Contingent on a Rise in Oil, to Hedge Geopolitical Risk ......................................................................................................................31

Protection Trade Idea: Buy May 2012 $30-40 Call Spreads on VIX .......................32

Sector Trade Idea: Buy 6M 95% or 90% Best-of Puts on Hong Kong Bank Basket.33

Relative Value Trades ...........................................................................................34

Sell S&P 500 Dec-12 Variance and Hedge Using KOSPI 200 ................................34

Option Strategies for EM versus DM Outperformance ...........................................35

Credit-Equity Outlook and Trade Idea ...................................................................36

Upside Participation Trades..................................................................................37

Bullish Positioning with Long-Dated Far OTM Index Call Options........................37

Europe: Buy OTM Calls on De-Rated Names ........................................................38

Using Seasonality in Japan to Trade Calendar Spread ............................................39

3



Equity Derivatives Outlook

2012 Global Volatility Outlook

During H1 2011, equities were in a low volatility regime with S&P 500 realized volatility reaching pre-Lehman low levels of ~12% (Figure 1). The low volatility regime of H1 was caused by a strong market performance in H2 2010 that triggered a record decline in equity correlations (Figure 2). Over the same time period, market liquidity reached new highs, and derivative hedging activity put downward pressure on realized volatility1. Given the positive macroeconomic sentiment and strong technicals (high liquidity, low correlation), even turmoil in the Middle East and the nuclear disaster in Japan in March did not result in a significant increase of equity volatility.

At the end of July, renewed concerns about European sovereign debt, the sustainability of US growth and fears of another global recession caused rapid market deterioration. Large risk on/off flows between government bonds and risky assets such as equities, commodities and currencies caused cross-asset correlations to reach all-time high levels (Figure 2). These macro risk on/off flows were transmitted to equities largely through index trading, giving rise to a record level of equity correlation (stock-to-stock correlation).

As most equity flows have been implemented with index instruments (e.g., futures and ETFs), equity volatility has been driven by risk on/off flows and the significantly reduced liquidity of equity index products. Figure 3 shows the liquidity of S&P 500 E-mini futures as measured by the number of contracts bid/offered within 5 futures ticks (1.25 index point). In August, liquidity dropped by more than 70% compared with the beginning of H1. It is interesting to note that the H2 changes in correlation (100% increase) and liquidity (70% decrease) were larger than changes in other equity risks, and were the key drivers of equity volatility, in our view.

The drop in equity liquidity in H2 suggests that the current system has significantly reduced capacity to store equity risk. This may be related to regulations (e.g., elimination of proprietary desks, increased capital requirements) and changes in the structure of equity liquidity, i.e., the increased role of computerized trading in liquidity provision2. High levels of correlation and low liquidity further discouraged fundamental equity investors from trading stocks. For that reason, a significant amount of stock trading in H2 was the result of index and statistical arbitrage programs putting further upward pressure on correlations. This hostile risk on/off environment started undermining confidence in equities as an asset class, resulting in persistent outflows from US equity mutual funds during H2 (Figure 3).

1 See our H2 2011 Volatility Outlook for Discussion of Structural Pressure on Equity Volatility in H1 2011 due to long gamma positions.2 This liquidity can quickly disappear, such as during the flash crash in May 2010.

Figure 1: S&P 500 Realized Volatility and the VIX – Note distinct regimes of volatility in H1 and H2 2011, and different duration of 2010 and 2011 volatility spikes both related to European debt crisis

Source: J.P. Morgan Equity Derivatives Strategy.

Figure 2: Cross-asset and equity correlations recently reached all-time high levels. High correlations are the main driver of equity index volatility.


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In addition to liquidity and correlations, the impact of index options hedging was another driver of equity volatility3. These products are used by asset managers, pension funds and hedge funds to reduce their equity risk exposure. The other side of these hedging transactions is taken by dealers who replicate their liability by daily delta hedging. Based on dealers’ exposure, hedging activity can increase market volatility (hedging of short gamma positions) or decrease market volatility (hedging of long gamma positions)4. Our estimates show that dealers were net long gamma in H1 2011, thus reducing market volatility by ~2 points. After the sharp drop in the market in August, the gamma exposure of outstanding protection became significantly short, putting upward pressure of ~3-4 points on short-term realized volatility (Figure 4).

Figure 5 shows an extreme example of the gamma hedging impact during the second week of August. As the amount of gamma exposure reached record levels, and liquidity fell to the lowest point for the year (Figures 3 and 4), gamma hedging flows caused a significant portion of market volatility that week. Figure 6 shows a more recent example from November 30th, when the market rallied on the coordinated action of central banks. A ~3% overnight move caused additional hedging flows that pushed the market another ~1% in the last hour of the trading day.

3 Hedging of levered ETFs and other volatility products such as variance swaps and CPPI structures can also have an impact on market volatility.4 See our report “Impact of Derivatives Hedging,” as well as a series of Market commentaries from August and September 2011.

Figure 3: Cumulative US mutual fund flows in 2011 (left axis), market liquidity as measured by the depth of S&P 500 futures (right axis)


Figure 4: Estimated S&P 500 options gamma exposure (left axis), net futures speculative open interest (right axis)


Figure 5: Impact of S&P 500 Gamma Hedging in Early August

Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg.

Figure 6: Impact of S&P 500 Gamma Hedging on November 30th


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In addition to poor liquidity and gamma hedging flows, large short interest in index products also contributed to market instability and higher volatility. Figure 4 shows record levels of speculative short interest in S&P 500 futures built up during the month of August. Stop-loss covering of shorts caused several market squeezes and contributed to end-of-the-day moves such as the one illustrated in Figure 6.

Volatility in 2012 will largely depend on the pace with which the European sovereign debt crisis is addressed by policymakers, as well as changes in the outlook for global growth. As it is not possible to forecast these developments with certainty, we build our forecast based on historical trends, our views on the structural drivers of correlation and volatility, and J.P. Morgan’s 2012 fundamental projections for the macroeconomy, equities and credit.

Larger market crises and outbursts of equity volatility usually take a longer time to resolve. This gives rise to the familiar “triangular shape” of VIX spike patterns5. Comparing the current pattern of the VIX with the market crisis last summer (shown in Figure 1), one can notice that the current market crisis is taking a significantly longer time to abate6. This can be directly attributed to the lack of progress made by European policymakers, and in particular the reluctance of Germany to endorse employing ECB resources in removing the tail risk. While one could argue that volatility may persist and equities are entering a secular bear market, we believe a stabilizing solution in Europe will be agreed upon, eventually causing volatility to decline from current high levels.

The current record levels of cross-asset correlations and equity correlations are not sustainable in our view. A prolonged period of risk on/off trading in illiquid markets is likely to cause significant underperformance for proponents of this approach and create divergences in valuations that will invite relative value investors. While many of the structural drivers should persist, we believe that the correlations will either collapse (with removal of tail risk, cyclical or seasonal effects), or will gradually wear off from the current extreme levels, in either case contributing to a decline in volatility during 20127.

Our forecast is that the average realized volatility of the S&P 500 in 2012 will decline to ~18.5% with a most likely range of ~15-20%. This represents a decline from the current high volatility regime (6-month realized volatility at 30%) into a medium volatility regime8.

Another consideration in forecasting volatility is J.P. Morgan’s fundamental projections. While the outlook for the US economy (e.g., GDP, unemployment) points to the same level of volatility that we saw this year (12-month volatility of 23%), our credit and equity strategists argue for a significant reduction of credit risk and higher equity valuations in 2012, thus supporting our view of declining volatility (Figure 7). We believe that the premium of implied to realized volatility will stay elevated, due to reduced capacity of the system to store risk and high demand for downside and tail risk protection. Our forecast for the average spread of the VIX to realized volatility is 4.5 points.

5 More accurately, volatility tends to decay in an exponential, rather than linear, fashion.6

This is also true when comparing the current outburst of volatility with volatility patterns over the past 20 years.7 See our report on the seasonality of equity correlations.8 Here we define medium volatility regime relative to the past 5 years. Over the past 100 years, an 18.5% target volatility would still be higher than about 75% of observations and could be classified as a high volatility regime.

Figure 7: S&P 500 Realized Volatility and Average VIX Forecast


Figure 8: Global Volatility Forecasts


Asset Current Target

Volatility

Impact

CDX Investment Grade 140 100 Lower

CDX High Yield 800 550 Lower

S&P 500 1245 1450 Lower

US GDP 1.68 1.75 Neutral

US Unemployment 8.6% 9.0% Neutral

S&P 500 Realized Volatility 23.2% 18.5% -4.7%

VIX 27.5 23 -4.5

Index Target Lower End Upper End YTD Realized 12M Implied

SPX 18.5% 15.0% 20.0% 23.7% 26.3%

SX5E 25.0% 22.0% 28.0% 28.9% 28.6%

DAX 25.0% 22.0% 28.0% 28.9% 28.1%

UKX 19.0% 16.0% 21.0% 21.6% 23.7%

HSI 21.5% 19.5% 24.0% 26.1% 25.5%

KOSPI2 23.0% 22.0% 29.0% 27.7% 25.0%

AS51 16.5% 13.5% 17.5% 19.6% 23.7%

NKY 24.0% 20.5% 25.5% 24.2% 21.9%

https://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-692879-0.pdf

6



Volatility Targets by Region

Europe continued to be the epicentre of the crisis for the second year, and remained the ‘problem region’ globally. The outlook for growth in Europe is relatively weak, with the Euro-zone expected to be in a mild recession in 2012, while the UK and the Nordic countries are expected to experience low, sub-trend growth. Peripheral Euro-zone countries will continue in their journey of higher fiscal austerity, and the ‘core’ of the region could experience fiscal tightening as well(e.g., France). The good news is that this weak scenario is already reflected in investors’ light European equity positioning and in the European equity derivatives’ risk parameters.

The sovereign debt sword continues to hang over Europe, while creating the conditions for stabilization will largely be in the hands of the European politicians and the ECB. J.P. Morgan European economist David Mackie9 argues that the ECB will increasingly be dragged into taking a larger role in easing funding pressures, in reaction to increasing market pressure, which will create a more credible backstop, although he thinks that the route towards greater fiscal integration is still very long. In our view, this should be sufficient to create the conditions for a decline in European equity volatility and correlation, which we expect to transition to a ‘medium vol’ regime from the current ‘high vol’ regime. However, we think that the path to stabilization will be bumpy as plenty of differences remain between European politicians’ views, and therefore we expect high ‘volatility of volatility’ in 2012, especially in the first half of the year.

Our 2012 base-case forecast for realized volatility of the Euro STOXX 50 is 25%, with a likely range of 22% to 28%.This implies a spread over our forecast for S&P 500 realized volatility of 6.5 vol points, well above the historical average of 2.5 vol points and somewhat higher than the latest 12M spread of 5.6 vol points. This value is justified by the expectations of a bumpy road towards the resolution of the European sovereign debt crisis and the weaker economic prospects for the region compared with the US. We expect the average value of the VSTOXX index for the year 2012 to be 3 points above our central estimate for realized volatility at 28% – a risk premium of implied to realized volatility in line with the historical long-term average over the year10. Our base case is therefore moderately bullish, but we acknowledge the continued risk of an escalation of the sovereign crisis (e.g., were Italy/Spain to lose debt market access), especially due to potential actions byEuropean policymakers. Taking a view on the likelihood of such an event is difficult if not impossible, but recent events have made such a dramatic outcome less likely in our economists’ view.

Our 2012 base-case forecast for realized volatility of the DAX index is in line with the Euro STOXX 50, which is consistent with what the two indices have recently realized. The introduction of the short-sale ban on financial stocks in France, Spain, Italy, and Belgium on the 12th of August affected the Euro STOXX 50 but not the DAX. This led to an increase of the DAX less Euro STOXX 50 volatility spread, as investors who would typically trade Euro STOXX 50 hedges used DAX futures and options instead, thus increasing the German benchmark’s volatility. An end of the short-sale ban would lead to some downside to our projection for DAX less Euro STOXX 50 volatility spread.

Our 2012 base-case forecast for realized volatility of the FTSE is 20%, with a volatility range of 17.5% to 22.5%. The FTSE volatility has behaved quite similarly to the S&P 500 volatility during this year, and has not been substantially affected by its exposure to the Euro-zone. We believe this behaviour will likely continue in the next year, but are slightly more pessimistic on FTSE volatility than on S&P 500 volatility due to the lower growth prospects of the UK economy compared with the USA, and also due to the potential of a negative feed-through effect from its main commercial partner –the Euro-zone.

Asia Pacific: The outlook for emerging Asian equities remains bullish for 2012 as their economies offer premium nominal growth and stronger fundamentals than developed economies. In 2011, policy flexibility was a moot point as countries fought inflation. This is likely to change in 2012 as policy shifts from fighting inflation to supporting growth and valuation de-rating reverses, hence our constructive outlook. While our bullish outlook for equity markets and solid economic growth expectations impose downward pressure on volatility, we are cognizant of the outstanding macro risk factors that can lead to volatility spikes and even derail our bullish thesis. Hence, after the high volatility realized in 2011, our core view for Asia is that volatility and equity risk premium will likely moderate in 2012 but not collapse sharply to the low levels experienced in

9 The ECB’s balance sheet is going to get very large, and stay very large, 05-Dec-11.10 The VSTOXX index measures 1M implied volatility for Euro STOXX 50 options.

https://mm.jpmorgan.com/MorganMarkets?page=analyst_page&sid=U047732

7



1H11. The macro beta trades that dominated during the bear market will become less important as bottom-up fundamental strategies and earnings estimate revisions should be key drivers of stock prices in the subsequent recovery phase in 2012, leading to a drop in correlation, which can drive down volatility. As investors start coming back to structured products with recovered confidence, the structural imbalance of supply and demand for volatility in Asia could provide the tailwinds for a decline in volatility in 2012. Barring significant market shocks or tail events, conditions remain supportive for lower index skew and flat to modestly upward-sloping term structure in 2012.

We calibrate the futures realized volatility based on J.P. Morgan fundamental views and outlooks as well as the relationship of volatilities across the regions. Our 2012 base-case realized volatility forecast for the ASX 200 is 16.5% with a most likely volatility range of 13.5% to 17.5%. For the Hang Seng, our 2012 base-case realized volatility forecast is 21.5% with a most likely range of 19.5% to 24%. For the KOSPI 200, our 2012 base-case realized volatility forecast is 23% with a most likely range of 22% to 29%. As compared with the volatility realized in 2011, our forecasts suggest that all those indices will see normalization, in line with our bullish outlook. Our base-case forecast for 2012 realized ASX 200 volatility is about 6 volatility points lower than current 1Y implied, while our forecasts for the KOSPI 200 and Hang Seng realized volatility are largely in line with current implied levels.

For Japan, our strategist is moderately constructive on the outlook for the equity market. The key driver should be a gradual but steady rise in the visibility of corporate earnings throughout the year. We expect Nikkei 225 volatility in 2012 to be similar to what it is today, and the 12M realized volatility to be close to the 10-year average of 24%, with a most likely range of 20.5% to 25.5%. Current 6M realized volatility stands at 20.5%. The average over the last 10 years is 24.2%, while the average during 2011 so far is 22.7%. The average during the tumultuous years of 2008-2009 was 37%.However, we do not expect it to approach anything near what we saw in 2008-2009, due to the low overall valuation in the equity market, i.e., the downside will probably be limited. The current index average Price/Book ratio stands at 1.08, as compared with the historical low of 0.91 (March 10, 2009) and pre-Lehman debacle level of 1.42 (September 15, 2008).

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Skew and Convexity

Historically, the cost of downside risk protection as measured by implied volatility skew has been re-priced on several occasions. Prior to the crash of 1987, index skews were largely flat, implying little or no market crash risk. After the 1987 crash, downside implied volatility became more expensive to more properly reflect the downside tail risk. Similarly, following the tech bubble burst in 2000, single-stock implied volatility developed a more pronounced downside skew. Since late 2008, index skew started creeping up, and now stands near multi-year highs.

Many investors are asking if this re-pricing is a permanent or a temporary effect. While the higher levels of market volatility post-Lehman did result in a larger risk of both downside and upside tail events, we believe that the current skew re-pricing is excessive and largely driven by limited supply of tail risk protection, i.e., limited capacity of the financial system to store the tail risk. In practice, the limited capacity is a result of the closure of proprietary desks and volatility-selling hedge funds, and increased cost of risk capital for dealers. On the other hand, this reduced supply is matched against an increased demand for downside protection coming from newly popular ‘tail risk’ protection funds, as well as steady demand from asset managers’ hedging programs and insurance companies hedging variable annuities.

Skew is directly related to another measure of tail risk: volatility of volatility (VoV). Large changes in volatility, i.e., high levels of VoV, cause variance swaps to be more valuable than volatility swaps. The difference between variance and volatility swap levels (i.e., a measure of VoV) is roughly proportional to skew 11. Figure 9 shows realized volatility of the VIX (VoV for one-month implied volatility) and Figure 10 shows realized volatility of 1-month S&P 500 realized volatility (VoV for realized volatility). One can notice that when volatility is high, VoV is high as well. Hence, it is normal to expect high levels of skew in a high volatility regime. However, we see that recent VoV for implied is significantly above historical trends, and recent VoV for realized is somewhat below historical trends (for a given level of market volatility). This tells us that skew is unusually high on account of supply/demand imbalance, rather than on account of unusually high levels of realized skew (realized VoV).

Figure 9: Volatility of VIX is significantly above historical trends. High VoV premium is reflected in higher levels of Skew and Convexity.


Figure 10: Volatility of S&P 500 Realized Volatility is in line with historical trends


In our trade idea section, we suggest several trades based on the view that investors should be short index downside skew and index convexity (the difference between variance swap levels and ATM volatility). Our view is that carrying the skew risk can pay either if the risk capacity of the system is restored/demand abates (resulting in a decline in implied skew) or more likely by investors carrying the position to maturity and profiting from the difference between implied and realized skew risk. We believe that in this way real money managers can monetize stable capital and lower mark-to-market risk sensitivity, effectively taking the role formerly played by proprietary desks.

11 There is also a mathematical relationship between VoV and Kurtosis, i.e., Tail Risk.

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Figure 11 shows recent history of skew for several indices globally. From a historical perspective, the 6M skews for these indices all stand above the 70th percentile based on data over the past five years (Figure 12). At the time of writing, across major global indices, the absolute level of 6M 90%-110% skew is highest on the S&P 500 followed by FTSE and DAX. It is interesting to note that S&P 500 skew during the Lehman crisis reached ~8.5%, lower than the levels we have seen in the past few weeks (~9.3%) (Figure 11). S&P 500 has the most liquid option market globally, and many non-US investors use S&P 500 puts to protect against a market decline or downside tail risk. In addition to demand for 1-12M S&P 500 puts, there is incremental demand for long-term variance and long-term out-of-the-money puts (~5Y to 10Y) from the insurance industry. Insurance demand for longer-dated skew is meeting short-term hedging demand at the 12-24M maturity point, providing support for skew across all maturities.

Figure 11: 6M 90%-110% skews of major indices6M 90%-110% skew


Figure 12: Summary of 6M and 12M skews across the globeBased on data over the past five years


Asian index skews reacted much more violently than skews in the rest of the world during the 3Q11 sell-offs, as they jumped from a lower base, which is partly a reflection of Asian investors holding less protection and historical supply of structured products that put pressure on skew. However, over the course of the year, the supply of downside volatility has dried up with retail structured product issuance slowing down, thus putting additional pressure on skews. Figure 15illustrates the year-to-date structured product weekly issuance activities in Hong Kong estimated by our marketing teams.

The price of convexity, as measured by the spread between variance and ATM volatility, is also close to historical highs across major global indices. Given that skew is a key pricing component of variance swaps, the current steepness across global index skews largely explains the high levels of convexity12. At the time of writing, across major global indices, the absolute level of 12M convexity is the highest on H-shares followed by Nikkei 225 and Hang Seng. From a historical perspective, the convexity for these indices all stands above the 96th percentile based on data over the past five years, whilethe DAX (99th percentile) and the Nikkei 225 (98th percentile) look the most elevated compared to their own history (Figure 14).

12 Derman’ s approximation: KVAR ≈ σATMF * sqrt (1 + 3 * T * skew2), where KVAR is the strike of the variance swap, σATMF is the implied volatility of the forward strike, T is the maturity in years, and skew is generally taken to be the slope of 90/100 skew.

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SPX SX5E HSI NKY6M 90% - 110% Skew SPX SX5E UKX DAX SMI HSI NKY KOSPI2 AS51

Current 8.4% 7.4% 8.1% 7.6% 7.2% 6.4% 6.5% 6.2% 7.0%

Global Rank 1 4 2 3 5 8 7 9 6

Percentile 90% 76% 84% 81% 87% 87% 74% 84% 80%

Average 7.2% 6.9% 7.2% 6.9% 6.1% 4.5% 5.3% 4.7% 6.2%

Maximum 9.3% 10.0% 9.7% 9.6% 7.7% 8.1% 9.8% 7.9% 8.3%

Minimum 5.3% 5.3% 5.7% 5.3% 4.2% 2.6% 1.0% 2.7% 4.0%

12M 90% - 110% Skew SPX SX5E UKX DAX SMI HSI NKY KOSPI2 AS51

Current 6.4% 5.7% 6.4% 6.0% 5.4% 4.7% 5.0% 4.8% 5.2%

Global Rank 1 4 2 3 5 9 7 8 6

Percentile 96.0% 81.1% 91.9% 89.3% 99.2% 90.0% 77.4% 91.1% 82.6%

Average 5.4% 5.3% 5.5% 5.2% 4.5% 3.4% 3.9% 3.5% 4.6%

Maximum 6.9% 6.8% 6.9% 7.0% 5.5% 5.8% 6.5% 5.5% 5.7%

Minimum 4.2% 4.2% 4.5% 4.4% 3.6% 2.1% 1.0% 2.1% 3.0%

10



Figure 13: 12M convexity of major indices12M variance swap strike minus 12M ATMF volatility


Figure 14: Summary of 6M and 12M convexity across the globe*Convexity = variance swap strike minus ATMF volatility

Based on data over the past five years

* Indices with decent variance swaps market liquidity.


The difference between the P/Ls of a long variance swap and a long volatility swap increases as volatility moves away from the initial implied variance swap level. Hence, the difference between the volatility swap price and the variance swap (i.e.,convexity) can be thought of as being linked to the VoV. Historically, the VoV has been proportionate to the absolute level of volatility. Based on this measure, the implied variance swap level also appears expensive compared to the volatility level. Figure 16 shows an example on the Nikkei 225, although the same observation applies to other indices.

Figure 15: Weekly structured product issuance in Hong Kong YTDWeekly Issuance (Notional in USD Mn) Hang Seng Index


Figure 16: Nikkei 225 6M convexity vs 6M ATM implied vol (past 5 yrs)6M variance swap strike minus 6M ATM volatility

6M ATM implied volatility


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6M Convexity SPX SX5E UKX DAX HSI HSCEI NKY AS51

Current 5.2% 8.3% 5.3% 7.1% 9.0% 9.6% 8.8% 4.6%

Global Rank 7 4 6 5 2 1 3 8

Percentile 85% 93% 81% 95% 97% 97% 98% 94%

Average 2.8% 3.8% 3.4% 3.0% 3.7% 4.1% 3.9% 2.5%

Maximum 11.8% 17.1% 10.5% 16.2% 10.9% 11.3% 9.9% 6.3%

12M Convexity SPX SX5E UKX DAX HSI HSCEI NKY AS51

Current 6.0% 8.9% 6.7% 7.5% 9.1% 10.8% 9.7% 5.6%

Glboal Rank 7 4 6 5 3 1 2 8

Percentile 94% 98% 93% 99% 96% 96% 98% 97%

Average 3.1% 4.0% 3.5% 2.9% 3.9% 4.4% 4.3% 2.8%

Maximum 7.8% 11.1% 8.1% 9.3% 13.1% 12.9% 10.9% 6.3%

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11



Term Structure

During H1 2011, volatility term structures were upward sloping (normal) for most indices globally. The only exception was the steep inversion of the Nikkei 225 term structure during the nuclear crisis in March (Figure 17). Escalation of the European crisis in August caused the inversion of all index term structures in H2. As the macro risks have eased somewhat, term structures are starting to flatten and normalize (Figure 17). Currently, the Euro STOXX 50 and DAX have the most inverted term structures, while the ASX 200 and SMI term structures are the steepest.

Figure 17: Term structures of major indices in 20113M-12M Implied Volatility Spread


Figure 18: Summary of 3M-12M and 6M-24M term structureBased on data over the past five years

* Z-Score of 3M-12M term structure is calculated based on current level vs predicted level from a

regression analysis.


Given the historical relationship between the level of volatility and the term structure, the current levels of inversion are inline with history for all indices. Figure 18 shows the historical term structure ranges over the last five years and highlights potential outliers. Relative to ATM implied volatility, the term structure seems to be most extremely inverted for the DAX and Euro STOXX 50. Overall, corresponding to our view on volatility, we believe that term structures of most indices globally should normalize as volatility subsides during 2012. Given historical curve moves and current z-scores (Figure 18), the DAX appears to have most room to steepen while the AS51 would have the least. The shape of the term structure for shorter maturities is largely driven by prevailing realized volatility, short-term risk aversion and hedging flows. By contrast, the longer end of the term structure is largely driven by supply/demand forces. For instance, S&P 500 long-dated implied variance is supported by continued demand from insurance companies hedging liability risk. Variable annuity providers frequently buy long-dated puts or long-dated variance swaps on the S&P 500 in order to hedge their equity exposure. The most challenging conditions for these market participants are periods of simultaneously falling interest rates (which lowers the discount rate and therefore increases the present value associated with future liabilities) and falling equities (which reduces the value of their current assets). The equity market correction of July-October of this year, combined with falling long-term interest rates, prompted an increase in demand for protection, and in particular for long-dated variance. Low interest rates have led to lower forward prices and left long-dated put options looking less cost effective. By contrast, variance swaps are less dependent on forward levels. Potential supply of S&P 500 long-dated implied variance has diminished due to increased costs associated with holding long-term short variance positions. Under Basel 3, holding assets with longer maturities incurs a higher risk-weighted asset charge. There are a limited number of counterparties that have historically supplied long-dated variance, including dealers and proprietary trading desks.

This supply/demand imbalance has caused S&P 500 implied variance to trade higher than realized volatility has ever been over the last 50 years for all maturities greater than two years. Figure 19 shows the current implied variance level for different maturities from 3 months to 5 years (orange line) compared to the maximum and minimum realized volatility over each maturity, based on all observations since 1961 (dotted brown lines).

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SPX SX5E UKX HSI KOSPI2 NKY3M-12M SPX SX5E UKX DAX SMI HSI KOSPI2 NKY AS51

Current -0.2% 3.1% -0.5% 2.1% -1.2% 1.6% 0.7% -0.6% -2.3%

Global Rank 5 1 6 2 8 3 4 7 9

Percentile 69% 86% 66% 86% 34% 63% 64% 28% 17%

Average -0.5% 0.4% -0.4% -0.4% -0.1% 1.4% 0.8% 1.4% -0.3%

Maximum 15.6% 17.7% 17.2% 17.9% 15.3% 27.9% 19.7% 23.3% 13.9%

Minimum -3.9% -3.2% -3.2% -3.5% -2.7% -4.2% -3.3% -3.2% -3.9%

Z-Score 0.20 1.07 0.15 1.13 -0.32 0.59 -0.04 -0.38 -0.82

6M-24M SPX SX5E UKX DAX SMI HSI KOSPI2 NKY AS51

Current -0.2% 2.7% -0.2% 2.1% -1.1% 0.3% 0.9% -0.3% -1.5%

Global Rank 5 1 6 2 8 4 3 7 9

Percentile 72% 85% 74% 88% 54% 55% 67% 36% 34%

Average -0.5% 0.1% -0.7% -0.8% -0.4% 1.0% 0.4% 1.0% -0.5%

Maximum 12.3% 12.9% 12.3% 12.8% 11.1% 22.6% 18.1% 18.8% 11.6%

Minimum -3.0% -3.0% -3.0% -4.1% -3.2% -4.5% -3.8% -1.9% -4.1%

12



Figure 20 illustrates the impact of supply/demand that caused a divergence between short-term volatility (VIX) and long-term volatility (5Y variance). We believe that this divergence offers a good entry point for an outright short 5Y variance position. A similar divergence occurred during the summer of 2010. This divergence subsequently reverted with five-year variance falling back to mid-20 levels at the end of 2010, resulting in gains for short variance positions.

Figure 19: S&P 500 implied variance is currently higher than realized has been (over the last 50 years) for maturities greater than 2 yearsS&P 500 Implied Variance/Realized Volatility

Maturity (Years)


S&P 500 implied variance data since November 2000, Realized volatility data since 1961.

Figure 20: Supply/demand driving divergence between long-dated (5Y) and short-dated (1M) S&P 500 varianceS&P 500 5Y Variance VIX


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Correlation

Equity correlations experienced extreme changes over the past year. In H2 2010 correlation had one of the fastest decreases on record (burst of the correlation ‘bubble’13), and similarly in H2 2011 correlation experienced the largest increase, reaching current all-time high levels (Figure 2). This extreme volatility of equity correlations is a result of structural changes in equity markets over the past few years. A disproportionate share of equity index product trading (e.g., futures and ETFs),changes in microstructure caused by high-frequency trading, and record levels of cross-asset correlations all contributed to high levels of equity correlations. Correlations also show more instability as the structural feedback loops that push correlations to extreme levels also tend to unravel correlations when macro risks abate.

Correlation levels in 2011 saw two distinct regimes with the first part of the year characterized by low realized correlation, declining implied volatility and good carry for dispersion trades, and the second half of the year seeing a sharp reversal ofthese trends as macro risk reignited (Figure 21). Performance of dispersion trades thus largely depended on the timing and maturity of positions entered by investors. Correlation instability rewarded investors who entered into shorter-dated trades at the end of 2010 or early 2011, and punished investors who entered positions shortly before the August escalation. Figure 22charts the performance of a Dec-11 Euro STOXX 50 volatility swap dispersion trade throughout the year, and illustrates mark-to-market of typical short correlation trades during the year. The first part of the year saw sizable gains, especially for correlation-weighted trades while the second half of the year saw the trades lose a large part of the H1 gains.

Figure 21: Implied correlations across the globe went through two distinct regimes this yearAvg 6M implied and realized correlation for 8 major global indices*


* S&P 500, Euro STOXX 50, FTSE, DAX, SMI, TOPIX Core 30, ASX 200, Hang Seng.

Figure 22: Dispersion trades performed well in the first half of the year, as the implied and realized correlation remained subduedEuro STOXX 50 Dec-11 dispersion P/L for EUR 0.25Mn SS vega (EUR Mn)


Our view for 2012 is that implied and realized correlations will decline globally from what we perceive to be unsustainable levels. A decline of correlation could either be quick as a result of abatement of macro risks, or slow as risk on/off approach starts wearing down its followers. Trading risk on/off in illiquid, mean-reverting markets can incur prohibitive trading costs and may eventually need to be abandoned. In addition, record cross-asset and equity correlations are bound to produce valuation discrepancies that will invite more relative value trading that would break down correlations. We do believe that most of the structural drivers of correlation will persist, causing correlation to settle down to a new higher normal, but still significantly below the current record levels.

Selling correlation is not without risks; in addition to mark-to-market volatility, there is a risk that the European sovereign debt crisis keeps on lingering, resulting in high realized correlations. This was the case over the past few months, during which carry of the trade has been weak.

13 Why We Have a Correlation Bubble, 05-Oct-10.

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Currently, there appear to be attractive correlation opportunities on the ASX 200, FTSE, and SPX. Risk-averse investors can consider vega-weighted dispersion trades to moderate the downside of these trades. Vega-weighted dispersion positions should be moved to correlation weighted at a later stage by adjusting exclusively the index leg of the trade, should the macro outlook improve after Q1 next year (as expected by the J.P. Morgan Economics Team) and sovereign risks in Europe start to ease.

We continue to like enhanced dispersion baskets, which proved their efficacy during this year, outperforming thevanilla dispersion trades consistently. The basket we proposed last year carried better throughout the year, as the cheap volatility basket selection added value in both halves of the year (Figure 23).

Figure 23: Enhanced dispersion trades outperformed the full index dispersion trade consistently during the yearEuro STOXX 50 Dec-11 dispersion P/L for EUR 0.25Mn SS vega (EUR Mn)


We examine some specific considerations for the regional markets: In Europe FTSE correlation is the most attractive to sell, both because of the high implied correlation bid and because of the good carry (Table 1). 1Y FTSE implied correlation is close to its all-time high. One caveat is that the recent decrease in European single-stock option liquidity has made it more difficult to build sizable positions in FTSE dispersion quickly. SMI correlation was a popular short at the start of the year, and surged in August as the effect of the market correction was compounded by the impact of FX volatility, which culminated in the introduction of a cap on the CHF exchange rate to the EUR. Euro STOXX 50 dispersion is somewhat less attractive than other European trades, particularly due to the relatively poor carry as of late. Euro STOXX 50 implied correlation was elevated even before the August regime shift – this partially explains why the mark-to-market of Euro STOXX 50 dispersion was less volatile during the summer than that of other indices.

In the US, S&P 500 Top 50, S&P 100 Top 30 and Nasdaq 100 Top 30 implied correlations are all close to their historical highs for both Jan-13 and Jan-14 maturities (all >98th percentile based on all observations over the last five years). Nasdaq 100 one-year realized correlation remains well below its 2008-09 high, unlike the S&P 500, for which realized correlation is ~6 correlation points higher. The absence of financials and materials (the worst-performing US sectors over the last twelve months) in the technology-heavy Nasdaq 100 likely allowed a greater balance between the idiosyncratic risk of the index members and the systemic risks associated with political and macroeconomic developments. On the other hand, continued demand for S&P 500 index put options (as protection for global equity portfolios) and reduced capacity for warehousing short volatility risk have likely exacerbated the increase in S&P 500 implied volatility. Consequently, short S&P 500 correlation trades look appealing at current levels. Furthermore, seasonal effects and upcoming Q4 earnings make current timing favourable, in our view. Equity correlations usually experience significant drops during peaks of quarterly earnings cycles in January, April, July, and October. Low average volatility near calendar year-end (holiday schedule) and year-end rebalances typically also cause a seasonal drop in realized correlation. Over the past 30 years, annual seasonality caused correlations to drop by ~5 points during earnings seasons and near year-end. More recently (over the past ten years), these seasonal effects have become more pronounced with correlation showing much larger swings through earnings seasons.

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In the Asia Pacific region, ASX 200 stands out versus other indices, in terms of implied-to-realized spreads as well as the implied correlation percentile relative to its own history and realized correlation. The implied correlation richness is driven by abundant single-stock volatility supply from overwriting activities in addition to index protection demand from investors using ASX 200 as a proxy hedge to both developed markets and China with lower volatility. Hence, it is our preferred index for dispersion trades going into 2012. At the opposite end of the spectrum, the implied correlation in Japan, as represented by TOPIX Core 30, remains rather low relative to the other indices as well as its own history. This is partially due to suppressed index volatility as a result of heavy structured product issuance on the main benchmark versus single stocks, as retail investors stay away from stock picking. In 2012, we expect the implied correlation in Japan to rise from the current levels but probably not significantly as bullish sentiment returns and retail investors refocus their attention on single stocks.

Table 1: Realized and implied correlations for the main global indices

1Y ATM implied correl

5Y percentile

6M realised correlation

5Y percentile

Current implied correl percentile of 1Y realised

1Y ATM vol spread avg single stocks vs. index

Dec-12 vol swap correlation bid

SPX 0.64 91% 0.68 99% 100% 6.4% N/A

SX5E 0.68 78% 0.74 99% 99% 6.0% 0.64

DAX 0.65 74% 0.73 99% 99% 6.2% 0.58

UKX 0.64 92% 0.63 98% 100% 5.5% 0.62

SMI 0.59 74% 0.67 94% 96% 5.2% 0.59

TPXC30 0.45 21% 0.46 46% 30% 9.2% 0.59

HSI 0.60 11% 0.62 79% 67% 7.0% N/A

AS51 0.73 98% 0.56 99% 100% 3.5% 0.64


16



Dividends

Global index dividends have suffered in 2011, along with global equity markets. Given their more defensive characteristics, shorter-dated dividends have outperformed, with 2011 dividend contracts actually delivering positive returns in all regions, ranging from +1.6% (for H-shares 2011 dividend futures) to +8.0% (for Nikkei 225). Longer-dated contracts have continued to exhibit higher volatility and a higher beta to their underlying indices. For example, the 2020 Euro Stoxx 50 dividend future (-24%) has been the worst-performing dividend contract this year, substantially underperforming the Euro Stoxx 50 index (-16%). This vindicates our preference for owning shorter-dated dividend futures. 2012 dividend futures are up +8.0% for Nikkei 225 and down -0.3% for Euro Stoxx 50 since our 2011 Outlook (versus the indices -14.2% and -15.3%). However, all dividend contracts have been under significant pressure given renewed concerns about sovereign debt, bank solvency and a potential global economic slowdown. For the year ahead, we recognize that substantial risks remain, and therefore we recommend that investors seeking long exposure do so via 2012 dividend futures. Euro Stoxx 50, FTSE 100 and (liquidity permitting) H-shares offer the most favourable 2012 expected return-to-risk, in our view.

All dividend term structures have flattened or become fully inverted. The S&P 500 dividend swap term structure remains upward-sloping, but has flattened considerably over the last year as longer-dated implied dividends have declined more than shorter-dated implied dividends. All other indices now have inverted dividend term structures. Euro Stoxx 50 dividend futures currently display the most extreme inversion, with 2013 contracts trading at a ~26% discount to 2011 and 2020 contracts trading at a discount of ~35%. Nikkei 225 dividend futures also reveal a steeper inversion than observed a year ago. The FTSE 100, H-shares and Hang Seng dividend futures term structures have changed considerably, having previously implied consistent year-on-year dividend growth but now pricing in year-on-year declines through 2015 for Hang Seng and H-shares dividend futures and through 2017 for FTSE 100 dividend futures (Figure 25).

Figure 24: 2012 dividend futures/swaps relative performance year-to-date, in local currency – Nikkei 225 dividend futures have outperformed year-to-dateImplied dividends (rebased to 100 on 31 Dec 2010)


Figure 25: Year-to-date change in dividend term structures – Euro Stoxx 50 and Nikkei 225 have become more inverted, while FTSE 100, Hang Seng and H-shares changed from upward- to downward-slopingDividend term structure (current 2011 div = 100), change from 31 Dec 2010

Source: J.P. Morgan Equity Derivatives Strategy. Dotted lines represent 31 Dec 2010 levels.

The table on the following page provides relevant details for all Euro Stoxx 50, FTSE 100, S&P 500, Nikkei 225, Hang Seng, and H-shares dividend contracts with 2011-2020 maturities. For each contract we show:

Current price and year-to-date performance

JPM/consensus bottom-up estimates (based on aggregated J.P. Morgan analyst dividend per share estimates, where available, or IBES/Bloomberg consensus estimates) and upside/downside potential through expiry

Average daily notional value traded and current open interest of listed dividend futures (in $m)

Year-to-date realized volatility (based on weekly returns) and beta versus the respective index

Information ratio (annualized YTD return divided by YTD realized volatility)

“Expected” information ratio (annualized upside potential between now and expiry divided by “expected” volatility)

2012 implied dividend yield: the current 2012 dividend as a percentage of the respective index level

85

90

95

100

105

110

115

31-Dec 28-Feb 30-Apr 30-Jun 31-Aug 31-Oct

SPXNKYUKXSX5EHSIHSCEI

6065707580859095

100105110115120125130135140145150155

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

SPXHSCEIHSIUKXNKYSX5E

17



Table 2: Euro Stoxx 50, FTSE 100 and H-shares 2012 dividends (highlighted) offer the best return-to-risk in our view. S&P 500 dividend swaps

offer more stable, but lower potential returns. We are neutral on Nikkei 225 dividends and longer-dated dividends.

Source: J.P. Morgan Equity Derivatives Strategy. Index “Daily Value Traded” and “Open Interest” reflect front-month index futures volume/open interest averages over the last month.

Euro Stoxx 50 (Ticker: DEDZ-) 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Index 2012 yield

Current Level 124.4 108.8 91.6 86.7 85.0 83.5 80.0 82.5 81.7 81.2 2,345 4.6%

YTD Return 6.9% -3.7% -13.7% -15.7% -17.2% -19.0% -22.6% -20.2% -22.6% -23.8% -16.0% 14.7%

Bottom up JPM / Consensus Estimates 124.3 120.6 128.4 141.0 2,700

Upside / Downside Potential 0.0% 10.8% 40.2% 62.6% 15.1%

YTD Avg. Daily Value Traded ($m) 24.0 84.1 61.6 33.6 18.9 7.2 3.7 3.7 2.3 2.0 40,313

Current Open Interest ($m) 2,072 2,732 1,879 1,147 893 369 222 238 103 76 94,891

YTD Beta to Index (5-day returns) 0.01 0.39 0.81 0.93 1.02 1.06 1.08 1.09 1.09 1.10

YTD Realized volatility (5-day returns) 2.3% 15.2% 27.1% 30.4% 33.4% 34.5% 34.9% 35.2% 35.4% 35.6% 29.7%

YTD Information Ratio 3.2 -0.3 -0.5 -0.6 -0.6 -0.6 -0.7 -0.6 -0.7 -0.7 -0.6

"Expected" Information Ratio -0.3 2.2 1.6 1.1 0.5

FTSE 100 (Ticker: UKDZ-)

Current Level 200.9 201.9 189.6 182.3 178.0 175.0 172.1 5,547 3.6%

YTD Return 5.2% 0.4% -6.1% -11.6% -14.8% -17.3% -19.5% -6.0% 6.8%



YTD Avg. Daily Value Traded ($m) 0.58 0.56 0.44 0.16 0.11 0.06 0.01 10,044

Current Open Interest ($m) 259 323 179 103 42 18 2 53,154

YTD Beta to Index (5-day returns) 0.02 0.25 0.58 0.70 0.72 0.76 0.75

YTD Realized volatility (5-day returns) 2.4% 10.0% 17.9% 20.0% 20.8% 21.4% 23.2% 22.2%

YTD Information Ratio 2.4 0.0 -0.4 -0.6 -0.8 -0.9 -0.9 -0.3

"Expected" Information Ratio 1.9 3.1 1.8 1.1 0.5

S&P 500 (OTC dividend swaps)

Current Level 26.4 28.7 29.8 30.9 32.0 33.0 34.0 35.3 36.3 37.0 1,256 2.3%

YTD Return 4.2% 4.6% 2.4% 0.0% -2.6% -5.3% -6.8% -7.5% -8.9% 4.5% -0.1% 4.8%





YTD Information Ratio 1.8 0.9 0.3 0.0 -0.2 -0.4 -0.4 -0.4 -0.5 0.2 0.0


Nikkei 225 (Tickers: MNDZ- and INTZ-)

Current Level 191.6 178.3 165.5 155.9 147.6 140.2 132.9 128.5 126.1 124.1 8,722 2.0%

YTD Return 8.0% 3.5% 0.5% -4.3% -7.8% -10.6% -14.3% -15.7% -16.4% -14.7% 21.4%

Bottom up JPM / Consensus Estimates 190.9 200.1 214.5 223.0 --

Upside / Downside Potential -0.4% 12.2% 29.6% 43.0%

YTD Avg. Daily Value Traded ($m) 0.83 2.30 0.98 0.58 0.09 0.18 0.11 0.04 0.01 0.04 10,405

Current Open Interest ($m) 149 210 115 75 17 23 5 3 6 4 43,258



YTD Information Ratio 0.5 0.2 0.0 -0.2 -0.3 -0.4 -0.5 -0.6 -0.6 -0.6

"Expected" Information Ratio -0.3 0.6 0.8 0.7

HSCEI (Ticker: DHCZ-)

Current Level 326.5 311.5 312.5 308.5 303.5 10,485 3.0%

YTD Return 1.6% -7.0% -8.7% -17.4% 12.6%



YTD Avg. Daily Value Traded ($m) 0.0 0.3 0.1 0.0 3,353

Current Open Interest ($m) 4 52 6 0.3 6,342

YTD Beta to Index (5-day returns) -0.05 0.08 0.22 0.34 0.40

YTD Realized volatility (5-day returns) 9.2% 15.0% 15.3% 25.2% 27.8% 34.8%

YTD Information Ratio 0.2 -0.5 -0.6 -0.5


HSI (Ticker: DHSZ-)

Current Level 700.0 670.0 666.0 661.0 661.0 19,241 3.5%

YTD Return 5.2% -6.1% -8.0% -16.5% 12.4%

Bottom up JPM / Consensus Estimates 693.7 775.5 818.3 20,000

Upside / Downside Potential -0.9% 15.7% 22.9% 3.9%

YTD Avg. Daily Value Traded ($m) 0.1 0.1 0.1 0.0 0.0 9,236

Current Open Interest ($m) 7 10 9 0.2 0.2 8,731

YTD Beta to Index (5-day returns) 0.01 0.07 0.20 0.33 0.35

YTD Realized volatility (5-day returns) 8.5% 13.3% 13.8% 20.6% 20.5% 27.2%

YTD Information Ratio 0.7 -0.5 -0.6 -0.6

"Expected" Information Ratio -1.6 1.6 0.9 0.1

18



The “expected” volatility is calculated by assuming that realized volatility for the respective forward dividend contracts will persist. For example, we assume Euro Stoxx 2014 dividend futures will deliver ~30% realized volatility through year-end (as 2014 dividend futures have realized this year), ~27% next year (as 2013 dividend futures realized this year), ~15% in 2013 (as 2012 dividend futures realized this year), and ~2.3% in 2014 (as 2011 dividend futures realized this year).

2012 dividend futures on the Euro Stoxx 50, FTSE 100 and H-shares currently offer the most attractive returns-to-risk, with “expected” information ratios all higher than 2. The 2013 dividend futures for these indices also offer “expected information ratios” greater than 1.5. While liquidity of Hang Seng and H-shares dividend futures may be restrictive, we suggest lifting H-shares dividend offers around current levels via OTC swaps. S&P 500 2012 and 2013 dividend swaps offer “expected” information ratios greater than 1.0 and may offer more defensive exposure to dividends, although expected returns are relatively low.

Euro Stoxx 50 dividend futures represent the largest dividend market globally and they are the most exposed to risks fromthe sovereign credit crisis in the region, so we provide a more detailed analysis of these contracts in this section. Euro Stoxx 50 dividend futures, as an asset class, delivered returns between equities and B-rated bonds in 2011 (Figure 26).Nonetheless, the overall return should not mask the divergence in performance of the 12s vs. the rest of the curve in the second half of the year, as a result of the pull-to-realized effect. The 13s and 14s, on the other hand, traded closely with the broader risky markets (Figure 27).

Figure 26: 2011 year-to-date returns across asset classes


SX5EDFT: Equally weighted, fully collateralised dividend futures 2011-2015.

Figure 27: 2012 dividend performance benefitted from pull-to-realized effect, whereas the 13s and 14s traded closely with macrosDiv Pts iTraxx (bps, inverted)


We believe 2012 will be a volatile year for Euro Stoxx 50 dividend futures due to the following risks: 1) financials dividends may remain under pressure, as borrowing costs reach record highs; 2) Italian/Spanish telcos/utilities may suffer funding stress as their sovereigns’ debt situations worsen; and 3) a potential deep/global recession may lead to dividend cuts in cyclicals. (For the sector breakdown of the 13s, see Figure 29.) On the other hand, as Figure 28 shows, the dividends are already trading at heavy discounts to JPM estimates, offering a significant cushion on the final payoff.

As a result of these risks, the payoff profile of the 12s is becoming increasingly binary and dependent on a small number of members (e.g., Spanish banks). However, in numerous stress tests we conducted, the floor of the realized is around 100 and should be largely realized by the end of Q1. At 109.6, the risk/reward for 2012 dividend futures is slightly skewed to the upside, in our view. The 13s and 14s appear to offer deep value, but investors may have to bear the demanding mark-to-market risk. We therefore recommend investors play the 13s and 14s through option strategies, which we propose in the Trade Ideas section. We are cautious on the 15s through 20s due to their much higher mark-to-market risk and lower liquidity. For further details of our views on Euro Stoxx 50 dividends, please see Euro Stoxx 50 Dividend Weekly, 23 November 2011.

3%

-4%

-8%

-12%-14%

-12%

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-8%

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-4%

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0%

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4%

€ BB € B SX5EDFT Index SX5E Index

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23070

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DEDZ2 IndexDEDZ3 Index

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iTraxx 5Y Main

19



Figure 28: SX5E dividends – JPM estimates vs. current pricingEuro Stoxx 50 Implied/Estimated Dividend (Index Points)

Maturity (Calendar Year)


Figure 29: SX5E dividends – 2013 sector breakdown


Nikkei 225 dividend futures represent the most liquid dividend futures market outside of Europe. As the Nikkei 225 dividend term structure is steeply inverted (similar to the Euro Stoxx 50 dividend term structure), we provide an analysis of the “liquidity-adjusted” upside potential for different maturities.

The 2013 futures are the most attractive for an outright long position in our view. Since the term structure of Nikkei dividends is generally inverted, longer maturities tend to have greater potential upside to bottom-up estimates than shorter maturities. However, Table 3 illustrates that:

1) Annualized potential upside is the highest for 2013 at over 13%, followed by 2014 and onward. For 2013, settlement is expected at the month-end of Mar ’14.

2) Taking relative liquidity into account, 2013 has the highest liquidity-adjusted potential upside of over 24%. Liquidity-adjusted potential upside is the non-annualized potential upside adjusted by relative liquidity of the underlying Nikkei dividend futures for the relevant maturity.

Table 3: Current bottom-up estimates of Nikkei dividends, annualized potential upside and liquidity-adjusted potential upside

Source: J.P. Morgan Equity Derivatives Strategy.* Relative liquidity is based on the open interest of Nikkei dividend futures on Singapore Exchange and the Tokyo Stock Exchange, with 2012 = 1.0. ** Non-annualized.

We believe Nikkei 225 dividend steepener spreads would benefit from improving market sentiment in Europe, should the situation there stabilize in the coming year. On ongoing concerns over the European debt crisis, steepener spreads have widened dramatically in recent months to 2-year lows. Steepener spreads for various maturity pairs have moved nearly in tandem with the MSCI Europe for the past year. Our European Equity Strategist, Mislav Matejka, believes that European equities “will be higher on a 6-12 month horizon.” For further details of our views on Nikkei 225 dividends, please see Nikkei 225 Dividend Weekly, 28 November 2011.

121.1 126.9

139.0

109.6

92.3

87.1

70

90

110

130

150

2012 2013 2014

JPM Estimates

Div Futures

C. Discret7%

C. Staples6%

Energy13%

Financials22%

Health Care6%

Industrials8%

IT2%

Materials6%

Telecom19%

Utilities11%

Maturity JPM Estimates Current Offer Potential Upside

Annualized

Potential Upside

2011 190.9 193.0 -1.1% -3.1%

2012 200.1 177.0 13.0% 9.6%

2013 214.5 160.5 33.6% 13.2%

2014 223.0 149.8 48.9% 12.7%

2015 229.7 142.8 60.9% 11.6%

2016 236.6 136.8 73.0% 10.8%

2017 243.7 131.8 84.9% 10.2%

2018 251.0 130.0 93.1% 9.4%

2019 258.5 128.0 102.0% 8.8%

2020 266.3 126.0 111.3% 8.3%

-5% 0% 5% 10%15% Relative

Liquidity*

Liquidity-Adjusted

Potential Upside**

0.49 -0.5%

1.00 13.0%

0.72 24.1%

0.41 20.1%

0.16 9.8%

0.12 9.1%

0.08 6.8%

0.00 0.1%

0.00 0.3%

0.00 0.2%

0% 10% 20% 30%

20



Systematic Strategies Update

In this section we review the performance of short-dated systematic option and volatility strategies in 2011, including volatility arbitrage (short variance) and index protection strategies.

Last year we highlighted call overwriting as an attractive strategy based on our view that implied volatility would trade rich in 2011, more than compensating for potential upside sold. This strategy outperformed long index positions globally this year, and we view call overwriting as attractive again in 2012 as we expect the implied volatility risk premium to remain high next year. Additionally, a short 105% call overlay has historically improved the returns of a long equity position over time (Figure 30).

Over the cycle, implied volatility and skew tend to trade rich to realized, leading long outright puts to underperform both the spot and put spreads on average. However, this year the large moves on the Nikkei in March and the Euro STOXX 50 in August more than compensated for the expensive premium, leading put overlays to outperform the cash index, while the sharpness of the sell-off in Japan led Nikkei puts to unusually outperform put spreads over the year.

Figure 30: Euro Stoxx 50 long put overlay strategies have performed poorly since 2000, despite weak equity market returnsRelative performance of overlay strategies since January 2000


Figure 31: Euro Stoxx 50 put spreads and put spread collars have delivered better returns than long put overlay strategiesAnnualised return since January 2000


Protection Strategies

The performance of 1-month systematic strategies varied throughout the year, as 2011 was characterized by two distinct volatility regimes: the first half of the year saw low volatility and rangebound markets, with the exception of Japan, which suffered high volatility due to the earthquake/tsunami in March. Outside of Japan, during this period implied vol traded rich but was low in absolute terms, so strategies that were short volatility (call overwriting, put spread collars) fared relatively well, but did not strongly outperform. In July, global markets fell sharply and entered a high volatility environment in whichrisk parameters such as volatility, skew and convexity spiked. This led protection strategies such as puts and put spreads to outperform during the sell-off, but outright long puts bled away this performance over the remainder of the year due to the sharp re-pricing of implied volatility and skew.

In Europe, systematic protection strategies generally outperformed cash equities in 2011, due to the sharp fall in equities in July/August and continued weakness, as Europe remains the main focus for macro worries (Figure 33). The exception to this outperformance was OTM puts, which only paid out in the July/August collapse, but then bled away this return through the elevated volatility and skew that followed. The best-performing strategy this year, among those plotted in Figure 33, was put spread collars, which sold the rich downside skew and volatility.

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2000 2002 2004 2006 2008 2010

Euro STOXX 50 Short 105 Call

95 / 100 Put Spread 95 Put

95 / 100 / 105 PS Collar ATM Put

Euro STOXX 50

Short 105 Call

95 / 100 Put Spread

95 Put

95 / 100 / 105 PS Collar

ATM Put-12%

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0%

2%

4%

0% 5% 10% 15% 20%

21



In the US, YTD returns are close to flat, leading rolling long puts to underperform (Figure 32). Volatility and skew were also generally rich in 2011, causing put spreads to outperform puts and short volatility strategies (put spread collars, call overwriting) to outperform long volatility strategies (long puts, put spreads).

Figure 32: With the S&P 500 performance close to flat and vol/skew rich, rolling put overlays underperformed and short volatility strategies outperformed the cash indexRelative performance of overlay protection strategies in 2011


Performance shown for mid-Dec-10 to mid-Nov-11.

Figure 33: Most protection overlay strategies outperformed an outright long SX5E position YTD, as Europe is the focus for bearish investorsRelative performance of overlay protection strategies in 2011



In Asia, systematic protection strategies also outperformed cash equities in general. Due to high short-term volatility and downside skew that has steepened close to the levels of developed market indices, put spreads and put spread collars performed well while OTM puts underperformed. In Japan, the sharp market sell-off during the March earthquake resulted in the outright put protections outperforming YTD. But, OTM puts performed poorly in the second half of the year as skew remained elevated, versus volatility that normalized quickly driven by low realized volatility.

Figure 34: High short-term volatility and exceptionally elevated downside skews contributed to the outperformance of put spreads and put spread collars on many Asian indices Relative performance of overlay protection strategies in 2011



Figure 35: Nikkei 225 ATM put protection performed the best, driven by the massive market sell-off in March and declining volatility in the second halfRelative performance of overlay protection strategies in 2011



90

95

100

105

110

Dec

-10

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11

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-11

Mar

-11

Ap

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Ma

y-11

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1

Au

g-1

1

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1

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-11

S&P 500Short 105 Call95 / 100 Put Spread95 Put95 / 100 / 105 PS CollarATM Put

70

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1

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1

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-11

Euro STOXX 50Short 105 Call

95 / 100 Put Spread95 Put

95 / 100 / 105 PS CollarATM Put

70

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80

85

90

95

100

105

110

De

c-1

0

Jan-

11

Feb

-11

Mar

-11

Ap

r-11

Ma

y-11

Jun-

11

Jul-1

1

Aug

-11

Sep

-11

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-11

No

v-1

1

HSIShort 105 Call95 / 100 Put Spread95 Put95 / 100 / 105 PS CollarATM Put

70

75

80

85

90

95

100

105

110

De

c-1

0

Jan-

11

Feb

-11

Mar

-11

Ap

r-11

Ma

y-11

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11

Jul-1

1

Aug

-11

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-11

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No

v-1

1

NKY Short 105 Call95 / 100 Put Spread 95 Put95 / 100 / 105 PS Collar ATM Put

22



Table 4: 2011 performance of systematic strategies

Strategy S&P 500 Euro STOXX 50 Hang Seng Nikkei 225

Return Vol Return Vol Return Vol Return Vol

Long index 2% 15% -21% 22% -16% 15% -17% 28%

Short 105 Call 5% 15% -16% 21% -11% 15% -16% 26%

95 / 100 Put Spread 0% 9% -14% 15% -8% 9% -15% 22%

95 Put -5% 12% -21% 15% -23% 14% -12% 14%

95 / 100 / 105 PS Collar 3% 9% -9% 14% -3% 8% -13% 20%

ATM Put -6% 7% -14% 9% -15% 8% -9% 8%

95 Put -5% 12% -21% 15% -23% 14% -12% 14%

Source: J.P. Morgan Equity Derivatives Strategy. Performance shown for mid-Dec-10 to mid-Nov-11.

Short Volatility Carry

The performance of systematic short variance was overall roughly flat over the year, but was dented by the spike in volatility in August (Figure 36). Japan fared relatively well through the August market turmoil, but underperformed strongly in March following the earthquake/tsunami/nuclear fallout. Variance traded rich throughout the year, apart from its inability to anticipate the earthquake in March and macro turmoil in July/August. Short variance on the S&P 500 initially underperformed other major indices in August, as the crisis originated from weak macroeconomic performance in the US, leading to its worst losses since the 2008 crisis.

Figure 36: Short variance performance was damaged in Japan in March by the earthquake, and everywhere else in August, but is close to flat YTDPayoff for selling 1M variance swap (vega)


Figure 37: Variance swap strikes changed regime after July/August

1M variance swap strike


-80

-60

-40

-20

0

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Jan-11 Apr-11 Jul-11 Oct-11

S&P 500

Euro STOXX 50NKYHSI 10

20

30

40

50

60

70

Jan-11 Apr-11 Jul-11 Oct-11

S&P 500Euro STOXX 50

NKYHSI

23



Derivative Trade Ideas

Risk Premium TradesMonetize High Index Skews

Implied skew remains elevated across the globe. The current extreme elevated levels of skew, coupled with high volatility levels, make some short skew strategies very attractive. Table 5 provides a list of short skew strategies and indicative index options prices.

For bearish strategies using vanilla options, investors can consider put ratios to take advantage of high skews. For example, investors who buy a 6M SPX 1x2 95%-85% put ratio (buying one 95% put and selling two 85% puts) will receive a net credit of 0.98% and the breakeven level is about 945. Put ladders also price nicely in the current environment and monetize the elevated skew convexity on top of the skew steepness. When buying put ratios/ladders, however, investors should consider the mark-to-market (MTM) risk. The structures become long delta and short vega if the index declines early in the life of the trade, possibly leading to MTM losses at spot levels at which the terminal P&L of the structure is positive. For those who are reluctant to be net short the downside risks, put fly or put spread structures would be more suitable.

For bullish short skew strategies using vanilla options, on the other hand, we like risk reversals, which involve selling OTM puts to fund upside calls as an effective strategy to extract value from the skew surface. By selling 6M 90%-110% risk reversals on the indices listed below, investors can receive a net premium of 0.50%-2.75% upfront. Investors may spend the net premium on leveraging up their long call exposure, increasing the delta of the position, especially in a market rally.

Strategies involving selling downside volatility and skew through barriers – buying knock-out puts for protection, or selling knock-in puts for yield or to finance upside participation in the form of knock-in risk reversals, etc., appear attractive at current levels, with investors being paid handsomely for selling deep out-of-the-money barriers. For example, 6M 95% puts with a 75% knock-out barrier cost merely 18%-30% of the equivalent vanilla puts across the indices shown below. Although these relatively low prices may be justified on technical grounds, those with a view that these barriers are highly unlikely to be breached can effectively express this view via these option positions.

Table 5: Indicative pricings (as % of notional) for various short skew strategies (for 6M tenors)

* Index affected by European short sale ban. Can still be traded, but new net short positions on restricted names are prohibited. ^ Knock-out occurs based on daily observation at the close.


Note that a short-sale ban on financial stocks in France, Spain, Italy, and Belgium was introduced on the 12th of August and has been extended yet again. The ban extends to short positions in indices comprising restricted stocks, most notably the Euro STOXX 50, IBEX, CAC, and FTSEMIB. Investors are still allowed to buy hedges on the above indices to protect European portfolios, on the condition that their overall delta on all restricted names remains positive after netting all cash and derivatives positions. Short delta positions in existence prior to the introduction of the ban have been ‘grandfathered,’ and investors can keep them and roll them under the condition of not increasing the net short delta exposure.

SPX SX5E* UKX DAX SMI NKY AS51 HSI KOSPI2

Bear Strategies95% Put Long 1x95% P 6.80 8.51 6.14 7.06 5.42 4.99 5.32 6.44 5.55

95%-85% Put Spread Long 1x95% P / Short 1x85% P 2.91 3.45 2.77 2.94 2.81 2.42 2.54 2.87 2.61

95%/85%/75% Put Fly Long 1x95% P+1x75% P / Short 2x85% P 1.22 1.34 1.27 1.20 1.50 1.34 1.22 1.36 1.28

95%/85%/75% Put Ladder Long 1x95% P / Short 1x85% P+1x75% P 0.71 0.50 0.90 0.56 1.51 0.93 1.08 0.81 1.00

1x2 95%-85% Put Ratio Long 1x95% P / Short 2x85% P -0.98 -1.61 -0.60 -1.18 0.20 -0.15 -0.24 -0.70 -0.33

95% Put with 75% KO^ Long 1.38 1.53 1.44 1.29 1.87 1.44 1.59 1.59 1.53

Bull Strategies

90%-110% Risk Reversal Long 1x110% C / Short 1x90% P -1.61 -2.75 -1.83 -0.51 -2.39 -1.42 -0.95 -1.61 -0.75

90% Put (Bid) 4.99 6.41 4.38 5.24 3.60 3.42 3.73 4.72 3.88

110% Call (Ask) 3.38 3.66 2.55 4.73 1.21 2.00 2.78 3.11 3.13

1.48 1.75 1.72 1.11 2.98 1.71 1.34 1.52 1.24

90% Put with 70% KI Short 3.73 5.23 3.28 4.22 2.06 2.03 2.77 3.30 3.06

1.10 1.43 1.29 0.89 1.70 1.02 1.00 1.06 0.98

No of 110% Calls to buy by selling a 90% Put

No of 110% Calls to buy by selling a 90% Put with 70% KI

24



Sell S&P 500 Skew via Dec12 1250-1150-1050 Put Ladder

What scenarios are discounted by S&P 500 index option prices?

Options on the S&P 500 currently imply a ~10% probability of the index falling below 775 (~39% below the current level) by December 2012 expiry. Similarly, option prices imply a ~10% probability of the index rising above 1620 (~28% above the current level) by December expiry. In Figure 38 we compare the “implied” distribution of the S&P 500 based on option prices for each maturity between Dec-11 and Dec-12 (thin orange lines) with the levels that would be associated with the actual S&P 500 returns that have been observed in the past – the historical “realized” distribution for the last 50 years (dashed grey lines) and for the last four years (dotted black lines). The realized distributions are based on all observed S&P 500 percentage returns, for timeframes corresponding to each option maturity. Both implied volatility (reflected in the “expectation” of large moves, either up or down) and especially implied skew (reflected in the higher “expectation” of large negative moves compared with large positive moves) are high compared with what the long-term historical distribution would suggest is appropriate. However, using the more recent four-year history of index returns (since December 2007, i.e., including the 2008-09 credit crisis and sovereign credit crisis of 2010-11) may be more relevant for providing perspective on what the appropriate implied distribution might be. Figure 38 illustrates that the current implied distribution corresponds more closely to the realized distribution of the last four years than it does to the longer-term historical realized distribution. In this context, the current high levels of S&P 500 index skew may appear more rational. Nonetheless, any forward-looking views that differ from this short-term, backward-looking view of potential returns can be expressed via S&P 500 options. As we have highlighted in the “Monetize High Index Skews” section (page 23), we recommend put ratios and put ladders as strategies that benefit from selling skew at the current elevated levels.

Figure 38: S&P 500 option implied distribution (orange), compared with historical realized distribution over last 50 years (dashed grey) and last four years – including the global credit crisis (dotted black)


Figure 39: Potential mark-to-market profit/loss progression for Dec-12 1250-1150-1050 put ladder across a range of potential S&P 500 levels

Mark-to-market profit/loss for Dec-12 put ladder (in index points)

S&P 500 index level


Buy a Dec-12 1250-1150-1050 put ladder on the S&P 500. Figure 39 shows the hypothetical mark-to-market profit/loss for the Dec-12 1250-1150-1050 put ladder, as time elapses (in two-month increments), for a range of potential S&P 500 index levels, from 750 (-40%) to 1750 (+40%). The strategy can be entered for a net credit of ~25 index points, or 2% of notional, and would profit, at expiry, as long as the S&P 500 is above 925 (~26% lower than the current ~1250 level). The put ladder would make a maximum profit of 125 index points (~10% of notional) in the event that the index is between 1050 and 1150 at December expiry. The strategy would effectively leave an investor long the S&P 500 below 925 and would therefore incur a loss if the index trades below this level.

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10%Deciles

Dec-11

Feb-12

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Jan-12

Option Maturities

Last 4 years distribution is more similar to current implied distribution

The last 50 years distribution would suggest current implied distribution is too wide

current implied distribution

-250

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-50

0

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750 1,000 1,250 1,500 1,750

0M2M4M6M8M10M12M

25



Correlation Trade Ideas: Sell ASX 200, FTSE and S&P 500

ASX 200 correlation

Across the global indices, we still prefer shorting ASX 200 correlation given the current entry level is close to multi-year highs relative to its implied and realized history. For dispersion trades, the absolute level of implied correlation is generally a useful signal for profitability, with higher implied correlation leading to higher expected profit. The importance of the absolute level of implied correlation is partly explained by the fact that correlation has a mean-reverting tendency. Clearly, for any mean-reverting asset, selling when high and buying when low is likely to be profitable. Hence, selling correlation when implied correlation is above a set threshold would be a sensible strategy. Fundamentally, our equity strategist believes that the Australian equity market trades at a modest discount to our base-case valuation, which assumes a soft landing in both the Australian and Chinese economies. With a target upside of around 15%, the potential equity market recovery will likely support a lower correlation environment.

The current 6M implied correlation level based on vol swaps is 64%, compared with the current 3M and 6M realized correlations at 65.1% and 64.7%. Versus the 6M realized correlation over the past four years, the implied entry level is inthe 98th percentile. In terms of implied-to-realized spreads as well as implied correlation percentile relative to its own history and realized correlation, ASX 200 stands out versus other indices in Asia.

Figure 40: ASX 200 realized and implied correlation (via vol swaps)Correlation


Figure 41: FTSE top 20 implied and realized single stock less index volatility spread (via vol swap)Top 20 single stock less index vol spread


In Europe our favorite index for dispersion is the FTSE, particularly on an equal vega-weighted basis as a protection trade. The current Jun-12 volatility swap single stock to index spread at 6% looks attractive to buy (Figure 41). An equal vega-weighted trade becomes long volatility as vol increases; thus, selling correlation in this way effectively allows investors to partially subsidize the cost of being long volatility by selling the expensive correlation risk premium. In case there is a re-ignition of the sovereign crisis in Europe leading to contagion, the long vol position should significantly more than compensate for the short correlation bias and act as a hedge. As a matter of reference, the realized 6M vol spread in times of distress, i.e., the 90th percentile of this vol spread over the last 7 years, was 14.2% points. The trade is strongly skewed to the upside as the historical lowest 6M realized vol spread is 4% points.

Sell S&P 500 correlation via volatility swap dispersion or delta hedged vanilla straddle dispersion. S&P 500 top 50 Dec-12 volatility swap dispersion is currently bid around 70, well above the level of S&P 500 realized correlation that we anticipate in 2012. For further details on our views on S&P 500 correlation, see “Expecting a Near-Term Decline in Correlation,” 11 October 2011.

0%

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Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

ASX200 6M Realized Correlation

ASX200 3M Realized Correlation

Current 6M Volswap Implied Correlation @64%

0%

5%

10%

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20%

25%

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6M realised volatility spread FTSE Top 20 SS less index

Jun-12 FTSE volatility swap (top 20 SS less index) @6%

26



Sell Convexity on Nikkei 225 and Hang Seng

As discussed in the Skew and Convexity section, convexity across major indices is near all-time highs, with the Nikkei 225 and Hang Seng appearing the most dislocated. We view the convexity premium as an attractive carry position, which is normally best held to maturity, similar to trading dispersion. The cleanest way to monetize this premium is trading variance versus volatility swaps on the same underlier, as the former has a convex payoff in realized volatility while the latter is linear in realized volatility.

The current high premium of variance over vol swaps allows investors to collect an attractive premium with a wide breakeven range. Investors can skew the breakeven range to target desired realized volatility levels, by adjusting the vega notional ratio of the vol swap to the variance swap. For example, buying a lower vega notional in vol swap than the vega notional of variance sold shifts down the breakeven range, but also reduces the maximum payout (as a multiple of the variance notional).

We recommend selling the 1Y variance swap-vol swap spread on the Nikkei and Hang Seng. On a 1Y trade, the Nikkei 225 and Hang Seng var-vol spreads are both indicatively bid at 4.2 points. This allows investors to collect a maximum 4.2 times the vega notional if the Nikkei 225 realizes near the variance strike of 32.5% and gives a breakeven range of ~16% to 49% for 1-year realized volatility on the Nikkei 225. Meanwhile, the maximum payout is 4.2 times the vega notional if the index realizes near the variance strike of 36%, with a breakeven range of ~18.5% to 53% on the Hang Seng. Investors could also look at shifting down the breakeven range, as volatility is more likely to realize below the variance strike than above it, in our view. For example, if investors buy $0.95 vega notional of vol swap for every $1 of variance sold on the Hang Seng, the maximum payout is just over 4.0 times the var swap vega notional if realized volatility is near 34%, with a breakeven range of ~17% to 51%.

Realized volatility on the Nikkei 225 has never exceeded the upper bound of the breakeven range and has very rarely done so on the Hang Seng, as the highest 1Y vol on the Nikkei 225 was 47% during the 2008/9 credit crisis (based on data since 1970) and on the Hang Seng was 53.8% during the 1998 Asian crisis (based on data since 1974). Meanwhile, we expect a medium volatility environment next year, and see limited risk of realized volatility falling below the bottom of the breakeven range.

Figure 42: Sell the Nikkei 225 variance-vol swap spread to monetize the record high variance premium…Payoff (vegas) Spread (vegas)


Figure 43: …a trade which also looks attractive on the Hang Seng

Payoff (vegas) Spread (vegas)


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10 15 20 25 30 35 40 45 50 55

NKY Volatility - Variance Payoff

Variance swap payoff

Volatility swap payoff

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27



Dividends: 12s Risk/Reward Balanced, Buy Protected Upside on 13s

The payoff on the Euro Stoxx 50 2012 dividend futures (currently at 109.6) is slightly skewed to the upside, in our view.Although it has become dependent on a small number of members, based on our stress tests, the floor for the 2012 realized dividend is ~100 (Figure 44), and the dividend futures will likely be trading close to their settlement value by 1Q1214. We maintain our recommendation of buying on any significant correction.

Given all the macro uncertainties, why hold the 13s and 14s dividends at all? With the 13s and 14s trading at ~73% and 63% of JPM estimates, respectively, they offer deep value on a held-to-maturity basis, in our view. They provide double the expected return (to IBES estimates) compared with Euro HY bonds (Figure 45). Admittedly, the analyst estimates have been revised down and likely have further downside risk. However, in our eight years of historical data, consensus estimates never overestimated the realized dividends by more than 35% one year ahead and 40% two years ahead.

Figure 44: 2012s most likely to realise between 120 and 100Euro Stoxx 50 Estimated Dividend (Index points)


Figure 45: Expected returns on divs are double the HY bond spreadRequired returns/credit spread (bps)

Source: J.P. Morgan.

Investors may be exposed to mark-to-market risk in the near term. In our view, the 13s/14s are likely to experience high volatility, mainly driven by macro headlines in 1H12. In addition to the downside risks specific to dividends outlined in the commentary section, we believe muddling through is no longer a viable solution for the Euro-zone and the market appears to be pushing for a permanent resolution sooner rather than later. Therefore, the volatility should be sustained going into next year, even taking into account the partial pull-to-realized effect on the 13s post March earnings season. In this context, we believe being long dividend volatility serves as a good hedge for both investors who are already long the dividend futures and those who are looking to hedge a tail-risk scenario in Europe.

In terms of pricing, the 13s and 14s have displayed a downside beta of approximately 1.0 relative to the SX5E index. In comparison, the 13s and 14s implied vols are trading at a discount to SX5E implied volatility for corresponding maturities (Figure 46). We wish to emphasize that although the upfront premium of dividend options appears large, the option strategies should be evaluated on a mark-to-market basis, especially given that the decay is relatively slow in the options’ early life.

For those who are long the dividends, a long put position mitigates the mark-to-market risk in the short term, and can be financed by the high carry of the underlying futures. The 13s 90 put option is indicated at 10.4 (ref. 92.3) and, when combined with a long futures position, breaks even with the outright long position at ~87.5 by Jun-12 (assuming constant volatility). Similarly, investors wishing to open new longs can buy calls.

14 See European Equity Derivatives Weekly Outlook, 10-Oct-2011 for details.

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28



For hedgers, being long dividend volatility offers a cheaper hedge relative to SX5E volatility without taking on any basis risk in the tail scenario. A naked Dec-13 90 put offered at 10.4 (ref. 92.3) breaks even at ~87 by June 2012. A 90-95 strangle on the 13s is offered at 20 and provides an upside and downside breakeven of 105 and 75, respectively (Figure 47).

Figure 46: Euro Stoxx 50 dividend option implied volatility appears attractive relative to underlying index implied volatility


Figure 47: Options on 2013s offer attractive breakeven by June ’12P&L in Jun-12 (pts)

DEDZ3 spot price


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29



Downside Protection Trades

Identifying Cheapest Index Put Hedges

As we look at the implied volatilities across global indices (Figure 48), SMI, Nikkei 225, ASX 200, and UKX are the cheapest while FTSEMIB, RDXUSD, MSCI Brazil, and RTY are the richest. However, index puts with the lowest premium/volatility may not always be the most cost effective. Here, we suggest one method of identifying index put options that are most cost effective for hedging against risk-off events by using 3M 95% puts of major global indices.

Table 6: Indicative put premium and return potential across major global indices – sorted by 3M 95% put premium

^ Index affected by European short sale ban. Can still be traded, but new net short positions on restricted names are prohibited. * Return on put premium assuming markets fall back to their 2008

lows. ** Normalized vs. SPX by dividing put premium (or return on put premium) of each index by that of SPX. Source: J.P. Morgan Equity Derivatives Strategy.

Cheapest hedge in terms of absolute premium levels (row 2): Nikkei 225 puts have the lowest absolute premium levels, closely followed by puts on the NIFTY, SMI and ASX 200.

Cheapest hedge in terms of return on premium should markets fall back to the lowest level since 2008 (row 3):Based on this measure, NIFTY puts would provide the highest return on premium, followed by NDX and KOSPI 200. This is not surprising given the magnitude of the market rally in these indices after the global financial crisis.

Cheapest hedge versus S&P 500 (rows 4 & 5): We believe that there is value in protecting against global risk-off events with index puts that price tail risk cheaply relative to SPX. Figure 49 compares the put premium and potential return on premium under a scenario of markets falling back to their 2008 lows, after being normalized against SPX. While SMI and Nikkei 225 puts are much cheaper than SPX puts, these markets did not rebound strongly post-credit crisis, lowering their downside risk and hence potential return on put premium versus 2008 lows. NIFTY, TWSE, INDU, and KOSPI 200 puts seem to be in the sweet spot, offering the best value as a crash hedge against SPX puts, with lower premium and higher potential return on premium against the lows since 2008.

Figure 48: 3M ATM implied volatility and 5Y percentiles of major global indicesImplied Volatility 5Y Percentile


Figure 49: 3M index put premium and potential returns under the scenario of market falling back to 2008 lows, normalized against SPXReturn on put premium vs SPX

3M 95% put premium vs SPXSource: J.P. Morgan Equity Derivatives Strategy.

0

NKY NIFTY SMI AS51 TWSE UKX INDU KOSPI2 AEX HSI SPX NDX OMX DAX CAC* HSCEI SX5E* IBEX* RTY RDXUSD MSCI

Brazil

FTSEMIB*

(1) Distance from Current

Levels to Lows since 2008-19% -50% -25% -27% -42% -37% -46% -51% -35% -43% -46% -55% -42% -39% -21% -52% -23% -22% -54% -60% -57% -20%

(2) 3M 95% Put Premium 3.1% 3.2% 3.3% 3.4% 3.7% 3.9% 4.0% 4.1% 4.2% 4.2% 4.5% 4.5% 4.6% 4.9% 5.1% 5.2% 5.3% 6.2% 6.2% 6.5% 6.7% 7.1%

(3) Return on 3M Put

Premium*3.5X 13.1X 5.2X 5.4X 8.8X 7.1X 9.3X 10.2X 6.1X 8.1X 8.3X 10.2X 7.1X 6.0X 2.1X 8.1X 2.4X 1.7X 6.9X 7.3X 6.7X 1.2X

(4) 3M Put Prem

Normalized vs SPX**0.71 0.72 0.74 0.76 0.84 0.88 0.90 0.92 0.93 0.93 1.00 1.01 1.03 1.10 1.14 1.17 1.20 1.38 1.39 1.47 1.51 1.58

(5) Return on 3M Put Prem

Normalized vs SPX**0.42 1.59 0.63 0.65 1.07 0.86 1.12 1.23 0.74 0.98 1.00 1.23 0.86 0.73 0.25 0.98 0.29 0.21 0.84 0.89 0.81 0.14

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30



Best liquid put hedges for regional equity portfolios

Next, we identify the most attractive liquid option underliers to hedge an equity portfolio in each region globally. We evaluate the put hedges based on the downside beta per unit of implied volatility, as this measure identifies which put option gives investors the most “bang for their buck”15. We note from Table 7, below, the following hedges look cheapest within each region:

Europe: FTSE, DAX and S&P 500 puts are currently the cheapest for hedging a diversified European equity portfolio, while Euro STOXX 50 puts are relatively expensive.

US: S&P 500 puts, followed by FTSE and DAX puts, are cheapest to hedge a diversified US equity portfolio.

Asia: KOSPI 200, followed by FTSE and S&P 500 puts, are cheapest for hedging an EM Asia equity portfolio, while the Hang Seng and Nikkei look relatively expensive.

Japan: Nikkei and ASX 200 puts are cheapest to hedge a diversified Japanese equity portfolio.

Table 7: Best liquid 3M put hedges for regional equity portfolios (cheapest hedges in each region are in red bold text)

Euro STOXX 50* FTSE 100 DAX S&P 500 Nikkei Hang Seng KOSPI 200 ASX 200

3M ATM Implied Vol 31.3% 22.9% 29.9% 25.8% 21.2% 27.0% 25.7% 21.5%

3M Realized Vol 39.7% 26.8% 40.0% 28.8% 21.2% 37.4% 34.9% 25.1%

Implied-Realized Vol -8.3% -3.9% -10.0% -3.0% 0.0% -10.4% -9.3% -3.7%

vs STOXX 600 for hedging European equity portfolios

2Y Downside Beta 0.99 0.94 1.19 1.05 0.68 0.72 0.97 0.77

Beta per vol unit (ATM) 3.2 4.1 4.0 4.1 3.2 2.6 3.8 3.6

Beta per vol unit (95%) 2.9 3.7 3.7 3.7 2.9 2.4 3.5 3.2

2Y Correlation 0.93 0.95 0.92 0.87 0.72 0.67 0.67 0.82

vs Russell 3000 for hedging US equity portfolios

2Y Downside Beta 0.61 0.73 0.91 0.93 0.51 0.55 0.68 0.62


Beta per vol unit (95%) 1.8 2.8 2.8 3.3 2.2 1.9 2.5 2.6

2Y Correlation 0.80 0.87 0.85 1.00 0.64 0.66 0.58 0.84

vs MSCI EM Asia (MXMS) for hedging Asia-Pac equity portfolios

2Y Downside Beta 0.59 0.78 0.74 0.88 0.52 0.69 0.99 0.70


Beta per vol unit (95%) 1.7 3.1 2.3 3.1 2.2 2.4 3.6 2.9

2Y Correlation 0.65 0.73 0.65 0.68 0.69 0.88 0.85 0.75

vs MSCI Topix for hedging Japanese equity portfolios

2Y Downside Beta 0.73 0.88 0.98 0.95 0.98 0.60 0.77 0.95


Beta per vol unit (95%) 2.2 3.4 3.0 3.4 4.1 2.1 2.8 3.9

2Y Correlation 0.61 0.66 0.64 0.59 0.97 0.53 0.65 0.65

Source: J.P. Morgan Equity Derivatives Strategy. Betas/correlations calculated based on weekly returns over last 2 years.

* Note: A short-sale ban on Financial stocks in Europe precludes investors from holding a net short position in the Euro STOXX 50.

15As beta has a theoretical linear relationship to volatility (for example, within a CAPM or APT framework).

31



Buy “Iran Puts”: S&P 500 Puts Contingent on a Rise in Oil, to Hedge Geopolitical Risk

We recommend buying S&P 500 95% strike 1-year put options, contingent on Brent Crude Oil above 105% at expiry. This option costs indicatively 3.1% of notional, compared with a vanilla S&P 500 put at 9.4%, representing a 67% reduction in premium.

The current correlation between equities and oil is strongly positive due to the link between expected economic activity and the demand for oil, since both represent risky assets that have been swept up by risk-on/risk-off trading in H2 2011, and because of the negative correlation between equities and the USD (the currency in which oil is priced)16.

Figure 50: The correlation between oil and equities is near multi-decade highs1Y correlation between Brent Oil and S&P 500


Figure 51: Brent oil is still 24% below its ’08 highs

Price per barrel


However, rising geopolitical tensions between Iran and some Western nations raises the risk of geopolitical escalation, and increasing the chance of an oil price shock that could suppress global economic growth. In addition, it appears that recent changes in MENA (Arab Spring) may destabilize the region rather than reduce geopolitical tensions. According to the BP Statistical Review of World Energy, Iran accounted for 5.2% of global oil production in 2010, at 4.25mn barrels per day. Iran has also threatened to choke off the Strait of Hormuz in response to a potential military aggression, through which 17% of all global oil trade flowed in 2009, according to the US Energy Information Administration.

16 See Rise of Cross-Asset Correlations, 16-May-2011 for further details.

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32



Protection Trade Idea: Buy May 2012 $30-40 Call Spreads on VIX

The VIX and its option implied volatility have fallen substantially from their August peak levels, although they remain above their longer-term average levels (Figure 52). While our base-case view is that the VIX is likely to decline further over the coming year, there remains a risk that volatility could spike again. Since many protection strategies can cause a significant drag on performance when volatility is declining, we seek protection strategies that can be expected to have a relatively low carry cost in such an environment. The term structure of VIX implied volatility is typically inverted, becausethe average annualized daily realized volatility of VIX futures increases as they approach expiry. This is reflected by the current implied volatility term structure of VIX options (Figure 53). Consequently, holding longer-dated options as they approach expiry may benefit from an increase in implied volatility even as the time-to-maturity diminishes.

Figure 52: The VIX and its option implied volatility have fallen substantially from their August peak levels, but remain above their long-term average levelsVIX VIX 3M ATM Implied volatility


Figure 53: The VIX typically has an inverted implied volatility term structure, which reflects the higher average realized volatility of VIX futures contracts as they approach maturityVIX Futures Average Realized Vol, Current VIX 3M Option Implied Volatility

Days to Expiry


Realized volatility of VIX based on historical daily returns for VIX Futures since 2004.

VIX implied skew is also typically inverted (deep out-of-the-money call options on the VIX have a higher implied volatility than at-the-money call options). Consequently, buying call spreads on the VIX exploits the high skew by selling out-of-the-money options. VIX implied skew is currently relatively steep, with 3-month 90-100 implied skew in its 60th percentileover the last 5 years. Maintaining exposure to volatility via short-dated VIX futures or options typically requires rolling these positions frequently. The cost associated with rolling these positions can represent a substantial drag on performance. Usually the shape of the term structure is relatively flat at longer maturities. Consequently, longer-dated VIX futures are less exposed to (positive or negative) slide cost and transaction costs. When the VIX futures term structure is upward-sloping (as it is currently), we believe it is generally preferable to buy longer-dated VIX futures positions and hold them for an extended period of time rather than buying shorter-dated positions that need to be rolled frequently. Longer-dated options positions that are held for a longer period of time are also likely to incur lower slide and transaction costs. Therefore, longer-dated call spreads on the VIX may offer a suitable protection strategy for investors to hold to maturity.

The May 2012 expiry VIX future is currently at ~30. Buying the May12 $30-40 call spread costs ~$2.80, offering a potential ~3.6x payout-to-cost multiple. In our view, this VIX call spread offers relatively inexpensive protection for an equity portfolio. Should the equity market suffer a severe correction, the VIX would likely spike up above 40 (the VIX index has closed above 40 on ~5% of days this year and reached a peak of 48 in August). This scenario would likely deliver a positive mark-to-market impact for the call spread. In the event of an equity rally, the VIX call spread would likely suffer only a limited mark-to-market loss. Indeed, the maximum potential loss from this protection strategy is the $2.80 premium paid upfront. In our view this offers relatively low-cost six-month protection, and may offer a smaller drag on performance relative to many other protection strategies. Owning call spreads on the VIX is more favourable than owning variance swaps (which are expensive compared with our expectation for realized volatility) or May-12 VIX futures (which would entail greater downside risk in the event that volatility falls between now and May expiry).

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33



Sector Trade Idea: Buy 6M 95% or 90% Best-of Puts on Hong Kong Bank Basket

Our regional strategist Adrian Mowat has an underweight position on the Hong Kong banking sector in his 2012 Asia ex-Japan portfolio and believes investors should avoid the sector for the Year of the Dragon. The sector will face more headwinds than in 2009 as Operation Twist and deposit competition will hurt net interest margins (“NIM”). Our sector analyst Joseph Leung also remains cautious on the sector’s fundamentals and believes the NIM pressure will likely continue in the coming quarter. The latest data show that the loan spread continued to widen in Nov-11 and deposit competition underpinned the NIM pressure in this interest rate cycle.

In addition, credit to China has grown significantly in the last two years, and this could drive credit quality deterioration of Hong Kong banks in the next cycle. Historical experience suggests credit charges likely will peak in 2H12-1H13, with NPL ratio rising from 0.3% to 0.7%. This would imply 20% earnings downside to J.P. Morgan estimates for the sector, which are 12% below consensus.

Investors who share our negative view on the Hong Kong banking industry can buy 6M 95% or 90% best-of puts on the Hong Kong bank basket to gain downside exposure to the sector. On the back of the stocks’ liquidity and availability of borrow, we suggest including 3 banks in the basket that have significant exposure to the Hong Kong banking industry –HSBC (5 HK), Bank of China HK (2388 HK) and Hang Seng Bank (11 HK). Although HSBC has a diversified geographic exposure of business operations, with over c.30% of its operating income derived from Hong Kong and with the largest market share in the sector, we believe it is reasonable to include the stock in the basket.

A best-of put has the same payoff as a standard ‘vanilla’ put option, but the underlying instrument is the best-performingconstituent within the basket. We believe it can offer less expensive downside protection on a basket of stocks, albeit at the cost of the payout being tied to the performance of the best underlying in the basket. Best-of puts can also offer a cheaper hedge against a sizeable market-wide sell-off, assuming the stocks in the basket move in line with the broad market. The instrument benefits from an increase in correlation and volatility, which both typically occur during a market correction.

Given that the value of best-of puts lies in its cost savings, investors may need to consider the balance between the option premium savings as compared with other vanilla option structures and the level of conviction on the basket components. The 6M 95% and 90% best-of puts on the Hong Kong bank basket cost 4.8% and 3.6% indicatively. This can offer an average of 39% option premium savings to vanilla puts on the bank basket itself or the individual stock components (see Figure 54 for the pricing comparison). We therefore believe this structure is attractive for investors to express their negative view on the sector.

Figure 54: Pricing comparison of various 6M 95% put structures


Note: HSBC (5 HK) rated OW by Josh Klaczek; Bank of China (HK) (2388 HK) rated

OW by Joseph Leung; Hang Seng Bank (11 HK) rated N by Joseph Leung.

Figure 55: Historical payout of 6M 95% best-of put option


Option Type 6M 95% Put Best-of Put Premium Savings

Vanilla Put on HSBC (5 HK) 9.2% -48.4%

Vanilla Put on BOC (HK) (2388 HK) 8.8% -46.1%

Vanilla Put on HSB (11 HK) 6.4% -26.0%

Vanilla Put on HSI 6.8% -30.6%

Best-of Put on 3 HK Banks 4.8% 0.0%

Vanilla put on 3 HK Banks 8.0% -40.3%

Option Type 6M 90% Put Best-of Put Premium Savings

Vanilla Put on HSBC (5 HK) 7.2% -50.8%

Vanilla Put on BOC (HK) (2388 HK) 6.7% -47.1%

Vanilla Put on HSB (11 HK) 4.6% -23.2%

Vanilla Put on HSI 5.3% -32.9%

Best-of Put on 3 HK Banks 3.6% 0.0%

Vanilla put on 3 HK Banks 6.1% -41.3%

34



Relative Value TradesSell S&P 500 Dec-12 Variance and Hedge Using KOSPI 200

As described in the Global Market Volatility Outlook, we anticipate S&P 500 realized volatility of around 18.5% in 2012. In this context S&P 500 Dec-12 variance looks expensive. S&P 500 one-year implied variance is ~32.5%, which over the past ten years is in its 90th percentile.

The S&P 500 variance term structure as measured by the difference between 3-month and 12-month maturities is currently in its 67th percentile. If the term structure maintains this shape, a short S&P 500 one-year volatility position would benefit from the “slide” down the term structure as time elapses. Beyond a one-year maturity, the term structure remains upward-sloping but is relatively flat.

The premium of one-year S&P 500 variance to ATM implied volatility is currently close to its highs (in 97th percentile). If this relationship persists, then a short S&P 500 Dec-12 variance position would benefit from the declining premium of variance to ATM volatility as time elapses.

The combination of these two factors suggests that Dec-12 variance is the sweet spot for a short S&P 500 volatility position, in our view. In Figure 56, we show the hypothetical P&L progression that would be generated by such a position, assuming that the term structure for both ATM implied volatility and implied variance remains as it is, and assuming realized volatility of 18.5% throughout. If our S&P 500 realized volatility forecast turns out to be accurate, investors would generate a profit of around 11 Vegas.

A short S&P 500 Dec-12 variance position could suffer substantial mark-to-market losses in the event of a spike in either implied or realized volatility. As a consequence, an outright short Dec-12 variance position may not be appropriate for all investors. As such, we suggest going long variance on another index as a hedge.

In Figure 57, we show six global indices with their one-year variance level and their spread of the one-year variance to S&P 500. We also show the three-month realized spread and the short-term carry (spread of 1Y implied to 3M realized). For example, entering into a long KOSPI 200 one-year variance swap overlaid with the short S&P 500 one-year variance would give an implied spread of -3% which over the past ten years is in its 65th percentile. The pair is realizing -7.6% over the past three months, giving a short-term positive carry of 4.6%. From all the pairs listed below, we like the S&P 500 and KOSPI 200 pair the most as the implied spread is in its 65th percentile (above average) and has a short-term carry of 4.6%. If we look at the short-term carry in isolation, then the short S&P 500/long DAX looks the most attractive with a short-term carry of 9.3% but the implied spread is below average in its 37th percentile.

Figure 56: Hypothetical profit/loss progression from a short Dec-12 S&P 500 variance position


Figure 57: One-year global index variance, implied and realized spread to S&P 500 and carry


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DAX 36.1% -3.6% 37% -13.0% 9.3%

HSI 37.9% -5.4% 30% -7.8% 2.4%

KOSPI2 35.5% -3.0% 65% -7.6% 4.6%

NKY 33.3% -0.8% 72% 6.2% -7.0%

SX5E 38.6% -6.1% 7% -12.7% 6.6%

UKX 31.4% 1.1% 72% 0.0% 1.1%

Implied Spre ad

35



Option Strategies for EM versus DM Outperformance

With EM policy priorities shifting from anti-inflation to a growth focus, our equity strategists have recently initiated an overweight position in EM versus DM equities. We see similarities with the post-Lehman period. In October 2008, EM equities started outperforming their DM counterparts, as EM policymakers started focusing on stimulating their economies. Just as then, EM policy priorities are shifting from controlling inflation to stimulating growth. Going into 2012, the outperformance of EM versus DM equities remains one of our key trades with high conviction.

To implement the EM versus DM outperformance view via options, call switch or outperformance option strategies can be used. In terms of underlyings, we can consider MSCI EM Asia (MXMS) for the long leg and S&P 500 (SPX) for the short leg, as a proxy benchmark for DM.

Call switch: Investors may buy call options on MXMS while selling call options on SPX to implement the relative value trade between EM and DM on the upside only. This type of option spread trade can capture the relative cheapness/richness of volatility in their pricing and, as a spread trade, may entail less outright directional risk. Due to the higher volatility levels in MXMS, the call switch strategy requires a net premium outlay. A switch strategy with call spreads would reduce the option premium outlay.

Outperformance option: Investors may buy an option that provides a payoff based on the relative performance between the two assets, minus the strike. Unlike call switches, outperformance options provide the relative performance exposure on the upside and downside. While the option premium is higher, losses are limited to the premium paid.

Table 8 summarizes the indicative option pricing and backtest results of 6M call switch and outperformance option strategies with different strikes. While the call switch strategy is more risky than the outperformance option, due to the substantially lower premium outlay, we prefer the call switch strategy over the outperformance option to implement our overweight EM versus DM view. Against the backdrop of our strategists’ bullish outlook, the risk of SPX rallying and outperforming MXMS on the upside is small, in our view, especially when SPX has already outperformed MXMS greatly over the past six months. In case the market moves against our bullish outlook, the possibility of MXMS outperforming SPX on the downside is also small as shown in the past history, supporting our preference for call switches over outperformance options. For investors who want further savings on option premium, the switch strategy with call spreads is also very attractive.

Table 8: Indicative pricings and backtest results of various 6M MXMS vs. SPX option strategies for the past 10 yearsBased on 6M rolling returns

Source: J.P. Morgan Equity Derivatives Strategy. Note: Return figures are based on gross P&L at maturity without including historical option costs.

Figure 58: Rolling performance of 6M MXMS vs. SPX call switch strategies for the past 10 years


ATM Call

Switch

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Avg Return 7.9% 7.3% 3.8% 9.7% 6.7%

Avg Gains 14.5% 14.2% 8.3% 14.6% 12.6%

Avg Losses -4.1% -4.0% -3.8% N/A N/A

Max Return 53.6% 52.7% 15.0% 53.6% 48.6%

Min Return -14.7% -14.7% -10.1% 0.0% 0.0%

% Occur Gain 58.8% 54.0% 49.7% 66.3% 53.3%

Option Premium 1.40% 1.50% 0.60% 6.85% 4.80%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

Nov-01 Nov-03 Nov-05 Nov-07 Nov-09 Nov-11

Gro

ss P

&L a

t M

atu

rity

ATM Call Switch

105% Call Switch

105% - 120% Call Spread Switch

36



Credit-Equity Outlook and Trade Idea

In 2011 European equity volatility lagged the spike in credit markedly at the onset of the sell-off in July, as illustrated by the z-score of our credit-equity CEV model (Figure 59). In comparison, the dislocation in the US was much smaller. We believe that in 2012 the macro-level relative value may still emerge, in particular in the US. However, Europe is unlikely to repeat the same extremity as in 2011. Instead, we believe investors may find more abundant the relative value opportunities at the single-stock level.

Figure 59: SX5E equity vs. iTraxx 5Y Main


Figure 60: SPX equity vs. CDX IG 5Y


For 2012, our credit analysts do not foresee high default rates in corporate bonds (see 2012 Credit Outlook, Dulake & team). Nonetheless, we believe there will be more distressed opportunities due to: 1) the looming recession in Europe which will likely impair companies’ operating performance; 2) cost of borrowing is the highest since 2008/09 credit crunch; and 3) European banks will have to deleverage by reducing their loan books. To be sure, we do not expect the same level of credit shortage as in 2008/09. Strong companies will still be able to access the funding markets, albeit at a cost. However, those with high leverage and weak balance sheets, especially in Europe, likely will experience difficulties, thus creating opportunities for investors, in our view.

Investors can take advantage of our credit-equity relative value screen, covering US and European names to identify potential opportunities. Table 9, below, shows the top 10 names in our universe with CDS > 500, ranked by the difference between market and equity implied CDS. We also show the hedge ratio according to our CEV model. Investors can go long risk in credit and short the equities based on the hedge ratio to take advantage of the mispricing. We emphasize that bottom-up analysis plays an important role in distressed situations and the screen is meant to be a starting point for further investigation.

Table 9: Credit-Equity relative value opportunities based on the CEV screen

Ticker Name 5Y CDS Equity Implied CDS Mkt – Implied CDS Hedge Ratio (CDS:Equity Notional)

ALU FP ALCATEL-LUCENT 1614 1273 341 8.5:1FST UN FOREST OIL CORP 536 235 301 6.9:1KBH UN KB HOME 930 698 232 5.4:1

S UN SPRINT NEXTEL CORP 916 805 111 5.3:1FTR UN FRONTIER COMMUN. 753 655 98 5.7:1HTZ UN HERTZ GLOBAL 631 540 91 6.3:1RSH UN RADIOSHACK CORP 539 452 87 5.4:1GT UN GOODYEAR TIRE 650 579 71 6.2:1

PHM UN PULTEGROUP INC 534 483 51 4.5:1JBLU US JETBLUE AIRWAYS CORP 1088 1040 48 8.9:1


1,800

2,000

2,200

2,400

2,600

2,800

3,000

-2

-1

0

1

2

3

4

5

Jan Apr Jul Oct

CEV Z-Score (LHS)

SX5E index (RHS) 1,000

1,050

1,100

1,150

1,200

1,250

1,300

1,350

1,400

-2

-1

0

1

2

3

4

5

Jan Apr Jul Oct

CEV Z-Score (LHS)

SPX index (RHS)

Equity protection cheap

Credit protection cheap

Equity protection cheap

Credit protection cheap

https://mm.jpmorgan.com/PubServlet?action=open&doc=MMRC-450846-1.pdf


37



Upside Participation TradesBullish Positioning with Long-Dated Far OTM Index Call Options

Although it is important to remember that macro risks are easing rather than evaporating, missing out on the upside is equally worrying for many investors. Implied volatility still remains quite elevated across the globe, making outright call options quite expensive. Options are not cheap in high volatility environments, especially for short-dated tenors on high-beta indices, even though term structures have become flattened recently.

Looking closely at the volatility surface across global indices, we think there are still pockets of value remaining in certain indices. In particular, due to the steep skews and rich short-dated implied volatilities, long-dated upside call options look rather cheap. With relatively muted responses to the recent risk-off period as compared with their historical percentiles, long-dated volatilities are more immune to volatility collapses should the risky asset rally continue. Investors can consider using long-dated far OTM call options to gain levered upside exposure at low premium cost outlay to implement bullish views. If the Euro sovereign debt crisis or other macro factors worsen, we expect the long-dated implied volatilities to significantly increase, which could also benefit the mark-to-market P/L of the long-dated OTM call option positions (see Table 11 for the scenario analysis of the return on premium with regard to changes in underlying prices and implied volatility).

In Table 10, among the major global indices, SMI, UKX and Nikkei 225 1Y 120% implied volatilities stand out as the cheapest, with levels trading below 20%. Meanwhile, S&P 500, Hang Seng and CAC all have 1Y 120% implied volatilities trading below 25%, although they have 3M ATM implied volatilities around 30%.

To identify the value embedded in long-dated upside options, we can look at the following measures: 1) cheapest upside exposure based on option premium, and 2) return on call option premium under a bullish blue-sky scenario such as the highs since 2008. For this analysis, we are using 1Y and 2Y 120% index call options.

Based on the measure of absolute premium levels, SMI is the cheapest, followed by UKX and Nikkei 225.

Based on the measure of potential return on premium under a blue-sky scenario (assuming the equity markets return to the highs since 2008), Nikkei 225 ranks at the top, followed by SMI and AEX.

Table 10: 1Y and 2Y 120% call option indicative premium and potential return on option premium if the market rallies to the highs since 2008– sorted by 1Y 120% call premium

Source: J.P. Morgan Equity Derivatives Strategy. * Return on option premium if equity markets revert back to their highs since 2008.

Table 11: Scenario analysis of the return on premium for a 12M 120% call option on ASX 200 assuming 1M into the trade

Source: J.P. Morgan Equity Derivatives Strategy. Note: Return on option premium represents the mark-to-market % change in option premium.

Underlying Move

-10% 0% +10% +20% +30% +40% +50%

-10% -1.0X -0.9X -0.5X 1.1X 4.3X 8.6X 13.3X

-8% -1.0X -0.9X -0.2X 1.6X 4.7X 8.8X 13.4X

-6% -1.0X -0.7X 0.1X 2.0X 5.1X 9.0X 13.5X

-4% -0.9X -0.5X 0.5X 2.5X 5.5X 9.3X 13.7X

-2% -0.8X -0.3X 0.9X 2.9X 5.9X 9.6X 13.9X

0% -0.7X -0.1X 1.2X 3.4X 6.3X 10.0X 14.1X

+2% -0.6X 0.2X 1.6X 3.8X 6.8X 10.4X 14.4X

+4% -0.4X 0.5X 2.0X 4.3X 7.2X 10.8X 14.7X

+6% -0.2X 0.8X 2.4X 4.7X 7.7X 11.2X 15.1X

+8% 0.0X 1.1X 2.8X 5.2X 8.1X 11.6X 15.4X

+10% 0.2X 1.4X 3.2X 5.6X 8.6X 12.0X 15.8X

Volatility Move

38



Europe: Buy OTM Calls on De-Rated Names

We recommend buying 25-delta calls on oversold stocks that have a chance of strongly rerating, according to J.P. Morgan Equity Strategist Mislav Matejka. Our European Equity Strategy team screened for de-rated European stocks that are the most oversold names and are consensus UW, and could thus rebound the most in the case of a market rally17. We narrowed down this list to liquid optionable names that offer attractive call pricing. The names in Table 12, below, have the following properties:

Low ROE: In the bottom 2 quartiles of ROE ranking;

Underperformed their sector year-to-date;

Cheap valuation: Trading near or below the trough Price/Book multiple seen in March 2009;

Inexpensive vol carry: 6M ATM implied volatility is below 3M realized vol;

Volatility not prohibitively expensive: The 6M 25-delta call strike is less than 130% of spot.

Table 12: De-rated European names with inexpensive upside optionality, sorted by strike of the 25-delta call

Ticker NameYTD

Return

Current P/Book vs '09

TroughROE

6M ATM Vol

3M Realised Volatility

Implied-Realised Spread

Indicative 25-Delta Call Strike

Indicative 25-Delta Call Premium

VIV FP Vivendi -24% -24% 7% 31.0% 39.9% -8.9% 110.0% 2.7%

TEF SQ Telefonica -24% -19% 9% 29.9% 37.4% -7.5% 111.5% 2.6%

EN FP Bouygues -32% -8% 9% 33.8% 38.9% -5.1% 112.0% 2.7%

HEIA NA Heineken -12% -2% 14% 23.2% 24.3% -1.1% 112.0% 2.1%

RWE GY RWE -45% -50% 8% 39.4% 56.9% -17.5% 115.5% 3.2%

FTE FP France Tel -26% -39% 9% 27.9% 33.5% -5.6% 116.0% 2.6%

GSZ FP GDF Suez -33% -30% 11% 35.6% 47.6% -12.0% 117.0% 3.0%

EDF FP EDF -41% -41% 11% 33.7% 44.4% -10.8% 117.5% 3.0%

CA FP Carrefour -37% -14% 13% 40.2% 52.1% -11.9% 120.5% 3.4%

UG FP Peugeot -57% -13% 5% 48.1% 61.2% -13.1% 125.5% 3.9%

LG FP Lafarge -50% -19% 11% 46.3% 64.5% -18.2% 127.5% 3.8%

Source: J.P. Morgan Equity Derivatives Strategy, J.P. Morgan Equity Strategy.

17 See p.20 of Equity Strategy Year Ahead 2012, Mislav Matejka, 5-Dec-2011 for details.


39



Using Seasonality in Japan to Trade Calendar Spread

The dislocation in the equity market in 2011 pushed share prices of many Japanese companies near to historical lows. The abysmal share price performance suggests that these companies, in our view, have not generated value to shareholders for years if not decades.

As we face potentially harder times to come in 2012, we believe we should be focusing on those stocks that have performed comparatively well over the years, i.e., the value creators. The table below shows the list of top 10 companies (from TOPIX100) ranked by their 30-year historical returns (from 1981 to 2011). Since during the same period Japanese real GDP grew by 86%, we can deem these companies as value creators, as the share prices have appreciated well in excess of the nation’s economic growth. Of the 10 companies, those rated Overweight by J.P. Morgan analysts also have substantialupside to J.P. Morgan analysts’ target prices.

Table 13: TOP10 companies ranked by 30-year share price growth


Seasonality is a well-known factor in determining TOPIX returns. In terms of average return, the months of March, April and December stand out, and in terms of the win/loss ratio, April is particularly impressive with 65%.

Since we believe that the near-term upside is limited due to uncertainty connected with the European debt issues, but that upside in spring is more likely, we suggest using the seasonality and current inverted term structure to trade calendar spreads in the above companies. Specifically, we suggest selling 110% 3M calls against purchasing 110% 5M calls on these stocks. Calendar spreads typically rise in value if the stock price doesn’t move too far, as the shorter-dated options that have been sold lose time value faster than the longer-dated options that have been bought.

Premiums (indicative) and volatility levels are given in table below.

Table 14: 3M-5M 110% calendar spread premiums (indicative)


Code Name30Yr %

Gain

J.P. Morgan

Rating

Target

Price% Upside

4063 JT Equity SHIN-ETSU CHEMICAL CO LTD 1223.2% OW 4500 21.5%

6367 JT Equity DAIKIN INDUSTRIES LTD 873.0% OW 3200 48.1%

7267 JT Equity HONDA MOTOR CO LTD 731.3% OW 3000 39.3%

7751 JT Equity CANON INC 720.6% OW 5000 49.7%

8591 JT Equity ORIX CORP 633.7% OW 10500 70.2%

8830 JT Equity SUMITOMO REALTY & DEVELOPMNT 543.6% OW 2100 43.7%

4452 JT Equity KAO CORP 448.9% N 2300 10.8%

6301 JT Equity KOMATSU LTD 439.4% OW 2700 41.0%

4502 JT Equity TAKEDA PHARMACEUTICAL CO LTD 403.9% N 3600 12.9%

7269 JT Equity SUZUKI MOTOR CORP 403.3% N 1600 4.6%

Code NameOption

PremiumVolatility Delta

4063 JT Equity SHIN-ETSU CHEMICAL CO LTD 1.13% 29.92% -3.45%

6367 JT Equity DAIKIN INDUSTRIES LTD 1.68% 36.95% -3.88%

7267 JT Equity HONDA MOTOR CO LTD 1.48% 32.78% -4.67%

7751 JT Equity CANON INC 1.32% 27.94% -6.99%

8591 JT Equity ORIX CORP 1.57% 37.06% -3.45%

8830 JT Equity SUMITOMO REALTY & DEVELOPMNT 1.79% 37.43% -4.24%

6301 JT Equity KOMATSU LTD 1.62% 37.79% -3.36%

40



Risks of Common Option Strategies

Risks to Strategies: Not all option strategies are suitable for investors; certain strategies may expose investors to significant potential losses. We have summarized the risks of selected derivative strategies. For additional risk information, please call your sales representative for a copy of “Characteristics and Risks of Standardized Options.” We advise investors to consult their tax advisors and legal counsel about the tax implications of these strategies. Please also refer to option risk disclosure documents.

Put Sale. Investors who sell put options will own the underlying stock if the stock price falls below the strike price of the put option. Investors, therefore, will be exposed to any decline in the stock price below the strike potentially to zero, and they will not participate in any stock appreciation if the option expires unexercised.

Call Sale. Investors who sell uncovered call options have exposure on the upside that is theoretically unlimited.

Call Overwrite or Buywrite. Investors who sell call options against a long position in the underlying stock give up any appreciation in the stock price above the strike price of the call option, and they remain exposed to the downside of the underlying stock in the return for the receipt of the option premium.

Booster. In a sell-off, the maximum realised downside potential of a double-up booster is the net premium paid. In a rally, option losses are potentially unlimited as the investor is net short a call. When overlaid onto a long stock position, upside losses are capped (as for a covered call), but downside losses are not.

Collar. Locks in the amount that can be realized at maturity to a range defined by the put and call strike. If the collar is not costless, investors risk losing 100% of the premium paid. Since investors are selling a call option, they give up any stock appreciation above the strike price of the call option.

Call Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the stock is below the strike price of the call option.

Put Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the stock is above the strike price of the put option.

Straddle or Strangle. The seller of a straddle or strangle is exposed to stock increases above the call strike and stock price declines below the put strike. Since exposure on the upside is theoretically unlimited, investors who also own the stock would have limited losses should the stock rally. Covered writers are exposed to declines in the long stock position as well as any additional shares put to them should the stock decline below the strike price of the put option. Having sold a coveredcall option, the investor gives up all appreciation in the stock above the strike price of the call option.

Put Spread. The buyer of a put spread risks losing 100% of the premium paid. The buyer of higher ratio put spread has unlimited downside below the lower strike (down to zero), dependent on the number of lower struck puts sold. The maximum gain is limited to the spread between the two put strikes, when the underlying is at the lower strike. Investors who own the underlying stock will have downside protection between the higher strike put and the lower strike put. However, should the stock price fall below the strike price of the lower strike put, investors regain exposure to the underlying stock, and this exposure is multiplied by the number of puts sold.

Call Spread. The buyer risks losing 100% of the premium paid. The gain is limited to the spread between the two strike prices. The seller of a call spread risks losing an amount equal to the spread between the two call strikes less the net premium received. By selling a covered call spread, the investor remains exposed to the downside of the stock and gives up the spread between the two call strikes should the stock rally.

Butterfly Spread. A butterfly spread consists of two spreads established simultaneously. One a bull spread and the other a bear spread. The resulting position is neutral, that is, the investor will profit if the underlying is stable. Butterfly spreads are established at a net debit. The maximum profit will occur at the middle strike price, the maximum loss is the net debit.

Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate of current market levels, and are not indicative trading levels.

41



金融商品取引法に基づく表示事項(Below statement explains possibilities of risk of financial instruments in Japanese language. This is to follow “the Financial Instruments and Exchange Law” regulated by Government of Japan.)

株式をお取引する場合には、約定代金に事前にお客様と個別に合意した手数料率を乗じて算出した委託手

数料及び消費税を頂くことになります。株式を募集等により取得する場合には、購入対価のみお支払いいただ

くことになります。株式取引は株価の変動等により損失が生じる恐れがあります。また、外国株式取引の場合、

為替相場の変動によっても損失が生じるおそれがあります。

転換社債を当社が相手方となりお買付いただく場合及び募集・売出しによりお買付いただく場合は、購入対価

のみお支払いただくことになります。また、債券の売却にあたり手数料は発生しません。債券の価格は、市場で

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には、損失が生じるおそれがあります。債券の発行者の業務や財産の状況の変化に伴い、債券の価格が変動

することによって損失が生じるおそれがあります。株式への転換を選択された場合、転換後の財産の価格や評

価額が債券の当初購入金額を下回るおそれがあります。新株予約権を行使できる期間に制限があります。

キャップ・フロアー、スワップション、通貨オプション取引、金利スワップ、通貨スワップ、クレジットデリバティブ、

個別株オプション等の「店頭デリバティブ取引」にあたっては、手数料その他の費用は頂戴しません。店頭デリ

バティブ取引は、金利指標、通貨の価格、金融指標の名称、参照先の信用状況、対象とする個別株式の株価

、等の変動を直接の原因として損失が生ずることとなるおそれがある取引です。また、ISDA マスター契約にお

けるクレジット・サポート・アネックス（Credit Support Annex）等の担保契約の適用がある場合、金利指標、通貨

の価格等の参照指標が大きく変動することで、あるいはクレジットイベントが発生して、プロテクションの売り手

側が支払うべき金額が差入れ済みの担保の額を上回る場合に、発生する損失の額が差し入れていただく担保

の額を上回る恐れがあります。店頭デリバティブ取引の想定元本は、当該デリバティブ取引等についてお客様

に差し入れていただく担保の額を上回る可能性があります。店頭デリバティブ取引にあたり差し入れていただく

担保の額は担保契約の内容により異なるため、想定元本の担保額に対する比率上限を算出することはできま

せん。店頭デリバティブ取引では反対取引を行おうとする場合は価格に差があり、原則として同じ価格での反

対売買を行うことは出来ません。

市場先物取引、市場オプション取引、市場先物オプション取引をお取引する場合には、約定代金または約定

枚数に対し、事前にお客様と個別に合意した手数料率を乗じて算出した委託手数料および消費税のみを頂く

ことになります。証拠金の額は、ＳＰＡＮ®等各取引所の定める方法により、先物取引、オプション取引、先物

オプション取引全体の建玉から生じるリスクに応じて計算されますので、市場先物取引、市場オプション取引、

市場先物オプション取引の額の証拠金の額に対する比率は、常に一定ではなく、取引の額が証拠金の額を上

回る場合があります。市場先物取引、市場オプション取引、市場先物オプションの価格は、対象とする株価指

数、有価証券の価格、金利、通貨の変動等により上下しますので、これにより損失が発生するおそれがあり、ま

た当該株価指数、有価証券の価格、金利、通貨が大きく変動することで発生する損失の額が差し入れていた

だく保証金の額を上回る恐れがあります。また、当該市場先物取引、市場オプション取引、市場先物オプショ

ン取引が外貨建て取引の場合、為替相場の変動によって損失が生じるおそれがあります。

商品毎に手数料等およびリスクは異なりますので、実際に上記取引を行っていただく前には当該商品等の契

約締結前交付書面や目論見書またはお客様向け資料をよくお読みください。金融商品取引業者 JP モルガン証券株式会社関東財務局長（金商）第 82 号加入協会/日本証券業協会、（社）金融先物取引業協会、一般社団法人第二種金融商品

取引業協会、社団法人日本証券投資顧問業協会

Disclosures

This report is a product of the research department's Global Equity Derivatives and Delta One Strategy group. Views expressed may differ from the views of the research analysts covering stocks or sectors mentioned in this report. Structured securities, options, futures and other derivatives are complex instruments, may involve a high degree of risk, and may be appropriate investments only for sophisticated

42



investors who are capable of understanding and assuming the risks involved. 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 option transactions.

Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

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Risks associated with Leveraged and Inverse ETFs: Leveraged ETFs seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETFs seek to provide the opposite, or multiple times the opposite, of the daily returns, of an underlying index or benchmark. Leveraged and inverse ETFs usually reset daily and track their intended indices on a daily basis, but may fail to correlate over longer periods. Due to the effects of compounding and possible correlation errors, leveraged and inverse ETFs may experience greater losses than expected. Compounding can also cause a widening differential between the performance of an ETF and its underlying index or benchmark so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETFs may experience losses even in situations where the underlying index or benchmark has performed as expected. Leveraged and inverse ETFs use aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives and options that may increase ETF volatility and may cause a drag on performance. Investors holding these ETFs should therefore monitor their positions frequently -- i.e., in most cases, daily -- to look for possible divergences. Leveraged and inverse ETFs may not be suitable for all investors and should be used only by knowledgeable investors who understand the potential consequences of their strategies, including seeking daily leverage or daily inverse leveraged investment results. The Financial Industry Regulatory Authority has indicated that, in its view, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets. Accordingly, prior to investing in these instruments, all potential investors and, particularly, retail investors, should evaluate whether the instruments are suitable for them in light of their risk tolerance and investment horizon, carefully read the prospectus and consult with a financial professional as needed. INVESTORS SHOULD NOT INVEST IN THESE INSTRUMENTS UNLESS THEY FULLY UNDERSTAND AND HAVE EVALUATED THE RISKS AND HAVE, INDEPENDENTLY OF JPM, DETERMINED THAT THE INVESTMENT IS SUITABLE FOR THEM.

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Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] In our Asia (ex-Australia) and UK small- and mid-cap equity research, each stock’s expected total return is compared to the expected total return of a benchmark country market index, not to those analysts’ coverage universe. If it does not appear in the Important Disclosures section of this report, the certifying analyst’s coverage universe can be found on J.P. Morgan’s research website, www.morganmarkets.com.

https://mm.jpmorgan.com/disclosures.jsp

43



J.P. Morgan Equity Research Ratings Distribution, as of September 30, 2011

Overweight(buy)

Neutral(hold)

Underweight(sell)

J.P. Morgan Global Equity Research Coverage 47% 42% 11%IB clients* 51% 44% 33%

JPMS Equity Research Coverage 45% 47% 7%IB clients* 70% 60% 52%

*Percentage of investment banking clients in each rating category.For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

Equity Valuation and Risks: For valuation methodology and risks associated with covered companies or price targets for covered companies, please see the most recent company-specific research report at http://www.morganmarkets.com , contact the primary analyst or your J.P. Morgan representative, or email [email protected] .

Equity Analysts' Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking.

Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-USaffiliates of JPMS, are not registered/qualified as research analysts under NASD/NYSE rules, may not be associated persons of JPMS, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.

Other Disclosures

J.P. Morgan ("JPM") is the global brand name for J.P. Morgan Securities LLC ("JPMS") and its affiliates worldwide. J.P. Morgan Cazenove is a marketing name for the U.K. investment banking businesses and EMEA cash equities and equity research businesses of JPMorgan Chase & Co. and its subsidiaries.

Options related research: If the information contained herein regards options related research, such information is available only to persons who have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporation's Characteristics and Risks of Standardized Options, please contact your J.P. Morgan Representative or visit the OCC's website at http://www.optionsclearing.com/publications/risks/riskstoc.pdf

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Country and Region Specific Disclosures U.K. and European Economic Area (EEA): Unless specified to the contrary, issued and approved for distribution in the U.K. and the EEA by JPMSL. Investment research issued by JPMSL has been prepared in accordance with JPMSL's policies for managing conflicts of interest arising as a result of

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publication and distribution of investment research. Many European regulators require a firm to establish, implement and maintain such a policy. This report has been issued in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEA countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction. Australia: This material is issued and distributed by JPMSAL in Australia to "wholesale clients" only. JPMSAL does not issue or distribute this material to "retail clients". The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms "wholesale client" and "retail client" have the meanings given to them in section 761G of the Corporations Act 2001. Germany: This material is distributed in Germany by J.P. Morgan Securities Ltd., Frankfurt Branch and J.P.Morgan Chase Bank, N.A., Frankfurt Branch which are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. Hong Kong: The 1% ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.5(a) of the Hong Kong Code of Conduct for Persons Licensed by or Registered withthe Securities and Futures Commission. (For research published within the first ten days of the month, the disclosure may be based on the month end data from two months prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider/market maker for derivative warrants, callable bull bear contracts and stock options listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website: http://www.hkex.com.hk. Japan: There is a risk that a loss may occur due to a change in the price of the shares in the case of share trading, and that a loss may occur due to the exchange rate in the case of foreign share trading. In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan, Type II Financial Instruments Firms Association and Japan Securities Investment Advisers Association. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. Singapore: JPMSS and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures section above. India: For private circulation only, not for sale. Pakistan: For private circulation only, not for sale. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money. JPMSAL does not issue or distribute this material to members of "the public" as determined in accordance with section 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement, a public offering, an offer to sell securities described herein, or solicitation of an offer to buy securities described herein, in Canada or any province or territory thereof. Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules.

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst's involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

"Other Disclosures" last revised September 30, 2011.

Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan. #$J&098$#*P

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