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Global Equity Derivatives &
Delta One Strategy

10 December 2012
Global Derivatives Themes

2013 Outlook for Equity Derivatives
For the first time in seven years there were no large spikes in the VIX as
low volatility in 2012 surprised investors. The key drivers of volatility
were the European debt crisis in H1, central banks actions in late
summer, and concerns about the US fiscal cliff in the fall. Scratching
below the surface of the low S&P 500 volatility, one discovers a
troubling picture of record-low stock volatility and high correlations
both are potentially damaging to fundamental stock investors. This
environment was a result of a downward spiral of low volumes, macro
uncertainty, declining participation of fundamental investors, and fund
outflows.
Global
Global Equity
Head ofDerivatives
Derivative &
&
Quantitative
Strategy
Quantitative Strategies
In 2013 the prevailing macro uncertainty should provide a floor to

volatility. Our quantitative analysis shows that the current low VIX level
is in stark contrast to virtually every macroeconomic indicator across the
globe. We believe that structural drivers will keep the average level of
stock correlation high. Given the already record-low levels of stock
volatility, S&P 500 volatility is likely to increase from current levels near
term.
(852) 2800-8857
tony.sk.lee@jpmorgan.com
Buoyed by central bank actions and macro uncertainty, assets

traditionally perceived as safe reached record levels. Not only have
equities underperformed, but stocks had lower volatility than gold or
long-term bonds. Medium term, flow of assets into equities should cause
outperformance and mitigate downside risk. Similarly, implied volatility
premium may come under pressure from the continued search for yield.
Investors currently overweight traditional safety assets can likely lower
risk and increase yield by allocation to high-quality, dividend yielding,
inflation-resistant stocks and overwriting strategies.
Equity Derivatives Strategy Team
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 Volatility Relative Value Trades: Asia versus DM
volatility spreads, long 2014 Euro STOXX 50 dividend volatility,
improved volatility carry strategies, taking advantage of flat skews,
dispersion; Macro/Directional Trades: Euro STOXX 50 vs. S&P 500
call spreads, EM Asia vs. US outperformance, S&P 500 ratio risk
reversals, buy calls on MSCI Mexico, Turkey vs. S. Africa call switch,
Nikkei dividend steepeners; Downside Protection Trades: cheapest
index put hedges, Jan VIX calls spread funded by selling puts, Japan
equity put contingent on rates, FTSE/GBP dual-digital.
Carmen Firescu
carmen.firescu@jpmorgan.com
Sahil Manocha
sahil.manocha@jpmorgan.com
AC
AC
Marko
Kolanovic
(Global)
Marko Kolanovic
(1-212) 272-1438
mkolanovic@jpmorgan.com
J.P.Morgan Securities LLC
Davide Silvestrini (EMEA)

(44-20) 7134-4082
davide.silvestrini@jpmorgan.com
J.P.Morgan Securities plc
Tony Lee (Asia Pacific)
J.P.Morgan Securities (Asia Pacific) Limited
Ruy Ribeiro (Rule-based)

(44-20) 7134-0626
ruy.m.ribeiro@jpmorgan.com
J.P.Morgan Securities plc
US
Marko Kolanovic
Bram Kaplan
Amyn Bharwani
marko.kolanovic@jpmorgan.com
bram.kaplan@jpmorgan.com
amyn.x.bharwani@jpmorgan.com
EMEA
Davide Silvestrini
Ruy Ribeiro
Peng Cheng
davide.silvestrini@jpmorgan.com
ruy.m.ribeiro@jpmorgan.com
peng.cheng@jpmorgan.com
Asia Pacific
Tony Lee
tony.sk.lee@jpmorgan.com
Sue Lee
sue.sj.lee@jpmorgan.com
Hayato Ono
hayato.ono@jpmorgan.com
Japan
Michiro Naito
michiro.naito@jpmorgan.com
See page 38 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.
www.jpmorganmarkets.com
Marko Kolanovic
(1-212) 272-1438
Global Equity Derivatives & Delta One Strategy

10 December 2012
Table of Contents
Outlook for Macro Volatility and Correlations .......................3
Outlook for Equity Risk ..........................................................................................3
Cross-Asset Portfolios .............................................................................................7
Implied Correlation .................................................................................................9
Skew and Convexity..............................................................................................12
Term Structure ......................................................................................................16
Dividends..............................................................................................................19
Derivatives Ideas for 2013 .....................................................23

Macro/Directional Trades......................................................................................29
Downside Protection Trades..................................................................................34
Risks of Common Option Strategies ......................................................................37

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Outlook for Macro Volatility and Correlations

Outlook for Equity Risk
Low levels of volatility in 2012 came as a surprise to investors used to years of market turmoil. At the time of writing
our 2012 Outlook, S&P 500 volatility was 31% and we predicted it to decline to a 15-20% range.1 Volatility in 2012
declined below our target and currently stands at 14%, in line with the median level over the last 100 years. For the first
time in seven years, there were no large spikes in the VIX (as measured by the ratio of Maximal and Average level) and
the VIX itself was range-bound, with the lowest dispersion of levels since 2006 (Figure 1). The key drivers of the market
volatility were a deterioration of the European sovereign debt crisis in H1 (Spanish sovereign spreads, Greek elections),
followed by accommodative actions of central banks (Draghis speech at the end of July, ECBs OMT and Feds QE3 in
September). In the last quarter of 2012, market focus started shifting from Europe to the US, where potentially large
fiscal adjustments known as the fiscal cliff are risking a decline in the stock market or even another US recession
(see Impact of Tax Rates on Stock Market Returns).2 In 2012, the premium of the VIX over short-term realized volatility
was above its long-term average (2012 average of 5.1 points vs. 20-year average of 4.4), but collapsed post US elections and
is now close to zero (Figure 2). The low levels of realized volatility and premium are counterintuitive, given the US fiscal
uncertainly and negative growth in Europe. As we will argue below, they are a result of the unique macro environment and
significant changes in market microstructure.
Figure 1: In 2012, the highest level of the VIX was 1.5 times its
average, and standard deviation was 2.7 points (inset table). This
was the most benign volatility environment since 2006
60%
2009
2010
2011
50%
VIX
40%
Figure 2: VIX and 1M S&P 500 realized volatility. The key drivers of
volatility were the European crisis, and actions of central banks.
The premium of VIX over realized volatility recently dropped to zero
35%
2005
2006
2007
2008
2009
2010
2011
2012
Max/Avg
1.4
1.9
1.8
2.5
1.8
2.0
2.0
1.5
Stdev
1.5
2.2
5.4
16.4
9.0
5.4
8.2
2.7
25%
Greek Debt
VIX
Spain Debt
Demand
15%
CBs Ease
$ Funding
20%
10%
0%
S&P 500
3M Realized
Volatility
Mar, 09
Dec, 09
5%
2012
Sep, 10
Source: J.P. Morgan Equity Derivatives Strategy.
Jun, 11
Mar, 12
Dec, 12
Short Sale Ban

Spain Debt
20%
30%
10%
Greek Elections
Euro Debt Concerns
VIX
30%
0%
TVIX
Collapse
Draghi
Speech
US Elections
ECB OMT
FED QE3
S&P 500
1M Realized
Volatility
Dec, 11
Feb, 12
Apr, 12
Jun, 12
Aug, 12
Oct, 12
Dec, 12
Scratching below the surface of the low headline level of the VIX and S&P 500 realized volatility, one discovers a troubling
picture of record low volatility of individual stocks and very high levels of correlation between them. In fact, the average
volatility of individual S&P 500 stocks is at 30-year lows.3 What appears to be a benign environment with moderate
levels of the VIX is a result of an extreme regime of low stock volatility and high market correlations, both of which
could prove very damaging for fundamental stock investors4 (Figure 3). This unique microstructure is a result of a
downward spiral of low equity volumes, macro uncertainty, declining participation of fundamental stock investors,
and fund outflows.
1
6M realized volatility of S&P 500 daily returns.

The full fiscal cliff amounts to $700bn in 2013, or ~4.5% of GDP. The risks of a larger adjustment and adverse market reaction are
substantial.
3
On November 1, average 3M volatility of stocks in the S&P 500 reached 18%, the lowest level in over 30 years.
4
See Why We Have a Correlation Bubble.
2
Marko Kolanovic
(1-212) 272-1438

10 December 2012
Equity share volumes are currently near record lows. Historically, low equity volumes cause low equity volatility (and vice
versa), which can help explain the decline in stock volatility (Figure 4). On the other hand, macro uncertainty and macro
trading based on central bank policy typically drive Index and Index derivatives volumes higher (Futures, ETFs, Index
options) and hence increase stock correlations (see Why We Have a Correlation Bubble, Rise of Cross-Asset Correlations).
The record low equity volumes in 2012 reflect even lower participation of active fundamental investors as ~55% of volume
is executed by High Frequency Trading programs (HFT) and ~30% is traded in Exchange Traded Funds (ETFs). While
there is a significant overlap between ETF and HFT participation, it is clear that a very small fraction of already low equity
volumes are due to fundamental stock investors. HFT trading typically employs index arbitrage, statistical arbitrage, and
automated market making, and these strategies further increase correlation and sap stock volatility.
As the spiral of high correlation and low stock volatility makes fundamental investing difficult, long/short stock investors
walk away from the market, and equity investments flow into passive (indexation) strategies. In addition to the shift from
active to passive or algorithmic strategies, funds further flow out of equities and into the fixed income space, buoyed by
their perceived safety and central bank interventions. For instance, Investment Company Institute (ICI) data show that over
the past four years, US equity funds recorded $400bn of outflows, while fixed income funds recorded $1,000bn of inflows.
80%
70%
70%
60%
Figure 4: Equity share volumes are currently near record lows.

Historically, low equity volumes cause low equity volatility (and vice
versa).
30000
2000
1500
60%
Stock Correlation
25000
50%
1000
NYSE Volume
40%
40%
30%
30%
20%
20%
10%
Stock Volatility
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
2000
500
S&P 500 Volatility
20000
50%
2400
Corr: 70%
NYSE Volume
Figure 3: What appears to be a benign environment of moderate

levels of the VIX is a result of record low stock volatility and high
correlations, both of which could prove damaging for fundamental
stock investors.
0%
20%
40%
1600
15000
1200
10000
800
Total US Equity Volume
10%
5000
0%
60%
2004
400
2006
2008
2010
2012
While political risk was the key driver of market performance and volatility, derivatives positioning often had a
notable impact on intraday price action and volatility. On September 6 and 13, ECB and Fed announcements caused the
market to gap up and a sharp drop in volatility. For several weeks before and after these announcements, the S&P 500 was
range-bound around the 1400-1450 levels (Figure 5). Earlier in the year, when the market was ~1300, many investors sold
call options at these levels as a part of overwriting or collaring strategies. This caused dealers to be long options (long
gamma), and their hedging activity suppressed market realized volatility in August and September, around the 1400
and 1500 levels, in effect similar to a pinning (for details on the mechanics of option hedging impact see Market Impact of
Derivatives Hedging).
In November, market performance and volatility were dominated by the US election and concerns around the fiscal cliff. On
November 7 the market dropped by 33 points after President Obama was re-elected (note that the size of the election move
was almost exactly predicted by the S&P 500 term structure as we noted in Election Day Expected Move). During
September and October, investors accumulated long put option positions below 1400, which made dealers short options
(gamma) below 1400. As the market dropped below 1400, hedging of short option positions created a predictable
end of the day momentum effect and subsequent reversal on November 7, 8, 9, and 13, increasing the daily market
volatility (Figure 6). Short positioning in S&P 500 options and VIX products did not cause a large increase in market
volatility in November. However, we believe there is still a significant overhang of short positions on S&P 500 options and
VIX products that could increase volatility if the market drops and the VIX term structure inverts.
4
Marko Kolanovic
(1-212) 272-1438

10 December 2012
Figure 5: ECB and FED announcements were key drivers of market

performance and volatility in September. Hedging of long S&P 500
option positions suppressed volatility around 1400 and 1450 levels
Figure 6: US Elections were key drivers of market performance and

volatility in November. Hedging of short S&P 500 option positions
increased volatility below the 1400 level
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg.
The cost of owning option- and VIX-based hedges has been declining throughout the year.5 The decline in the cost of
derivative protection is a result of investors scaling down hedges due to their poor performance, selling of premium
to generate yield, overall low levels of equity exposure, and a larger risk complacency post ECB and Fed actions.
Holding equity protection in 2012 was very expensive. This can be illustrated by a 70% annualized drop in the VXX just on
account of term structure rolldown, and an average 30% loss on long option positions on account of low realized volatility
(e.g., 1Y volatility averaged 20%, and realized was 14%). Given the high cost, demand for hedging waned (especially in the
second half of the year). As central banks pushed real rates on bonds into negative territory, many investors started outright
selling volatility to generate yield. The perception of lower systemic risk prompted investors to sell the volatility premium
(e.g., overwriting, short variance strategies) and volatility term structure (e.g. VIX roll-down strategies).
In order to forecast volatility in 2013, we start by estimating the likely macro environment and stability of high equity
correlation. The European sovereign debt crisis, and more generally the debt problems of the developed world,
should continue to be the main source of macro risk. Compared to a year ago, debt to GDP ratios for most of the
developed world countries have increased. While the budget deficits have modestly declined, they are still significant
(Figure 7). The uncertainty related to the debt crisis and low expected GDP growth rate6 should provide a floor to market
volatility. At this point in time, it is not clear how the US fiscal cliff will be resolved, but we do know that it can have a
significant implication on equity markets and the rating of US sovereign debt (e.g., large changes in capital gain, dividend,
and small business tax rates can have a meaningful impact on stock market performance and volatility, see Impact of Tax
Rates on Stock Market Returns).
To compare the current VIX levels to macro fundamental risk, we have performed a simple quantitative exercise: we
compiled a list of 484 macro indicators published by Bloomberg that have a significant correlation to the VIX index
and regressed them against the current reading of the VIX. Results show that the current low VIX level is in stark
contrast to virtually every macroeconomic indicator across the globe. These indicators include PMI, GDP, payroll and
unemployment, housing, retail sales, consumption, inventory, business and consumer confidence, delinquencies, and other
economic activity indicators. The 81 US macro series point to a VIX level on average 7.2 points higher, the 214 European
indicators point to a VSTOXX level 9.7 points higher, and the 186 Asia economic indicators point to a VNKY level 8.9
points higher (Figure 8). While these results dont signal an imminent increase in the VIX, they do point to a large
discrepancy between the market volatility and macro fundamentals. As we do not think that the macro environment will
drastically change over the next year, we believe risk for market volatility is to the upside.
The cost of option hedges is measured by the premium of implied volatility over realized volatility (Figure 2), and the cost of being long
the VIX is measured by the steepness of the term structure.
6
Expected GDP growth for US: 1.7%, Europe 0.0%, Japan 0.0%, Asia-ex 6.5% (see Global Markets Outlook and Strategy).
5

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Figure 7: Debt and Deficit (as % of GDP) for 10 developed world

countries with largest amount of debt outstanding
Country
Japan
USA
Italy
UK
France
Germany
Spain
Canada
Belgium
Netherlands
Debt (% of GDP)
Latest Year ago Change
214%
207%
7.5%
103%
99%
4.1%
126%
122%
4.4%
86%
83%
3.2%
91%
86%
5.0%
83%
81%
1.7%
76%
67%
9.3%
86%
84%
1.8%
103%
98%
4.9%
68%
64%
4.0%
Deficit (% of GDP)
2012
2011
% Chg.
-9.9%
-9.5%
4%
-8.3%
-9.7%
-15%
-1.7%
-3.8%
-55%
-7.7%
-8.4%
-8%
-4.5%
-5.2%
-14%
-0.9%
-1.0%
-11%
-5.4%
-8.5%
-37%
-3.5%
-4.5%
-24%
-2.8%
-3.9%
-28%
-4.3%
-4.6%
-7%
Figure 8: Based on the past 10 years of historical data,

macroeconomic indicators across the globe unambiguously point
to a higher level of the VIX
10Y Regression of VIX

Against Macro Data
# of Macro Indicators
# point Volatility Cheap
# point Volatility Rich
Average Points Cheap
Standard deviation
USA
VIX
81
81
0
-7.2
2.5
Europe
V2X
215
214
1
-9.7
3.3
Asia
VNKY
188
186
2
-8.9
3.5
Next we focus on market correlations. Over the past 20 years, correlation between stocks showed not only a strong cyclical
behavior but also a secular increase from levels of ~20% to the current average level of ~40% (see Why We Have a
Correlation Bubble). In addition, the volatility of correlations has increased substantially (Figure 9). We believe that the
prevailing macro uncertainty and structural drivers described earlier in this section will keep the average level of
stock correlation high. Given the already record low levels of stock volatility, we believe S&P 500 volatility is likely
to increase from current levels. Our 2013 forecast for average realized volatility is 16% (up from the current 14%)
with a most likely range of 14-19%. We believe the VIX will trade at an average premium of 4 points over realized
volatility, which is lower than 2012 average premium of 5 points.
Figure 10 shows S&P 500 realized volatility (vertical axis) against average stock volatility (horizontal axis) over the past 20
years. The current level of stock and S&P 500 volatility is illustrated by a red dot. As stock volatility increases, S&P 500
volatility typically increases as well, and the rate of increase is determined by the level of correlation. During periods of low
correlations, such as during the Tech Bubble in 2000, substantial increases in stock volatility led only to modest increases in
S&P 500 volatility. However, in 2008 and especially 2011, the high level of correlation translated even small increases of
stock volatility into significant increases of S&P 500 volatility. The still-high correlation environment leads to higher risk of
a volatility spike going forward, in our view.
70%
60%
Stock Correlation
50%
40%
30%
40%
30%
20%
20%
10%
0%
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Figure 10: S&P 500 realized volatility (vertical axis) vs. average
stock volatility (horizontal axis). Current level is illustrated by a red
dot. There are many different ways for volatility to increase
40%
35%
30%
25%
20%
S&P 500 Volatility
Figure 9: Over the past 20 years, correlation between stocks

experienced a secular increase from ~20% to the current average
level of ~40%
2008
2011
Tech
Bubble
15%
10%
Stock Volatility
5%
15%
25%
35%
45%
55%
The risk to our view is that volatility stays at current low levels or decreases further. For volatility to decrease, we would
need to see a meaningful decrease in stock correlations, which we think is unlikely. Even if HFT activity declines (as
expected by Tabb group), and index volumes decline, stock correlations would likely stay elevated. The reason for this is
6
Marko Kolanovic
(1-212) 272-1438

10 December 2012
because HFT and index trading are essentially only a transmission mechanism and not the principal source of high
correlation. The main source of high correlations is macro uncertainty and political risk that is driving the prices of all risky
assets. This becomes obvious if one looks at the evolution of correlation of Equities to Interest Rates, Commodities, and
Currencies (Figure 11).7 The correlation of equities to other asset classes has increased dramatically since 2008 as the price
of risky assets became largely dependent on the resolution of sovereign debt problems, growth expectations, and monetary
policy.
Cross-Asset Portfolios
Equity volatility and correlations are important inputs for the asset allocation process. The described macro and political
risks are not only driving cross-asset correlations but also the relative performance of risky assets. Treasury bonds and gold
reached record levels, as these assets were directly impacted by central bank actions (outright purchases, inflation hedges).
For instance, Treasuries have added almost 10% of pure alpha annually since QE2 (Figure 12). As this outperformance is
not based on economic fundamentals, medium term, it is expected to reverse and cause outperformance of equities
relative to Treasuries and gold. Not only have equities underperformed these assets, but over the past year, equities
have been less risky: volatility of the S&P 500 was 14%, 20Y Bond volatility was 15%, and volatility of gold was
17%. In addition, in the scenario of increased inflation expectations, equities are expected to outperform bonds. We believe
that beyond the potential near-term equity weakness and increased volatility, medium term, inflows into equities should
cause outperformance over bonds and gold and hence put a ceiling on equity volatility. Similarly, the implied volatility
premium may come under pressure from fixed income investors searching for yield. Given the prospect of negative real
yields, they may engage in selling equity options and volatility, buying dividends, and other short equity risk premium
trades.
Figure 11: Similar to correlation between stocks, correlation of
stocks to other asset classes increased as a result of macro
uncertainty and monetary policy responses.
80%
Commodity / Equity
Currency / Equity
60%
Rates / Equity
Figure 12: Treasury bonds and gold reached record levels as these
assets are supported by central bank actions and investors fear of
inflation. For instance, Treasuries have added almost 10% of pure
alpha annually since QE2.
180
160
140
40%
20%
800
S&P 500 (Left)

10Y Bond (Left)
Gold (Right)
700
600
120
QEs
100
200
60
100
40
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
-20%
400
300
80
0%
500
2000
2002
2004
2006
2008
2010
2012
Investors that are currently overweight bonds and gold can likely lower their risk by increasing allocation to stocks. Stocks
should be chosen from the high-quality and low-volatility universe, and sectors resistant to inflation (Figure 13). To
generate yield, investors can increase allocation to high dividend yielding stocks and overwrite positions by selling
call options. Overwriting would not just increase yield but would also significantly cut the risk (e.g., selling at-the-money
call option would reduce equity risk by ~50%). Given the medium-term risk of inflation, and what appears to be inflated
prices of traditional relatively safe assets, we believe that these equity strategies may provide a more robust relative
safe haven than investing in government bonds or gold.
7
For a detailed review of cross-asset correlations see our report Rise of Cross-Asset Correlations.
7

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Despite modest levels of market volatility, we believe there is still a meaningful risk of a tail event in 2013. On the
downside, triggers could be the failure to resolve the US fiscal cliff, leading to a debt downgrade and recession, rapid
deterioration of the crisis in the Eurozone, or geopolitical escalation in the Middle East. On the upside, a tail event could
result from a quick resolution of the US fiscal cliff, upside surprise in global growth, and start of bonds to stocks rotation.
Given the high levels of correlation, cross-asset investors looking to hedge tail risk should compare the pricing of tail
hedges in different asset classes. To assess the relative cost of tail risk hedges, we compared long-term historical
probabilities (over ~100 years) of realized tail events vs. current option implied probabilities. In particular, Figure 14 shows
the ratio of implied to realized tail event probabilities for the S&P 500, Gold, Japanese Yen and 10Y Treasury (for 1M, 3M,
6M, and 1Y time horizons and returns in a -40% to 40% range). Comparing the ratios of implied to realized tail event
probabilities across asset classes, we note that in equities, upside tail protection looks cheap and downside tail
protection looks the most expensive, compared to other asset classes. This is a result of the supply/demand imbalance
for equity index options in which investors are typically buying put options to hedge and selling call options to generate
yield or collar positions. Buying far out of the money S&P 500 calls or risk reversals (selling out of the money puts
and buying calls) appear to be the cheapest upside tail hedges across-asset classes.
Figure 13: Exposure of sectors to increases in Inflation (CPI). Table
shows Z-scores of the response to inflation (from 5 months before
to 5 months after an increase in CPI). Positive values indicate
sectors that may do well, and negative values indicate sectors that
may do poorly in a high inflation environment
Sector
-5 -4 -3
Food Beverage & Tobacco
0.0 0.3 0.9
Pharma Biotech & Life Sci.
0.1 0.2 0.7
Food & Staples Retailing
0.1 0.8 1.5
Utilities
1.0 1.1 1.5
Health C. Equipment & Serv. 0.4 0.6 1.2
Transportation
0.5 0.3 0.7
Energy
2.2 2.1 2.0
Household & Pers. Prod.
-0.1 0.1 0.6
Commercial & Prof. Serv.
-0.2 0.2 0.4
Telecomms
-0.7 -0.3 -0.5
Consumer Services
-2.7 -2.1 -1.7
Retailing
-2.0 -1.8 -1.6
Consumer Durable & App.
-1.5 -1.6 -1.4
Capital Goods
1.3 0.9 0.7
Real Estate
0.6 0.3 0.2
Semi & Semi Eqipment
0.1 0.0 -0.5
Materials
0.2 0.1 0.2
Insurance
0.3 0.1 0.0
Banks
-1.1 -1.3 -1.5
Div Financial
-0.4 -1.1 -1.4
Software & Services
-1.0 -1.0 -1.1
Tech Hardware & Eqipment -0.6 -0.5 -1.1
Media
-1.2 -1.4 -1.6
Auto & Components
-2.0 -1.8 -1.7
-2
1.5
1.4
1.5
2.0
1.6
1.3
2.3
1.0
0.3
-0.7
-1.6
-1.2
-1.1
0.4
0.5
-0.6
0.3
-0.4
-1.4
-1.6
-1.4
-1.6
-1.4
-1.9
-1
1.9
1.6
1.1
1.9
1.5
0.9
1.8
1.0
-0.1
-0.8
-1.9
-1.2
-1.2
-0.1
0.1
-0.2
-0.4
-1.4
-1.1
-1.4
-0.9
-1.2
-1.4
-1.9
0
2.4
1.9
1.7
1.7
1.5
1.6
0.3
1.4
0.3
-0.1
-0.9
-0.7
-0.6
-0.2
-0.3
-0.5
-0.9
-1.3
-0.1
-0.7
-0.9
-1.3
-1.6
-2.0
+1
2.7
2.2
2.3
1.7
1.2
1.9
-0.1
1.9
1.1
0.4
0.1
-0.1
0.3
-0.3
-0.6
-0.5
-1.3
-0.7
0.7
-0.5
-1.3
-1.6
-1.7
-1.8
+2
2.7
2.4
2.5
1.5
0.9
1.6
0.0
1.5
1.8
0.3
0.6
0.3
0.7
-0.5
-0.5
-0.3
-1.1
-0.4
0.9
-0.4
-1.2
-1.5
-1.5
-1.8
+3
2.8
2.5
2.0
1.6
0.8
1.1
0.4
1.3
1.7
0.5
0.9
0.1
-0.2
-1.0
-1.0
-0.3
-0.7
-0.8
-0.3
-0.8
-0.9
-1.3
-1.5
-2.4
+4
2.9
2.5
2.1
1.6
1.2
0.8
0.1
1.2
1.7
0.6
1.1
0.6
-0.1
-1.7
-1.2
-0.2
-0.7
-1.2
-1.0
-0.9
-0.6
-1.1
-1.6
-3.0
+5
2.4
2.1
1.8
1.1
1.2
0.4
-0.2
0.8
1.6
0.4
0.9
1.0
0.1
-1.8
-1.1
-0.2
0.0
-0.9
-0.8
-0.2
-0.4
-1.2
-1.5
-2.8
Figure 14: Ratio of options implied to historical realized tail event

probability in the S&P 500, Gold, JPY, and 10Y Treasury. Equity
upside tail protection looks cheap and downside tail protection
looks expensive
Ratio of Implied to Realized Tail Probability
-40% -30% -20% -10% -5%
S&P 500
1M
4.1 2.8 1.9
3M
4.6 3.0 2.4 1.9
6M
7.2 4.3 3.2 2.2 1.8
1Y
6.4 4.1 3.3 2.1 1.9
Average
6.8 4.3 3.4 2.3 1.8
GOLD
1M
4.8 1.4 1.2
3M
4.8 1.8 1.4
6M
3.5 1.8 1.4
1Y
4.1 2.7 1.7 1.5
Average
4.1 3.9 1.7 1.1
JPY
1M
1.9 0.5
3M
0.6 0.5
6M
0.7 0.5 0.7
1Y
0.8 1.1 0.6 0.7
Average
0.8 0.9 0.9 1.0
10Y Bond
1M
0.4
3M
0.8
6M
0.4 1.0
1Y
0.7 1.0
Average
0.5 0.8
5%
10%
20%
30%
40%
0.6
0.6
0.6
0.6
0.5
0.2
0.4
0.5
0.5
0.4
0.1
0.2
0.3
0.2
0.1
0.2
0.2
0.2
0.2
0.8
0.9
0.8
0.8
0.7
0.4
0.7
0.7
0.7
0.7
0.2
0.6
0.8
0.7
0.6
0.5
0.8
0.8
0.7
0.2
0.6
0.9
0.6
1.1
0.9
1.0
1.2
1.9
1.7
1.2
1.1
1.3
4.2
2.4
3.3
0.4
0.5
0.6
0.7
0.6
0.4
0.5
0.6
0.5
0.6
0.4
0.5
0.4
0.4

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Implied Correlation
In the previous section we discussed our view that stock correlations will stay elevated on account of macro uncertainty and
the structural impact of HFT and elevated index trading activity. Despite high levels of realized correlation, implied
correlation in 2012 has been trading at a significant premium relative to realized correlation for the S&P 500 (Figure 15).
This was also the case for most global indices (Figure 16). During the bull market of 2003 to 2007, correlation was one of
the more popular volatility arbitrage trades. By selling correlation, hedge funds provided liquidity needed to meet demand
for index protection and at the same time absorbed excessive supply of single-stock volatility coming from overwriting
programs and structured product issuance. While selling correlation is an arbitrage trade that in principle can be made
market and volatility neutral, the trade has higher order volatility exposures that usually make it short volatility (e.g., see
Dispersion Trading and Volatility Gamma Risk). Moreover, during volatility spikes, index volatility tends to react faster
than stock volatility, and this can lead to additional short volatility exposure. For these reasons, correlation trades, like other
volatility carry trades, worked extremely well during the low volatility period of 2003-2007.
Figure 15 : Despite high levels of realized correlation, implied
correlation in 2012 has been trading at a significant premium relative
to realized correlation for the S&P 500
80%
70%
60%
100%
Figure 16: Implied and realized correlations across global indices

declined throughout the year from the elevated 2H11 levels
Avg implied and realized correlation for 8 major global indices*
70%
Correlation Carry
Implied Correlation
80%
Realized Correlation
60%
50%
40%
40%
30%
60%
50%
Avg 6M Realised
20%
20%
0%
10%
0%
2000
40%
Jan-12
-20%
2002
2004
2006
2008
2010
2012
Avg 6M Implied
Apr-12
Jul-12
Oct-12

* S&P 500, Euro STOXX 50, FTSE, DAX, SMI, TOPIX Core 30, ASX 200, Hang Seng.
Since 2009, the correlation premium has stayed high, but volatility of correlation has increased substantially, increasing the
risk for short correlation positions (see Expecting a Near-Term Decline in Stock Correlations). In particular, volatility of
realized correlation post 2008 almost doubled to an average volatility of 14 correlation points (Figure 17).
In addition to higher risk for correlation trades, the potential return has diminished, despite the high implied-realized
correlation spread. To understand these dynamics, one needs to look at the mechanics of correlation trades. Correlation
trades are nowadays implemented by trading variance or volatility swaps (rather than correlation swaps). At high levels of
correlation and low levels of stock volatility, capturing the same spread of implied to realized correlation translates into less
actual PnL as expressed in point gains on volatility or variance swaps. For instance, Figure 18 shows that to capture 1 vega
profit on the stock volatility leg, the implied-realized correlation spread that needs to be captured is twice as high now
compared to the period prior to the 2008 crisis. Similar is true for capturing profit on the index volatility leg. The same
analysis applies to the bid-offer spread investors need to pay on a correlation trade. For instance, paying a 2 vega bid-offer
spread on single stock variance pre-crisis would translate into 4 correlation points, while now it takes away 8 correlation
points from the trade.
Marko Kolanovic
(1-212) 272-1438

10 December 2012
Figure 17: Dispersion of realized correlation levels doubled post

2008 crisis, increasing the risk for short correlation trades
25%
20%
15%
Volatility of Correlation:
Pre Crisis: 7 Correlation Points
Post Crisis: 14 Correlation Points
Figure 18: High levels of correlation and low levels of stock volatility
reduce the profitability of correlation trades as the same impliedrealized correlation spreads translate into lower profits on the trade
7
6
5
1 Index Vega
Pre-Crisis: 4 Correlation points
Post-Crisis: 6 Correlation points
4
10%
5%
3
2
1
0%
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
1 Stock Vega
Pre-Crisis: 2 Correlation points
Post-Crisis: 4 Correlation points
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Given the high levels of correlation and low level of volatility, the potential for profit in correlation trades decreased post2008 relative to the 2003-2007 time period (or alternatively to keep the same profitability, investors needed to significantly
increase the risk). At the same time, volatility of correlation increased, further reducing the risk-reward attractiveness of
short correlation trades. The attractiveness of correlation trades also decreased relative to other carry trades. For instance,
during 2012, capturing 1Y correlation premium would have resulted in approximately 3 index point Vega, while selling
VIX 4M-7M term structure would have resulted in a ~6 Vega annual profit, at a comparable level of market risk and lower
liquidity risk.
Looking into 2013, we believe that investors should be more selective with regards to correlation/dispersion trades as
opportunities are scarcer. In the sections below we highlight where we think the attractive trades lie:
Europe: For 2013, the multi-year low skew has rendered short correlation trades unattractive at the moment for Euro
STOXX 50 and DAX, in our view. However, we note that the FTSE 100 and SMI remain outliers with a different dynamic.
Although the absolute level of implied correlation is lower now, FTSE still presents a good opportunity, mainly in its skew
differential versus its single-stock constituents. Index skew has rebounded recently, while single-stock skew had its biggest
drop in two weeks. Therefore, investors can currently buy the volatility spread between the index and single stocks 90%
strike options at an attractive level of ~4.8%, while it is realizing ~6.5%. This trade idea is detailed further in the Volatility
Trades section of the report.
The SMI represented another interesting opportunity for dispersion trades in 2012. Dynamics in this market were mostly
driven by the EUR/CHF peg and investor fears that the SNB would be unable to cope with the amount of FX reserves
required to maintain its currency peg to the EUR at 1.20. After the ECBs intervention and EUR/USD rally, these worries
abated, and EUR/CHF volatility collapsed (with ATM trading ~1.9% volatility). During the course of the year, SMI
volatility showed similar patterns to EUR/CHF volatility; however, SMI volatility lagged the retracement in EUR/CHF
volatility. It is exactly this delay that created trade opportunities in SMI dispersion in late August/September as the SMI
index volatility and skew appeared rich, while its constituents vols were trading considerably cheaper, in line with
economic fundamentals and currency risk.
In their 2013 FX Outlook, our FX strategists remain cautious on EUR/CHF. Their view is that even though most FX
markets will be range-bound, they expect the EUR/CHF peg to remain under pressure. This will likely provide opportunities
in both EUR/CHF and SMI volatility next year as well as SMI dispersion.
10
Marko Kolanovic
(1-212) 272-1438

10 December 2012
Asia: With the Fed and ECB policy actions keeping volatility in check, implied correlations across Asia have come down
significantly, similar to the pattern in other regions. The modest year-to-date return of 9% for the MSCI Asia Pacific
benchmark and index EPS downgrades throughout the year hide a large dispersion in country/sector/stocks returns and the
importance of relative EPS revisions driving relative returns. The year 2012 provided a good environment for active
managers as indicated by the much lower levels of realized correlations, resulting in the wide implied-to-realized spreads
versus levels one year ago. ASX 200 stands out in the region, in terms of implied-to-realized spreads as well as the implied
correlation percentile relative to its realized correlation history. The structural drivers of volatility continue to have an
impact on correlation as investors look for ways to enhance yield through overwriting activities, which provide abundant
single-stock volatility supply. Hence, it is our preferred index for dispersion trades going into 2013 for this region. TOPIX
Core 30 is another index that ranks highly as a dispersion trade candidate, largely due to its rich implied-to-realized spread.
Going into 2013, with financial repression and QE3/infinity forcing investors to consider equities, P/E multiples are likely
to rise while relative EPS revisions will continue to drive relative returns. Under this environment, correlations in Asia
should remain under pressure while the implied to realized spread should continue to widen, in our view.
Table 1: Realized and implied correlations for the main global indices
1Y ATM implied
correlation
5Y percentile
6M realised
correlation
5Y
percentile
Implied %ile of 1Y
realised correlation
1Y ATM vol spread avg

single stocks vs. index
SPX
61%
55%
45%
29%
100%
5.1%
SX5E
66%
59%
56%
53%
86%
5.9%
DAX
64%
55%
53%
59%
82%
4.8%
UKX
50%
28%
36%
21%
72%
4.8%
SMI
HSI Top 15
51%
20%
35%
22%
66%
5.2%
56%
4%
49%
17%
29%
5.3%
AS51 Top 15
54%
22%
36%
19%
77%
4.4%
TPCX30 (vs. NKY)
56%
60%
35%
4%
61%
5.9%
11

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Skew and Convexity

In our 2012 Outlook we highlighted how the cost of downside risk protection was sharply re-priced in the aftermath of the
2008 financial crisis and stood near all-time highs. We further noted that this re-pricing was largely driven by technical
factors and overestimated the risk of both downside and upside tail events, and thus we recommended selling the rich skew
through a number of derivatives structures. In the last six months, global index skews have dropped significantly and
for European and Asian underliers are near post-crisis lows. Figure 19 shows the recent history of skew for several
indices globally, illustrating the sharp re-pricing of global skews in the last six months. This picture looks similar for both
upside (ATM-110%) and downside (90%-ATM) skews as both the put and call wings have flattened. For example, in Figure
20 we can see how the S&P 500 3M fixed strike skew has flattened from mid June, with both the downside skew coming
down and upside skew shifting up, even though the spot index is little changed over the period.
Figure 19: 6M 90%-110% skews of major indices have fallen
significantly over the last 6 months
Figure 20: S&P 500 fixed strike skew flattened on both wings over
the last 6 months
6M 90%-110% skew
3M Implied Vol
5-Dec-12
10%
30%
19-Jun-12
8%
30-Dec-11
25%
6%
20%
4%
2%
0%
2009
SPX
SX5E
HSI
NKY
2010
2011
15%
2012
10%
1050
1150
1250
1350
1450
1550
Strike
Source: J.P. Morgan Equity Derivatives Strategy. Based on data over the past 5 years
The recent repricing of skew is in part attributable to decreased demand for hedges this year, for example evidenced by the
sharp decline in the S&P 500 put/call open interest ratio since Q1. The put/call ratio typically rises alongside the market as
investors increasingly seek to protect their gains, while when the market falls equity exposure is typically cut, reducing the
need for hedging. However, during the latest rally since June, it appears investors bought considerably less protection than
historically (Figure 21). We attribute this fall in demand for hedges to:
8
9
Low realized volatilityS&P 500 realized volatility is just ~13% YTD. This has caused hedges to underperform and
sapped investor demand for continuing to buy expensive volatility in hedging structures.
Investor complacencyThe perception of tail risks has waned as investors gained comfort from the idea that central
bank actions can cure economic woes, leading to lower protection buying. Markets appear to have put confidence in
monetary policy actions as risk parameters (e.g., VIX at 16, skew near post-crisis lows) do not reflect the fact that
Europe spent 2012 in recession and US growth was consistently downgraded throughout the year.
Investors low equity exposureFor example, ICI fund flow data have shown persistent mutual fund outflows from
equities since March; US mutual fund beta to equities dropped to its lowest level since 19988; while our Asset
Allocation team shows below-average equity exposure in balanced funds most of the time since Q1.9
Central bank support after central banks committed unlimited support to markets, the perception of tail risks fell,
leading investors to require less protection. This further contributed to the divergence seen in Figure 21.
See US Equity Strategy FLASH, 29-Nov-2012

See Flows & Liquidity, 8-Nov-2012
12

10 December 2012
Marko Kolanovic
(1-212) 272-1438
In addition to the low demand for hedging, the search for yield led investors to sell downside through risk reversals, reverse
convertibles, and outright variance selling, further compressing skew. Another manifestation of the collapse in skew is the
low spot sensitivity of implied volatility this year. The average beta of the VIX to the market over the last six months is onethird lower compared to 2H11, leading implied volatility to underperform the moves that were priced into the (record high)
skew earlier this year (Figure 22).
Figure 21: S&P 500 put/call ratio reflects decreased protection
buying since Q1
Index level
Put/call open interest ratio
1500
2
SPX Index
1400
1.9
Put/Call Ratio
1.8
1300
1200
1.6
1.4
1.2
1.6
1.5
1000
2010
1.4
2012
Rolling 6M beta of VIX to S&P 500
1.8
1.7
1100
2011
Figure 22: Vol has become less sensitive to spot moves, leading it to
underperform what was priced into the record high skew earlier this
year
0.8
0.6
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
While in late 2011/early 2012 most indices faced near-record high skew levels, most Asian and European index skews are
now near their post-crisis lows (Figure 23). 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 the FTSE, Nasdaq, and DAX (Figure 23).
Figure 23: Summary of 6M skews across the globe
6M 90-110%
Current
Skew
Global
Rank
5Y %ile
Avg
Max
Min
SPX
7.2%
42%
7.5%
9.5%
5.3%
NDX
6.0%
23%
6.7%
8.7%
3.9%
SX5E
4.5%
0%
6.9%
10.0%
4.5%
UKX
6.3%
10%
7.4%
9.7%
5.7%
DAX
5.5%
1%
6.9%
9.6%
5.3%
SMI
4.6%
2%
6.2%
7.7%
4.2%
NKY
0.8%
11
1%
5.5%
9.8%
0.1%
HSI
1.7%
0%
4.5%
8.1%
1.6%
AS51
4.8%
2%
6.1%
8.3%
4.4%
HSCEI
0.9%
10
1%
4.2%
8.1%
0.7%
KOSPI
1.8%
1%
4.9%
7.9%
1.8%
Source: J.P. Morgan Equity Derivatives Strategy. As of 5-Dec-12, and based on data over the
past five years.
US: The 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 event. Additionally, the S&P 500 has one of the lowest volatility levels among
global indices, leading the skew to price in a larger boost to volatility to the downside (and hence steeper skew). Further, the
low implied volatility level leads to higher skew when measured in non-normalized terms, since the deltas of the 90% and
110% strikes are lower than on higher volatility indices. Together these factors help explain why S&P 500 skew remains
significantly steeper than its international counterparts. In addition to demand for short-dated S&P 500 puts, there is
13

10 December 2012
Marko Kolanovic
(1-212) 272-1438
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 meets short-term hedging demand at the 1-2Y maturity point, providing support for
skew across all maturities. However, insurance demand for long-dated variance/puts has weakened in the latter part of this
year, also contributing to the decrease in skew (see the Term Structure section).
Europe: Euro STOXX 50 skew is near post-Lehman lows, likely driven by low investor positioning in Europe as the
Eurozone debt crisis wears on, reduced perception of tail risk in the region after the ECB finally assumed the role of buyer
of last resort, and the orderly nature of the years main sell-off (the Euro STOXX 50 fell over 20% from March to May, but
did so on just 23% annualized volatility). FTSE skew remains elevated relative to other major indices for similar reasons to
the S&P 500 (low volatility) and due to its high correlation to the S&P 500. It also reached record skew levels early this
year but fell sharply over the summer.
Asia: Driven by the hunger for yield under a prolonged low interest rate environment, domestic retail investors have flocked
to structured products for income generation, which offer considerably higher yield than fixed deposits but with a higher
possibility of capital being at risk. For Japan and Korea, issuance activities set historical highs this year (see Figure 24 and
Figure 25). Recall that the structured products in this region are predominantly volatility-selling in nature, where the coupon
is funded from the selling of put options that can sometimes have exotic barrier features. The significant growth of this
market can lead to an imbalance of volatility supply and demand as the product issuers hedge their long vega exposure,
suppressing market volatility and skew (see Figure 19 and Figure 23). Hence it is not surprising to find that skews for Asian
markets normalized quickly post the May 2012 correction, particularly in Hang Seng, H-shares, KOSPI 200, and Nikkei
225, where there are active structured product issuance, and are currently among the lowest in the world. Going into 2013,
with investors continuing to focus on the search for yield theme, we expect structured product issuance in Asia will remain
vibrant, leading to an oversupply of volatility that will continue to suppress the volatility risk premium and skew, while
providing interesting opportunities for volatility trading.
Figure 24: Monthly structured product issuance in Korea
Monthly issuance (KRW Bn) as of Sep-12 month end
6000
5000
Figure 25: Annual structured product issuance in Japan

KOSPI 200
350
ELS Issuance Notional (KRW Bn)

KOSPI 200
300
Annual issuance (JPY Bn) as of Sep-12 month end

1600
Nikkei 225
Single Stock
Total
1400
1200
4000
250
3000
200
2000
150
1000
100
1000
800
600
400
0
Jan-09
50
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
200
0
2009
2010
2011
2012 YTD
The price of convexity, as measured by the spread between variance and ATM volatility, has also fallen from record
highs across global indices this year but remains considerably more expensive than prior to the 2008 crisis. In light of
the drop in skew this year, the fall in convexity is not surprising as skew is a key pricing component of variance swaps.
However, as we argued previously, convexity remains elevated due to the reduced capacity of the financial system to store
this risk10 and the continued demand for tail risk protection as the 2008 crisis remains vivid in investors minds. At the time
of writing, across major global indices, the absolute level of 12M convexity is the highest on H-shares followed by KOSPI
10
Regulatory changes in the last couple of years have forced the closure of proprietary trading desks and increased the cost of capital for
dealers, reducing the supply of tail risk.
14

10 December 2012
Marko Kolanovic
(1-212) 272-1438
200 and Nikkei 225. Most major indices convexity levels are below their post-Lehman average, with the exception of the
ASX 200 (Figure 27).
Figure 26: 12M convexity of major indices
Figure 27: Summary of 12M convexity across the globe
12M variance swap strike minus 12M ATM volatility
12M Var-ATM
Spread
Current
Global
Rank
5Y %ile
Avg
Max
SPX
4.1%
48%
4.0%
7.8%
NDX
4.3%
62%
3.8%
8.0%
SX5E
4.1%
24%
5.1%
11.1%
8%
UKX
4.5%
48%
4.5%
8.1%
6%
DAX
3.7%
10
41%
4.0%
8.2%
SMI
3.4%
11
47%
3.6%
7.1%
NKY
4.7%
34%
5.5%
10.9%
HSI
4.5%
36%
5.3%
13.1%
AS51
4.1%
70%
3.3%
6.4%
HSCEI
5.7%
57%
5.9%
12.9%
KOSPI2
4.8%
38%
5.1%
11.3%
14%
S&P 500
Euro STOXX 50
Nikkei
Hang Seng
12%
10%
4%
2%
0%
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Source: J.P. Morgan Equity Derivatives Strategy. Based on data over the past 5 years
Although Nikkei volatility and skew are currently depressed to multi-year lows due to the aforementioned structured
product-related hedging activities, the price of convexity remains relatively elevated, largely driven by the demand for
variance swaps from product issuers to hedge their volga exposure. Similar to index skews, which are often used as a metric
of risk premium in the equity derivatives world, convexity reset higher throughout the March 2011 earthquake event and the
risk-off period in 3Q11. Unlike skew, convexity remains stubbornly high even after the announcement of QE3, which is
effectively perceived as an open-ended put option that has removed tail risks from the market (see Figure 28). In addition to
trading at elevated levels, Nikkei convexity shows relative richness when measured against the Derman approximation (see
Figure 29). Given that skew is a major component that affects the pricing of variance swaps (in addition to implied
volatility), the current flatness in the Nikkei skew further reinforces the notion that variance convexity is rich, creating
opportunities for volatility arbitrageurs.
Figure 28: Nikkei 12M convexity versus 12M 90-110% skew
Figure 29: 12M variance vs. Derman approx. across major indices
Convexity and skew
Variance minus Derman approximation
12%
10%
8%
NKY 12M 90-110% Skew

NKY 12M Convexity
NKY
7%
6%
8%
SX5E
SPX
5%
6%
4%
4%
3%
2%
2%
1%
0%
Nov-08
May-09
Nov-09
May-10
Nov-10
May-11
Nov-11
May-12
Nov-12
0%
Nov-09
May-10
Nov-10
May-11
Nov-11
May-12
Nov-12
15

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Term Structure
In 2012, volatility term structures across the globe were upward sloping (normal) for most of the time. Following ECB and
Fed easing in September, and the drop in short-term implied volatility, term structure reached record levels of steepness in
some major indices such as S&P 500 and ASX 200. Only during the risk-off period following the Greek elections in May
did most indices exhibit the inversions in their term structures. However, the inversions were rather modest and quickly
normalized, which illustrated perhaps too much risk premium and expectation of volatility being priced in at the time.
Although concerns related to the US fiscal cliff led to some flattening, in particular in the short end of the curve, all term
structures remain upward sloping. Based on the 12M-3M term structure spread, Nikkei 225 is currently the flattest while
ASX 200 is the steepest (see Figure 30). Relative to the history over the past five years, ASX 200 and Swiss Market Index
are at the high end of the range with average percentiles of 85% for different parts of the curve while S&P 500 and Nikkei
225 are much flatter with average percentiles of over 60% (see Figure 31).
Despite the ongoing macro uncertainty throughout 2012, equity markets were oscillating with an upward trend amid low
realized volatility and low volumes. The environment was very frustrating for option investors as the collapse in risk
premium did not improve the carry aspect of long option positions. The very low levels of implied volatility were still
relatively rich versus realized volatility, although the calendar was packed with various events that could have become
volatility catalysts. Hence, option strategies that can help mitigate the cost of carry or lower the option premium have been
very popular. One such strategy is the calendar call spread or put spread, of which our team has been a strong advocate
(European Equity Derivatives Weekly Outlook, 12-Jun-12 and Asia Pacific Equity Derivatives Weekly Highlights, 16-Jul12). The structure consists of buying a shorter dated option and selling a longer dated option, taking advantage of the steep
term structure. Depending on the indices, the strikes of the two option legs can also be varied to take advantage of the skew
differentials along the term structure. For example, as a protection strategy, investors can consider buying a diagonal put
spread, which consists of buying a 3M 95% put while selling a 6M 85% put.
Figure 30: Term structures in 2012 were mostly upward sloping
Figure 31: Term structure spread percentiles over the past 5 years
12M-3M Implied Volatility Spread (%)
Term structure spread 5Y percentiles (sorted by descending order for 6M-1M)
6%
100%
5%
90%
80%
4%
70%
3%
60%
2%
50%
1%
40%
30%
0%
20%
-1%
-2%
Jan-12
6M-1M
12M-3M
24M-12M
Mar-12
May-12
Jul-12
SPX
SX5E
UKX
HSI
NKY
AS51
Sep-12
Nov-12
10%
0%
AS51
SMI
SX5E
DAX
HSI
KOSPI2
UKX
SPX
NKY
US: The subdued level of realized volatility in 2012 on the S&P 500 (~13% YTD) has put persistent downward pressure on
the short end of the S&P 500 term structure this year. Unlike Asia and Europe, where structured product issuance is the
main driver of long-dated volatility, on the S&P 500 long-dated volatility continues to be driven by the demand for longterm variance and long-term out-of-the-money puts (~5-10Y maturity) from the insurance industry to hedge their variable
annuity products. The combination of these short- and long-end term structure effects led the S&P 500 to have the steepest
average term structure among major global indices in 2012.
The term structure steepness will be related to realized volatility, and for this reason, the S&P 500 term structure of longdated variance (i.e., past 1Y) remains steep by historical standards at the time of writing. However, unusually, the fall in
implied volatility year-to-date has been close to parallel across the term structure, with long-dated volatilities re-pricing
16

10 December 2012
Marko Kolanovic
(1-212) 272-1438
materially over the last year (Figure 32). For example, 10-year variance fell from the mid/high 30s late last year to the high
20s at the time of writing, and is close to its post-crisis lows. Typically, longer dated vols move with much lower beta to the
shorter end of the curveover the last five years, the average beta of 10Y to 6M variance was ~30%, while the YTD fall in
10Y variance was ~90% of the move in 6M variance. Long-dated vols have come in strongly over the last few months as
demand from traditional insurance buyers waned, and some at times even turned into sellers as some insurers found
themselves over-hedged. This has led to a flattening of the long end of the term structure over Q4-12. In our 2012 Outlook,
we highlighted the richness of long-dated variance, pointing out that variance strikes beyond two years were higher than
was realized at any point since the Great Depression. Now this is only (more narrowly) true beyond five-year maturities.
On the VIX, last year the front end of the term structure was primarily driven by the large investment into directional
systematic volatility ETNs like the VXX and TVIX. However, this year, the front-end term structure (2nd-1st month future)
diverged from the funds invested in directional strategies (see Figure 33). In our view, this is due to the recent popularity of
dynamic VIX strategies that sell the short-dated futures opportunistically to exploit their expensive carry cost and offset part
of the systematic flow from the long volatility products.
Figure 32: The SPX variance curve shifted in a near-parallel fashion
YTD, resulting in a large beta-adjusted fall in long-term variance
S&P 500 Variance Strike
40%
Net vega outstanding for largest VIX ETNs

(VXX+TVIX+UVXY+VIXY-XIV)
5-Dec-12
35%
Figure 33: The VIX front end term structure was less driven by
systematic directional strategies like VXX as dynamic strategies
gained favor
30-Dec-11
Aggregate net vega oustanding

(Mn USD, left)
VIX 2nd-1st month futures spread
(% of VIX spot, right)
175
150
30%
125
25%
VIX 2nd-1st future spread
45%
35%
25%
100
20%
75
15%
50
108 120
-15%
Oct-12
96
Jul-12
84
Apr-12
72
Jan-12
60
Oct-11
48
Jul-11
36
Apr-11
24
-5%
Jan-11
12
25
Oct-10
5%
Jul-10
maturity (months)
10%
15%
Europe: The Euro STOXX 50 term structure was the flattest/most inverted among major global indices throughout most of
2012 as front-end volatilities priced in continuing near-term risks for the peripheral debt crisis, and due to the indexs
relatively high realized volatility. As we predicted in our 2012 Outlook, the bumpy road toward resolution of the Eurozone
debt crisis drove Euro STOXX 50 to a much wider than normal realized volatility spread vs. the S&P 500. Year-to-date, the
realized volatility spread between the Euro STOXX 50 and S&P 500 was ~8.5% compared to a long-term historical average
of ~2.5%.
Meanwhile, longer dated Euro STOXX 50 volatilities are mostly driven by structured product flows. The most popular
structures this year were reverse convertibles/autocallables (which sell volatility and skew), followed by capped/uncapped
calls (which buy volatility). Reverse convertibles, which sell an OTM (sometimes knock-in) put to fund a coupon, gained in
popularity this year as investors desperately searched for yield in a zero rate environment. Despite a significant YoY decline
in total European structured product issuance, the popularity of reverse convertible structures likely exerted downward
pressure on long-term implied volatilities and helps explain the narrowing term premium (e.g., Euro STOXX 50 3M
variance swaps trade at nearly a 5 vega premium to the S&P 500, while 5Y variance strikes only differ by ~1.7 points).
Asia: Overall term structure movements should be directional, in particular in the short end of the curve, as bullish equity
markets and low volatility lead to the steepening of the curve (see Figure 34). In the medium to long end of the curve,
17

10 December 2012
Marko Kolanovic
(1-212) 272-1438
however, term structure should be largely driven by the supply and demand for structured products. With interest rates
remaining low for a prolonged period of time, we expect the search for yield theme will continue to be the focus of many
investors in 2013. For Japan and Korea, where popular structured products involve the selling of longer dated volatility for
yield enhancement, the continued issuance of such products in a low interest rate, low volatility environment would likely
depress long-dated volatility further, flattening the term structure at that part of the curve. Hence it is not surprising to see
that the 3Y-1Y volatility spreads for KOSPI 200 and Nikkei 225 have been much flatter than that for S&P 500, especially
with the issuance of structured products setting record high levels this year (see Skew Section and Figure 35).
Figure 34: Term structure steepens with falling volatility
Figure 35: NKY and KOSPI2 3Y-1Y term structures much flatter vs.
Term Structure Volatility Spread (Reverse) S&P 500

-1% 3Y-1Y Implied Volatility Spread
Implied Volatility
30%
ASX 200 3M ATM Implied Volatility (LHS)
5%
ASX 200 12M-3M Term Structure (RHS)

0%
25%
4%
3%
1%
20%
2%
2%
1%
0%
3% -1%
15%
-2%
4%
10%
Nov-11
Feb-12
May-12
Aug-12
KOSPI2
NKY
SPX
-3%
-4%
5%
Nov-12
-5%
Nov-09
May-10
Nov-10
May-11
18
Nov-11
May-12
Nov-12

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Dividends
2012 has proven to be a good year for global index dividends as the front-dated expiries generally performed well relative to
their respective equity indices. Looking into 2013, however, we believe there will likely be more divergence in performance
between global index dividends as the differentiation in market environments increases. As discussed in detail below, for
2013 we are positive on the FTSE dividends, look for better entry points on the Euro STOXX 50 dividends, remain
cautiously optimistic on the Nikkei dividends, and turn neutral on HSCEI and S&P 500 dividends.
Euro STOXX 50 Dividends
Although the Euro STOXX 50 dividend market experienced some major setbacks such as Telefonicas dividend cut, year to
date the 13s and 14s have delivered respectable double-digit returns. This was not the result of a high beta rally since the
short-dated futures performed in line with their longer dated peers as well as the Euro STOXX 50 index (Figure 36). On the
other hand, dividend returns were dwarfed by the Euro HY bond YTD returns of 26%.
Besides the general compression in risk premium, the driver of the performance across asset classes, in our view, can be
largely attributed to investors search for yield. Given the low economic growth outlook, the abatement of tail risk in
Europe, and suppressed yields on relatively safe assets, credit has become investors favored asset class. Within credit, we
witnessed the reach for low-quality issues. Looking into next year, investors preference is unlikely to change:
European economic growth is expected to slowly pick up by the middle of 2013, but strong growth is unlikely,
according to JPM economists. Therefore, growth assets such as equities will likely continue to take a back seat to
yielding assets.
On the other hand, we expect yields to remain suppressed due to central bank policies. The Feds QE and ECBs
OMT are expected to keep yields low and put a ceiling on volatility.
Under these two opposing forces, we believe dividends will continue to benefit from investors hunt for yield in 2013:
Our credit strategists see limited upside in HY credit for 2013 (base case +6% from the current level).
Therefore, we believe the search for yield will lead investors to continue widening their investment universe, i.e.,
to peripheral bonds, high dividend stocks, and naturally, dividend futures.
Figure 36: 2012 Year-to-date total returns across asset classes
Figure 37: Dividends still trade at an elevated risk premium

compared to HY bonds
% YTD return
50%
Credit spread / dividend annualised upside (bps)
2,000
42%
40%
30%
1,500
30%
21%
20%
15%
17%
17%
17%
2Y Div Futures
Upside to IBES
JPM Euro HY
spread to worst
1,000
10%
500
0%
CCC
BB
DEDZ3 DEDZ4 DEDZ8 SX5E

TR
Source: J.P. Morgan, Bloomberg

Return of dividend futures include 1Y Euribor swap yield
0
Mar 04
Mar 06
Feb 08
Feb 10
Feb 12
Source: J.P. Morgan
To forecast the returns of dividends next year, we decompose the dividend futures prices into two parts and analyze
separately: Dividend Futures Price Target = Discount Factor Bottom-Up Estimates.
19

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Discount Factor: As Figure 37 shows, the annualised upside on dividends still trades at elevated levels relative to HY
credit spreads, and we expect both to compress next year. In their base case, JPM credit strategists Dulake and team forecast
a spread compression of 81 bps for Euro HY bonds from the current level. In Figure 38 we show the historical relationship
between the 1Y changes in HY spreads and upside on 1 year dividend futures. Based on this relationship, the change in HY
spread should correspond to a compression of 180 bps on the 2014s upside, in addition to the pull-to-realized slide of 360
bps, by the end of 2013.
Figure 38: Annual changes in 1 year dividend upside shows strong
correlation with changes in HY spreads
Figure 39: Bottom-up estimates have been continually revised down

since 2008
Annual changes in 1 year to maturity dividend upside
IBES bottom up estimates
5,000
y = 1.8427x - 29.715
R = 0.9112
150
130
1,000
110
-1,000
2009
2012
2010
2011
2006
2013
2005
90
70
-3,000
Annual changes in Euro HY credit spread
Jan 12
Jan 11
Jan 10
Jan 09
2,000
Jan 08
1,000
Jan 07
Jan 06
-1,000
Jan 04
50
-5,000
-2,000
2008
2007
170
Jan 05
3,000
190
Source: J.P. Morgan Equity Derivatives Strategy
Bottom-up estimates: As Figure 39 shows, since 2008 analysts have continually overestimated Euro STOXX 50 dividends.
We expect this trend to continue for 2014/15 dividends. With the anemic economic growth as previously discussed, JPM
equity strategists Matejka and Cau forecast EPS growth of 0% for 2013 and 5% for 2014 in EMU. Therefore, the consensus
dividend growth rates of 7% each year still appear high. Using 108.3 as a base case for the 2013s, and applying our equity
strategists zero EPS growth rate to the dividends, we arrive at a target bottom-up estimate for 2014s of 108.
Combined with the risk premium derived previously, we see a 1Y price target of 105 for the 2014s (6% upside). This
compares to the 6% return forecast on Euro HY bonds by our credit strategists and 5% on the MSCI EMU equity index by
our equity strategists. Using the same methodology, we see a 1-year price target of 102 (6% upside) for the 2015s.
Downside risks to our base case: Although we believe the dividends will continue to perform well relative to other assets
in 2013, we see two main ways a slower than expected economic growth rate in 2013 could impact our base case:
Spanish banks: These are still the biggest risk, in our view. Higher than expected deficits could make the environment
more hostile for Santander and BBVA; for example, the Spanish government raising taxes on scrip dividends may force
the two banks to cut them to zero.
Cyclicals: Slower than expected economic growth globally could affect the bottom line of export-oriented cyclicals,
which have so far largely escaped the impacts of the adverse European economy. However, we are seeing some
negatives beginning to emerge, such as Daimler struggling to maintain its dividends.
Taking into account the risks and their strong rally recently, tactically, we believe there may be better entry points to
go long dividends next year. In the trade idea section we also suggest ways to take advantage of the low implied volatility
via dividend options.
We still prefer the front end (2013s 2015s) to back end dividend futures as we believe the low growth environment
benefits yield trades, whereas long dated dividends move more in line with equities. As growth continues to be sub-trend we
see potential for short-dated dividends to outperform long-dated ones in 2013. We also continue to see more value in single
stock dividend futures than the index dividend futures, due to the discount of the single stock to the index dividend futures.
20

10 December 2012
Marko Kolanovic
(1-212) 272-1438
FTSE Dividends
We initiated our recommendation to go long FTSE dividends in March 2012, and we continue to favor FTSE dividends into
next year. They offer similar upside potential to the Euro STOXX 50 dividends (Figure 40) but with lower risks. As shown
in Figure 41, the biggest payers in the FTSE generally bear lower risks than those in the Euro STOXX 50.
Figure 40: FTSE divs still offer attractive upsides
Figure 41: Biggest payers of FTSE 2014 dividends (JPM estimates)
Potential upsides to estimates
30%
HSBA, 12%
Upside to IBES
25%
Upside to Bbg Ests
20%
Upside to JPM Ests
24% 25% 24%

17% 17%
15%
10%
BP/, 8%
GSK, 7%
Others, 48%
15%
VOD, 6%
6%
6%
RDSA, 5%
6%
5%
RDSB, 5%
AZN, 4%
0%
2013
2014
2015
BATS, 5%
Nikkei Dividends
The 13s have posted an impressive performance of over 21% this year, nearly double the performance of Nikkei 225. We
believe the driver of this outperformance is not only due to investors search for yield but also the overall resilient guidance
for March 2013 dividendsnow nearly 90% guideddespite weaker than expected earnings (see Table 2). With upside to
our bottom-up estimate standing at less than 4% for the 13s, we believe 14s have the most attractive risk/reward profile
for the coming year (see Table 3).
Political tailwinds may also benefit Nikkei dividends as Shinzo Abe, the Liberal Democratic Party leader who is proinflation and pro-QE, looks likely to win the upcoming election. His unusually aggressive stance on pro-inflationstating
that the Bank of Japan should pursue unlimited easing to achieve a 2-3% inflation targethas helped drive the yen and
Nikkei 225 to seven-month low and high, respectively. The end of deflation and achieving Abes inflation target may lead to
EPS improvement, in particular for the upcoming FY ending March 2014, and hence benefit Nikkei dividends as well.
Table 2: Earnings summary for CY2012 Q3
EPS
Table 3: Bottom-up estimates, potential upside, and Sharpe Ratio

Sales
Beat
Hit
41.9%
7.0%
16.3%
47.6%
Missed
51.1%
36.1%

Based on TOPIX constituents that have announced earnings from Oct-Nov 12.
Maturity
JPM
Estimates
Current
Offer
Potential
Upside*
Potential
Upside (ann.)
90D Realized
Vol (ann.)
Sharpe Ratio
2012
208.0
208.1
0.0%
-0.1%
2.7%
-0.03
2013
2014
2015
2016
213.0
225.8
238.2
241.5
206.3
205.0
200.8
196.8
3.2%
10.1%
18.6%
22.7%
2.4%
4.2%
5.2%
4.8%
4.1%
6.4%
9.6%
11.2%
0.59
0.66
0.55
0.43
2017
2018
2019
244.9
248.3
251.8
192.5
188.5
184.3
27.2%
31.7%
36.6%
4.6%
4.4%
4.3%
12.4%
12.9%
15.1%
0.37
0.34
0.29
2020
255.3
180.0
41.8%
4.3%
14.1%
0.30

*Potential upside is with respect to the offer side of the dividend swaps.
21

10 December 2012
Marko Kolanovic
(1-212) 272-1438
H-shares/Hang Seng Dividends

H-shares 12s returned 21% over the past year while the underlying index eked out less than a 2% return. Due to its attractive
upside potential, H-share dividend futures drew investors attention and the total traded value for the year increased
significantly from USD 80mn to USD 430mn.
This year, H-shares/Hang Seng dividends overall do not appear as attractive as they were last year. Based on the bottom-up
estimates from various sources, we see upside potential for H-shares of 0-4% in 13s and 9-14% in 14s, while we see
potential upside for the Hang Seng of 4-7% in 13s and 11-16% in 14s. Taking these magnitudes of upside potential,
liquidity (bid/ask spread) and uncertainties into account, we remain neutral on H-shares/Hang Seng dividends at this point.
Figure 42: H-shares Dividend (HSCEIDPI) Bottom-up Estimate
500
Historical
JPM est.
Curr Dividend Futures

Consensus est.
Markit est.
900
Bloomberg est.
407
400
380
389 392
379 374 385
378
414 419 429
326
300
Figure 43: Hang Seng Dividend (HSIDPI) Bottom-up Estimate

Historical
JPM est.
Curr Dividend Futures

Consensus est.
Markit est.
800
753 762
692
700
290
Bloomberg est.
848
819 815 824
709
772
765
733
721
631
600
200
500
100
400
2010
2011
2012
2013
2014
2010
2011
2012
2013
2014
S&P 500 Dividends

Concerns over the fiscal cliff have led the S&P 500 dividend term structure to flatten significantly since the US presidential
election (Figure 44). This concern stems from changes in taxation should the cliff fail to be resolved favorably for
dividends. Under existing law, the taxation of dividends reverts from a flat 15% rate in 2012 to being treated as ordinary
income in 2013, and thus potentially being subject to a maximum federal tax rate of 43.4% (39.6% top bracket rate + 3.8%
Affordable Care Act levy). Should this negative scenario materialize, where dividend tax rates rise significantly above those
applied to long-term capital gains, we expect high yielding stocks to underperform and companies on aggregate to shift part
of their shareholder remuneration policy from dividends to buybacks. In response to the cliff threat, a number of US
companies paid special cash dividends in late 2012 (Costco, Las Vegas Sands, Wynn Resorts, Franklin Resources, etc.) or
pulled forward part of their 2013 payout (Walmart, Oracle, DR Horton, General Dynamics, etc.). Due to the binary risk
associated with the fiscal cliff, we currently hold a neutral view on S&P 500 dividends, expecting the term structure to
flatten further if taxes rise to regular income levels, or steepen if they remain in line with long-term capital gains.
Figure 44: The S&P 500 dividend swap term structure has flattened
significantly since the US elections
46
44
27-Nov-12
42
6-Nov-12
40
38
36
34
32
30
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
22

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Derivatives Ideas for 2013

Volatility Trades
Relative Value Asia versus DM Volatility Spreads Remain Attractive
On the back of the policy actions from the ECB/Fed, which are perceived to have removed tail risks and provided a put
option to the market, risk premia have contracted substantially. As equity volatility and skew drop to multi-year lows across
the globe, Asia volatility continues to trade relatively cheap compared to volatility in the developed markets (DM). With
robust structured product issuance activities, the volatility supply/demand imbalance continues to weigh heavily on Asian
volatility markets, especially with lower market liquidity as well as the lower risk capacity for structured product dealers
going into year-end. Hence, a number of interesting relative value opportunities, such as going long Asia volatility versus
going short SPX, UKX, or AS51 volatility, remain attractive going into 2013.
Although we do not expect any imminent catalyst for the structural dynamics of Asia volatility to change, the realized
spreads are carrying positively against the implied levels, in particular for indices associated with active structured product
markets such as HSCEI, KOSPI2, and NKY. Should there be another risk-off event, we would expect Asia volatility to react
more violently than DM volatility, both on an implied and realized basis, similar to history. Hence, at this time, we continue
to see value in going long Asia volatility through these indices versus going short DM volatility as the current depressed
spread levels give investors long carry and volatility without being short tail risks. For trade implementation, we prefer
using delta-hedged puts rather than variance swaps, in order to avoid the relatively rich Asian variance convexity while
taking advantage of the wide gap in Asian vs. DM downside skews. Volatility pairs that stand out from this analysis include
HSCEI, NKY, or the Asia Basket vs. SPX, HSCEI vs. UKX, and HSCEI vs. AS51.
Figure 45: Volatility spread of H-shares versus S&P 500
50%
Figure 46: Volatility spread of Asia Basket versus S&P 500
12M 90% Implied Volatility Spread

12M Realized Volatility Spread
Current Entry
40%
20%
12M 90% Implied Volatility Spread

Current Entry
15%
30%
10%
20%
5%
10%
0%
Nov-07
Nov-08
Nov-09
Nov-10
Nov-11
Nov-12
-10%
0%
Nov-07
Nov-08
Nov-09
Nov-10
Nov-11
Nov-12
-5%
Table 4: Indicative tradable levels and statistics of various Asia versus DM volatility spreads (Dec-13 maturity)
Implied
5Y %tiles
12M Realized Volatilty

Spread 5Y History
Implied
Entry
Levels
H-shares KOSPI 200 Nikkei 225 Asia Basket H-shares KOSPI 200 Nikkei 225 H-shares Nikkei 225
vs S&P 500 vs S&P 500 vs S&P 500 vs S&P 500* vs FTSE 100 vs FTSE 100 vs FTSE 100 vs ASX 200 vs ASX 200
Dec-13 90% ATMF IV Spread
2.5%
-1.8%
-1.7%
-0.3%
4.2%
-0.1%
0.0%
6.7%
2.5%
Variance Spread over Put IV Spread
2.1%
1.7%
2.1%
2.0%
4.2%
3.8%
4.2%
3.8%
3.7%
Current
8.8%
4.3%
2.2%
5.1%
7.9%
3.4%
1.3%
9.6%
3.0%
Max
27.5%
7.7%
9.1%
13.2%
27.7%
6.8%
10.4%
30.8%
14.8%
Min
3.1%
-4.3%
-5.2%
-0.3%
3.4%
-2.9%
-3.4%
5.3%
-1.9%
Average
13.0%
1.2%
2.3%
5.5%
14.4%
2.5%
3.7%
16.2%
5.5%
3M RV Spread vs Put IV Spread (Carry)
4.7%
4.4%
5.5%
4.9%
2.5%
2.3%
3.4%
3.7%
4.5%
Put IV Spread %tile vs IV Spread
13.6%
42.2%
29.5%
25.4%
22.4%
63.2%
45.2%
22.8%
76.8%
Put IV Spread %tile vs RV Spread
0.0%
29.3%
9.8%
0.0%
5.0%
18.5%
11.0%
9.6%
29.5%
#REF!
#REF!
#REF!
#REF!
#REF!
*Asia Basket is equally weighted basket of H-shares, KOSPI 200, and Nikkei 225.
23

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Go long 2014 Euro STOXX 50 dividend volatility

We recommend investors to go long 2014 Euro STOXX 50 dividend implied volatility as it appears attractive both on a
stand-alone basis and compared to the Euro STOXX 50 equity implied volatility. Although we are positive on Euro STOXX
50 dividends, we also see the likelihood of a pickup in volatility early next year due to factors both specific to dividends
(see Where we stand on the 2013 Euro STOXX dividends) and at a macro level (US fiscal cliff, Greek/Spanish situations).
The implied volatility on the 2014s is trading at an attractively low level. Figure 47 shows the ratio of Euro STOXX 50
dividend ATMF implied volatility to the cash indexs ATMF implied volatility as a function of the time to expiry for the
dividend contract. Here we demonstrate that as a % of like-maturity Euro STOXX 50 equity implied volatility, the 2014s
(52% of SX5E implied volatility) are significantly below both the 2012s (61%) and 2013s levels (73%) at the same point
in their life. Additionally, the current implied volatility level also appears cheap compared to our expectations of what the
2014s are likely to realize for their remaining life, based on historical realized volatilities of past futures contracts. Investors
can buy a 95 put on the 2014s as an overlay on a long futures position for 5.0 points (ref. 99.5). Although the initial
premium appears high, investors would be able to monetize on a mark-to-market basis should a sell-off happen prior to its
pull-to-realized.
Furthermore, given our aforementioned comparison between dividend volatility and equity volatility, investors can play the
relative value and buy DEDZ4 95 strike puts (5% OTM) at 5.0%, funded by selling Dec 13 SX5E 2300 strike puts
(~12% OTM) at 5.1% for a small credit. In addition to taking advantage of the negative convexity of dividends
(downside beta greater than upside beta), the trade also provides a 7% margin of safety on the short Euro STOXX 50 put leg
(Figure 48). The Dec-13 expiry is preferred, in our view, as beyond this date, the dividends are driven more by the pull to
realized effect and tend to de-correlate from equities.
Figure 47: 2014 dividend implied volatility trading significantly below
2012s and 13s as % of Euro STOXX 50 volatility
Figure 48: Selling Euro STOXX 50 2300 puts provide 7% margin of

safety vs. buying DEDZ4 95 puts
Div ATMF vol as % of SX5E ATMF vol
2014s
2013s
2012s
SX5E Px
90%
2800
70%
2600
50%
2400
DEDZ4 Px
100
DEDZ4
95
90
85
2.3
1.8
1.3
30%
2200
10%
2000
Jan-12
0.8
Years to Expiry
SX5E
SX5E put strike
DEDZ4 put strike
Apr-12
Jul-12
80
75
Oct-12
Exploit Volatility Spillover and Clustering to Improve Carry Strategies

Many investors looking for yield believe there are currently opportunities in equity volatility carry. However, investors
looking to exploit volatility carry are faced with a dilemma in that they capture potentially large premia in good times but
a likelihood of large losses when volatility spikes. While spikes are not easily predictable, in our paper Risk Premia in
Volatility Markets: Exploiting Volatility Spillover and Clustering, we find that we can enhance the performance of
volatility carry strategies and mitigate draw-downs from volatility spikes by exploiting two characteristics of
volatility:
24

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Clustering (or persistency)Whenever volatility is above (below) average it is more likely that volatility will
remain higher (lower) than average.
SpilloverAfter an increase in volatility in one particular market, it is more likely that volatility will remain
higher than average in related markets.
Our strategy that selects in which market to go short volatility and whether to go short, based on an econometric model that
forecasts the probability of a positive risk premium, outperformed simply being short S&P 500 volatility by nearly 5%
annualized since 2001 (Figure 49). The latest parameters for the selected model are shown in Table 5,11 where we apply a
VAR approach12 to the volatility premium in the US, Europe, and Japan in order to derive a trading strategy. With this
model in hand, our selected strategy applies the following modifications to a traditional short volatility strategy:
Frequent monitoring and trading: Instead of trading once a month and praying for nothing to happen over the
next 30 days as in the case of a single variance swap, we use overlapping positions, trading a fraction of the
notional invested every day (this enhancement is also incorporated into the benchmark in Figure 49).
Conditional on the expected premium: We only go short volatility at any day if the probability of a positive
realized premium is high, as losses can be large. If over the next 30 days the probability of a positive premium
according to our model is >85%, we go short volatility, if the probability is <65% we go long volatility, and we do
nothing if the expected probability is 65-85%.
Figure 49: Exploiting Persistence and Spillover in Equities Markets
Table 5: Forecasting Volatility PremiumSelected Model
Excess return index
Regression coefficients and t-stats, constants are not reported

US(t)
Europe(t)
Japan(t)
Daily
US(t-1)
0.42
0.51
0.44
(t-stat)
2.57
5.45
1.52
Europe(t-1)
0.18
0.08
0.11
(t-stat)
1.80
0.97
0.88
Japan(t-1)
0.04
-0.09
0.25
(t-stat)
0.33
-1.56
1.31
R-sqr
0.12
0.14
0.14
Monthly
US(t-1)
0.59
0.93
0.40
(t-stat)
3.26
6.04
1.83
Europe(t-1)
0.19
-0.04
0.01
(t-stat)
1.30
-0.36
0.07
Japan(t-1)
-0.06
-0.26
0.36
(t-stat)
-0.41
-2.11
2.06
R-sqr
0.13
0.23
0.13
380
330
Strategy
Benchmark
280
230
180
130
80
Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
Jan-11
Source: J.P. Morgan, Bloomberg. Calculations are net of transaction costs and based on the
model (described above) that trades US, Europe, or Japan variance swaps based on the
probabilities of a positive premium. Probabilities are based on a limited dependent variable
model where the probability of a positive premium depends on past values of realized and
implied volatility in all the markets. The benchmark shown is always short S&P 500 volatility
with daily overlapping variance swaps.
Source: J.P. Morgan, Bloomberg. Premium is measured as the difference between implied
volatility at the beginning of the period and the average squared daily returns over the next
month. Regressors are based on the monthly average of the implied volatility and range
volatility computed using 10 business days.
See the report for more details on the model and methodology as well alternative implementations.
11
Our trading strategy actually re-estimates these equations every day, using only previous data.
VAR (Vector Autoregression) is a statistical model used to capture the linear interdependencies among multiple time series, where the
evolution of each series depends on the past realizations of the same variable and other variables in the system. We use VAR(1) here,
implying that only one lag is used.
12
25

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Option Strategies to Take Advantage of Flat Skews

As we noted in the previous section, implied skews have come down significantly in 2H12, especially in some Asian
indices. The suppressed levels of skew, coupled with low volatility, make some long skew strategies attractive. Table 6
summarizes the list of option strategies to take advantage of flat skews and indicative options prices.
For bullish strategies using vanilla options, investors can consider call spreads or call ratios to take advantage of rich
upside skew. For instance, HSCEI 6M 105%-115% call spreads and 6M 1x2 105%-115% call ratios (buying one 105% call
and selling two 115% calls) would cost 2.34% and 0.86% respectively, providing 39% and 77% savings vs. outright 105%
calls (3.82% premium). NKY follows with the second highest savings of 33% and 65% for the same call spreads and call
ratio structures, respectively. Given the breakeven levels vs. historical index range (Figure 51), NKY 1x2 105%-115% call
ratios look appealing for investors chasing further upside in Japanese equities. Strategies involving selling upside volatility
and skew through barriers, such as buying knock-out calls, appear attractive at current levels. For example, 6M ATM calls
with a 115% knock-out barrier cost less than half of the equivalent vanilla puts in HSCEI, NKY and KOSPI 200.
For bearish strategies, we like risk reversals, which involve selling OTM calls to fund puts, as an effective strategy to
extract value from the volatility curve. To buy 6M 90%-110% risk reversals, investors pay nothing for KOSPI 200 and even
receive a small net credit for HSCEI. A short put ratio strategy also provides a handsome credit upfront due to low
downside skews while providing protection against large market corrections. This strategy is suitable for investors who
believe that the market is likely to remain range-bound but who want to hedge against a potential market crash scenario, as
the strategy would do well on MTM being long volatility and long skew. Investors can receive over 2% by shorting 6M 1x2
95%-85% put ratios in SX5E, HSCEI and NKY.
Table 6: Indicative pricings for various short skew strategies (for 6M tenors)
Bull Strategies
105%-115% Call Spread
Savings vs Long 105% Call
105%-115% 1x2 Call Ratio
100% Call with 115% KO*
100% Call with 115% KO w/ Full Rebate*
Bear Strategies
90%-110% Collar
Savings vs Long 90% Put
95%-85% Put Ratio
Long 1x105%C + Short 1x115%C

Long 1x105%C + Short 2x115%C
Long
Long
Long 1x90%P + Short 1x110%C

Short 1x95%P + Long 2x85%P
SPX
SX5E
UKX
DAX
SMI
NKY
AS51
KOSPI2
HSI
HSCEI
1.80%
-7%
1.67%
-13%
3.73%
-11%
3.91%
-6%
1.78%
-19%
1.37%
-37%
2.33%
-42%
2.69%
-34%
1.21%
-6%
1.13%
-12%
3.08%
-6%
3.18%
-3%
2.35%
-16%
1.91%
-32%
3.33%
-35%
3.79%
-26%
0.59%
-3%
0.57%
-7%
2.20%
7%
2.22%
8%
1.93%
-33%
1.00%
-65%
1.99%
-57%
2.42%
-48%
1.24%
-9%
1.12%
-18%
3.02%
-10%
3.14%
-7%
2.10%
-28%
1.29%
-56%
2.29%
-54%
2.69%
-46%
1.84%
-26%
1.18%
-53%
2.49%
-43%
2.95%
-33%
2.34%
-39%
0.86%
-77%
1.85%
-68%
2.45%
-58%
1.48%
-27%
-1.79%
1.89%
-34%
-2.55%
1.44%
-19%
-1.63%
0.77%
-61%
-1.83%
1.20%
-8%
-1.66%
0.26%
-86%
-2.09%
0.72%
-36%
-1.23%
-0.01%
-101%
-1.78%
0.45%
-74%
-1.95%
-0.08%
-104%
-2.32%
* Knock-in and knock-out occur based on daily observation at the close.
Figure 50: 6M 90-110% skew spread for major global indices

Skew Spread
Figure 51:NKY 6M 105%-115% 1x2 call ratio strike and breakevens
5Y Percentile Index Level
8%
6M 90%-110% Skew Spread
7%
5Y Percentile
50%
41%
115% Strike (= max return point)
11000
5%
30%
4%
18%
3%
20%
2%
1%
0%
0%
0%
0%
3%
10%
2%
0%
10000
9000
SPX
UKX
DAX
AS51
SMI
SX5E
KOSPI2
HSI
HSCEI
0%
NKY
0%
26
Range with Net Profit
40%
6%
1%
12000
8000
Nov-09
May-10
Nov-10
May-11
Nov-11
May-12
Nov-12
Marko Kolanovic
(1-212) 272-1438

10 December 2012
Dispersion Opportunities
FTSE TOP 20 (ex RB/ LN) Skew Spread: While several European index skews have reached record lows (e.g.,
SX5E), FTSE skew continues to be a suitable selling candidate. We have seen FTSE 6M skew significantly rebound from
its lows recently, even as implied volatility came down across indices and other asset classes. The difference between FTSE
index skew and the skew of its constituents is highlighted in a previous report.
The absence of Q3 negative surprises (ex BG/ LN) brought single-stock implied volatility and skew down. The Barclays
headlines surrounding its Dec-13 warrant sale further enhanced the trend. We have seen significant size of downside
volatility being sold in Jun-13 and Dec-13 maturities. Other single names also had large down moves in the 6M 90-100%
skew over the past two weeks: VOD LN -0.60%, BP/ LN -0.50%, BG/ LN -0.50%, ULVR LN -0.50%, RDSA and RDSB
-0.40% and TSCO -0.30%.
Figure 52: There is a significant discrepancy between the FTSE Index
skew and the skew of its constituents
6M 90-100% Skew
UKX Index
VOD LN Equity
BP/ LN Equity
BG/ LN Equity
BARC LN Equity
ULVR LN Equity
TSCO LN Equity
Current
2w absolute
Skew Level 5Y History %ile skew change
4.3%
62%
0.2%
1.9%
9%
-0.6%
2.2%
18%
-0.5%
0.5%
1%
-0.8%
1.7%
0%
-1.0%
1.6%
1%
-0.3%
1.6%
4%
-0.3%
Figure 53: The spread between FTSE single stocks and index at 90%
strikes looks attractive
6.50%
6.00%
6M Realised Vol
Spread
5.50%
5.00%
Actual Implied
vol Spread Level
4.50%
4.00%
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
We suggest buying FTSE Top 20 single name (ex RB/ LN) Jun-13 90% strike options versus short FTSE Index Jun-13 90%
strike options. On the downside, we would be looking to reverse the trade if/when the carry of the spread disappears. The
volatility spread entry level of 4.8% represents, in our view, a good level versus the recent 6M realized level of ~6.3%
(Figure 53). The entry level looks interesting also when compared with a longer history as it is only 1 vol point away form
the 5Y low.
AS51: Within Asia, although implied correlation levels have come down significantly, we prefer going long ASX 200
dispersion through buying single-stock Jun-13 90% options versus selling the index Jun-13 90% options. This trading
strategy takes advantage of the cheap single-stock volatility and skew relative to the index, which is a result of heavy singlestock overwriting activities from investors searching for yield and index protection demand from investors using ASX 200
as a proxy hedge to both developed markets and China, with lower volatility. The current indicative level of the Jun-13 90%
top 15 single-stock versus ASX 200 option spread is at 4.7% (see Figure 54) versus the recent 6M realized spread of 6.0%.
Relative to the 5Y realized spread history, the implied level is at the 20th percentile. In terms of implied correlation, the
volatility spread represents a level of 55.5%. Although the volatility spread and correlation levels are not at the extremes,
performance will likely be driven by sector rotation as capital flows from unattractive sectors (such as the defensives, which
look quite fully valued) to more attractive sectors, hence driving sector and stock dispersions and supporting a lower
correlation environment, in our view.
27
Marko Kolanovic
(1-212) 272-1438

10 December 2012
Figure 54: AS51 6M Top 15 90% stocks to index implied volatility

spread vs. realized history
Volatility Spread
25%

Jun13 90% Straddle Volatility Spread (Top 15 vs AS51)
20%
15%
10%
5%
0%
Dec-07
Dec-08
Dec-09
28
Dec-10
Dec-11
Dec-12

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Macro/Directional Trades
Long Euro STOXX 50 Jun-13 call spreads funded by selling Jun-13 S&P 500 call spreads
In their 2013 Outlook, JPM European Equity Strategists Matejka and Cau expect Eurozone equities to continue to
outperform the US. In our strategists view, the source of risks appears to be shifting. In a sense, the Eurozone is more
advanced in the adjustment process, and fiscal drag will likely be greater in the US in 2013. Meanwhile, Eurozone earnings
and margins have already repriced lower, and Eurozone valuations still look extremely cheap when contrasted with their US
counterparts, at more than a 40% P/B and cycle-adjusted P/E discount. Accordingly, we recommend buying Euro STOXX
50 Jun-13 100-110% call spreads funded by selling S&P 500 Jun-13 100-110% call spreads for an overall credit of
0.3% of notional, to play our strategists view and take advantage of the skew differential between the two indices. The
structure additionally buys the implied volatility spread between the Euro STOXX 50 and S&P 500 at ~2.2%, while the
most recent 6M realized volatility spread between the two indices was ~7.8%.
We choose a 6M tenor for the structure as this expiry fits well with the time horizon of our strategists view and works well
from a skew standpoint. Euro STOXX 50 implied volatility remains higher than that of the S&P 500 index, and the
volatility spread between the two indices widens as maturity increases. Therefore, an outright call switch is less attractive
(Figure 55). On the other hand, the 6M call wing skew for the S&P 500 remains elevated, especially compared to that of the
Euro STOXX 50 index (Figure 56), allowing investors to achieve favorable pricing in the call spread switch.
Figure 55: Euro STOXX 50 implied volatility is higher than that of the
S&P 500, making an outright call switch less attractive
Figure 56: The Euro STOXX 50 6M upside skew has been declining
throughout the year, while it has held firm for the S&P 500
Euro STOXX 50 and S&P 500 ATMF volatility and their spread
Euro STOXX 50 and S&P 500 6M ATM-110% skew
22%
5%
18%
4%
14%
SPX
SX5E
3%
SX5E 6M ATM - 110 skew

SPX 6M ATM-110 skew
10%
2%
1M
2M
3M
6M
9M
12M
Dec-10
Jun-11
Dec-11
Jun-12
EM Asia versus US Outperformance Strategies

The recent improvement in Chinas flash PMI provides more evidence to the view that the economic recovery is gaining
traction, lending more support to our equity strategists regional current trade preference of OW in EM Asia versus the
S&P 500. This trade is not merely tactical. We believe it is a longer term theme for 2013 justified by the growth and flow
improvement in EM Asia and the fiscal cliff risks in the US. In terms of countries that are most attractive in Asia, our EM
strategist has India as the top pick. India combines improving policy, easier monetary conditions, and pent-up investment
demand with a market that generated EPS growth despite significant macro headwinds in 2012. Add to this a huge
demographic dividend and an equity market with low exposure to government sponsored companies. The Philippines and
Thailand are next. The Philippines stands out as a country with improving economic growth, with consumption picking up
(same-store retail sales growth at 10%), along with a newfound investment up cycle. The pervasiveness of record-low
interest rates is a key driver of these positive trends, with policy rates of 3.5% forecast to come off further in 1Q13. After
growing below potential from 2004, Thailand is now enjoying a period of economic strength. Our Thailand OW is based on
robust domestic demand, sustained low interest rates, undemanding valuations, and scope for positive EPS revisions.
29
Marko Kolanovic
(1-212) 272-1438

10 December 2012
To implement the EM Asia versus US 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. For the call switch strategy, investors are going long call options on MXMS while going short call options on
SPX to implement the relative value trade on the upside only. For the outperformance option strategy, investors are going
long an option that provides a payoff based on the relative performance between 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. In terms of country weighting, China is the largest country in EM
Asia at 30%, while the countries with OW ratingsIndia, Philippines, and Thailandhave weightings of 11%, 4%, and
2%, respectively.
Table 7 summarizes the indicative option pricing and backtest results of 6M call switch and outperformance option
strategies with different strikes. Since MXMS is a USD composite index, it provides full exposure to the equity markets in
EM Asia as well as their currencies (versus USD), which tend to be highly correlated due to capital inflows during risk-on
periods. While the call switch strategy is more risky than the outperformance option, the option premium outlay for
the call switch strategy is also substantially lower. For investors who want further savings on option premium, the switch
strategy with call spreads is also very attractive. Against the backdrop of our strategists relative view, 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 two years.
Table 7: Indicative pricings and backtest results of various 6M
MXMS vs. SPX option strategies for the past 10 years
Figure 57: Rolling performance of various 6M MXMS vs. SPX option

strategies for the past 10 years
Based on 6M rolling returns
Gross P&L at Maturity
Avg Return
Avg Gains
Avg Losses
Max Return
Min Return
% Occur Gain
Option Premium
ATM Call
Switch
6.1%
13.4%
-4.5%
53.6%
-19.0%
53.1%
0.75%
105% Call
Switch
5.9%
13.4%
-4.3%
52.7%
-15.6%
48.8%
0.90%
105% - 120%
Call Spread
Switch
2.9%
7.9%
-4.2%
15.0%
-15.0%
44.3%
0.65%
6M ATM
Outperf
Option
7.6%
13.2%
N/A
53.6%
0.0%
57.6%
4.90%
6M 105%
Outperf
Option
5.1%
11.3%
N/A
48.6%
0.0%
44.7%
2.80%
60%
50%
40%
ATM Call Switch

105% Call Switch
105% - 120% Call Spread Switch
6M 105% Outperformance
30%
20%
10%
0%
-10%
-20%
Nov-02
Nov-04
Nov-06
Nov-08
Nov-10
Nov-12
Sell S&P 500 ratio risk reversals to exploit the structural mispricing of tail events
As discussed in the Outlook for Volatility section, S&P 500 upside options significantly under-price the probability of
upside tail events while overpricing the downside compared to the long-term likelihood of such events. For example, the
realized frequency of a 10% up move in six months is ~2 times more likely than options imply, while the realized frequency
of a 10% down move in 6M is less than half as likely as implied by options (Figure 14). Although skew on the S&P 500 has
flattened materially over the last six months, it remains the steepest among global indices and remains steep relative to the
levels of implied volatility. For example, the ratio of 6M 90-110% skew to ATM implied volatility, and the ratio of 90%
strike volatility to 110% strike implied volatility are both elevated relative to history (both at their ~85th percentile relative
to the last five years of data, Figure 58).
Accordingly, we recommend selling levered risk reversals on the S&P 500 to exploit the continued mispricing of tail events.
Investors can currently buy 2.8x 6M 110% strike calls vs. selling 1x 90% strike puts on the S&P 500 at zero cost
(indicative), giving a levered upside exposure. For example, these risk reversals could be overlaid to an underweight equity
30

10 December 2012
Marko Kolanovic
(1-212) 272-1438
position to permit investors to quickly pick up delta in case of a rally. This leverage ratio is attractive relative to history, in
its 97th percentile compared to the last 10 years of data (Figure 59).
Figure 58: S&P 500 skew remains steep relative to implied vol
levels, giving attractive leverage on risk reversals
180%
170%
160%
Figure 59: S&P 500 6M 90-110% risk reversal gives high leverage
relative to history
60%
Ratio of 90%/110% strike 6M

implied vol
6M 90-110% Skew / ATM (right)
50%
40%
150%
140%
30%
130%
20%
120%
10%
110%
100%
2009
0%
2010
2011
2012
Ratio of 6M 110% call to 90% put in a costless risk reversal
3.5
3.0
2.5
2.0
1.5
1.0
0.5
2001
2003
2005
2007
2009
2011
Buy calls on MSCI Mexico for cheap exposure to our EM Strategists favored market
Mexico is one of our EM Equity Strategy teams top picks for 2013 (see Latam Year Ahead 2013). They see limited
downside to earnings estimates, supported by strong macro, with room for an upside surprise due to structural reforms of
labor, fiscal, and energy policies. Further, consumer demand is expected to remain strong, fueled by credit growth. The
Mexican peso is one of our FX strategists favorite Latam currencies for 2013, and they expect it to appreciate ~5% vs. the
USD by mid 2013. This would provide a further boost to the EWW, which is priced in USD.
Mexico, however, was one of the top performing emerging markets in 2012 and has relatively expensive valuation, while
delays to the anticipated structural reforms could cause its market to de-rate. As a result, we prefer to play the market
through options rather than delta-1 in order to limit downside risks. EWW implied volatilities are currently at 5+ year lows
(Figure 60), pulled down by the subdued realized volatility this year, while upside skew is relatively steep (6M ATM-110%
skew is in its 76th percentile over the last five years). This makes OTM calls relatively attractive in our view, despite their
recent negative carry. For example, 6M 105% calls are currently indicated at ~3.1% of notional.
Figure 60: EWW implied vol is at 5+ year lows, while Mexico is one of
our EM Strategists favorite markets for 2013
80%
70%
6M ATM implied
volatility
60%
50%
40%
30%
20%
10%
2008
2009
2010
2011
2012
31

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Call switch to play long Turkey / short South Africa

In the context of a positive 2013 outlook for the CEEMEA region in the CEEMEA Year Ahead by JPM Strategist Aserkoff,
Turkey continues to be our key Overweight for four reasons: 1) accelerating GDP and EPS growth; 2) reasonable
valuations; 3) improving current account deficit; and 4) it has a more positive macro outlook than the rest of CEEMEA. On
the other hand, South Africa is the key Underweight due to our cautious outlook on the mining sector given weak
commodity prices and the labor strife.
In terms of volatility, South Africas Top40 implied volatility ranks as one of the richest across global indices, based on its
implied to EWMA realized volatility spread (Figure 61), whereas Turkeys ISE30 (XU030) appears less expensive.
Therefore, we favor going long ISE30 calls and short Top40 calls to play the relative value in implied volatility.
Additionally, the Top40 index is heavily overweight materials companies compared to the MSCI South Africa, a more
widely followed index (Figure 62). Therefore, our cautious stance on the mining companies can be better expressed via the
Top40 index. A 6M 105% call switch (long ISE30 vs. short Top40) costs indicatively 0.82%.
Figure 61: Top40 implied vol among the richest across global indices
Figure 62: Top40 sector weights vs. MSCI South Africa
6M ATM implied less EWMA realised volatility spread across sector indices
% index weight
35%
7%
TOP40
30%
MSCI SA
25%
20%
2%
15%
10%
5%
Telecom
Materials
Industrials
Health
Care
Financials
Energy
C. Staples
EWW
EEM
TOP40
EWZ
SPX
RDXUSD
NKY
DAX
OMX
HSI
XU030
SX5E
AEX
UKX
HSCEI
SMI
CAC
IBEX
FTSEMIB
C. Disc
0%
-3%
In addition, FX also plays an important role when investing in the two indices. As Figure 63 shows, in USD terms, the
Top40 index behaves differently from its ZAR version. The effect is less pronounced for ISE30. Our strategists expect the
ZAR weakness to continue until mining output and exports pick up (mid Q1 seems likely). Investors can be protected from
the FX effect by entering into a call switch struck in USD: a 6M 105% call switch between ISE30 and Top40 struck in
USD can be entered for an indicative credit of 0.3%.
Figure 63: Top40 YTD performance in local currency and USD
120%
Figure 64: ISE30 YTD performance in local currency and USD

170%
ZAR denom.
115%
USD denom.
110%
TRY denom.
150%
105%
USD denom.
130%
100%
110%
95%
90%
90%
Jan
Apr
32
Jul
Oct
Jan
Apr
Jul
Oct

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Maintain Cautiously Bullish Stance on Nikkei Dividend Steepeners

We have highlighted previously that EUR/JPY appears to be a good indicator of risk-on sentiment in Japan, and Nikkei
dividend steepeners historically have tracked it closely (see Figure 65). Shinzo Abe, the current favored candidate for Japan
Prime minister, has been touting a pro-inflation stance that has already weakened the yen to a seven-month low.
Furthermore, recent Eurozone talks on saving Greece have led to EUR/USD strengthening back up to the 1.3 level after
plunging below 1.21 in July as Spanish regions sought out aid from the central government. The weakening yen and the
strengthening euro have led to EUR/JPY rising above 107, a level not seen since April. We believe Nikkei dividend
steepeners may benefit as the yen weakens against the euro on monetary policies in Japan and an improving
macroeconomic environment in the Eurozone.
Figure 65: Historical performance of steepener spreads and comparison to EUR/JPY for the past two years
125
Feb-11
May-11
Aug-11
Feb-12
May-12
Aug-12
Nov-12
As EUR/JPY recovered from the lowest level since

2000, Nikkei dividend steepener spreads all
narrowed substantially.
-10
Nikkei dividend steepener (div pts)
Nov-11
120
115
-20
110
-30
105
-40
-50
-60
EUR/JPY
0
Nov-10
100
2013/2017 steepener
2013/2018 steepener
2013/2019 steepener
2014/2018 steepener
2014/2019 steepener
EUR/JPY
95
90
We have compared the performance of various steepeners since they hit their widest on July 24. The analysis suggests that
steepeners with 14s as the short leg have lagged other pairs, and hence pairs of 14/19, 14/18, 14/17, and 14/16 look the
most attractive for potential tightening in the coming months (see Table 8). Our most preferred pair, 14/19, has tightened
from -45.0 pts on July 24 to -21.3 pts in the course of four months. However, given the move on EUR/JPY, we believe the
14/19 spread can narrow further to as tight as -13.2 pts, based on our regression (see Figure 66). As steepeners have
posted impressive performance over the past month on talks of the potential election of pro-QE Shinzo Abe, we may see a
pullback going into year-end. However, any pullback is an opportunity to buy on a dip, in our view, as steepeners are
poised to benefit from political tailwind and potentially improving market sentiment at year-start.
Steepener
Pair
As of Jul
24, 12
As of Nov
26, 12
Change
(div pt)
Change
(abs %)
14/19
14/18
14/17
14/16
13/19
12/18
14/15
13/18
-45.0
-38.0
-30.5
-21.5
-58.5
-56.1
-11.5
-51.5
-21.3
-17.0
-12.8
-8.5
-22.5
-20.8
-4.3
-18.3
23.8
21.0
17.8
13.0
36.0
35.4
7.3
33.3
53%
55%
58%
60%
62%
63%
63%
65%
Figure 66: Regression of 1M change of 14/19 steepener vs EUR/JPY

y = 0.6763x - 0.4456
R = 0.3012
15
10
1M chg of 14/19 steepener
Table 8: Performance of Nikkei dividend steepeners since hitting their

YTD widest on July 24
-10
5
0
-5
10
-5
-10
-15
1M chg of EUR/JPY
Source: J.P. Morgan Equity Derivatives Strategy. Data since Jan 11.
33

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Downside Protection Trades

Identifying Cheapest Index Put Hedges
In this section, we attempt to identify 3M 95% puts on major global indices that are most cost efficient, by looking at how
the indices have performed historically during market downturns. With a market correction defined as when MSCI AC
World (MXWD) falls more than 5% within a three-month period, we calculate the median returns of all the indices over the
same three-month periods for the past five years and compare them with the current 3M 95% put option prices. Through this
analysis, we have found:
In terms of absolute premium levels (row 2 in Table 9), SMI puts currently have the lowest absolute premium level,
closely followed by AS51 and NIFTY, all being less than 1.0%.
Out of 1,795 three-month rolling returns, there were 585 data points with MXWD falling more than 5%. In such
occasions, indices such as FTSEMIB, HSCEI, RDXUSD, and CECEEUR fell most sharply with the median loss greater
than 16%. On the other end of the spectrum, indices such NDX, NIFTY, XU030, DJI, and SPX posted less than 9.5%
median losses (Figure 67).
In terms of the median return on put premium, SMI, AS51, AEX, HSI, TWSE, and HSCEI seem to be the most
attractive as their 3M 95% puts would have provided greater than 5.0x median returns on the premium. On the other
hand, for US indices (such as NDX, INDU, RTY, SPX), XU030, and MSCI Mexico, put prices seem to be least justified
with the median 3M return on put premium being less than 1.8x.
Figure 67: Median return of global indices when MXWD has fallen
more than 5% over 3 months
Figure 68: 3M 95% put premium and median return on premium under
the scenario of MXWD falling more than 5%
% of Times Median Return on Premium
3M Median Return
-20%
100%
Median Loss (LHS, reversed)

% of Data w/ 3M Return <-5% (RHS)
-15%
SMI
6.0X
90%
-10%
7.0X
80%
AS51
5.0X
TWSE
AEX
HSI
HSCEI
OMX
4.0X
DAX
3.0X
-5%
NIFTY
70%
FTSEMIB
HSCEI
RDXUSD
CECEEUR
IBEX
MSCI Brazil
AEX
SX5E
WIG20
TWSE
CAC
HSI
OMX
KOSPI2
NKY
DAX
AS51
RTY
MSCI Mexico
SMI
UKX
SPX
INDU
XU030
NIFTY
NDX
60%
CECEEUR
EWZ IBEX
SPX
RDXUSD
RTY
INDU
EWW
1.0X
NDX
0.0X
0.0%
Source: J.P. Morgan Equity Derivatives Strategy. *Based on 3M rolling returns for the past 5Y.
FTSEMIB
UKX
2.0X
0%
WIG20
KOSPI2
CAC
SX5E
NKY
0.8%
XU030
1.6%
2.4%
3.2%
3M 95% put premium

*Based on 3M rolling returns for the past 5Y.
Table 9: Indicative 3M 95% put premium and potential return on put premium during the market downturns (MXWD falling more than 5%)
SMI
AS51 NIFTY
UKX
HSI TWSE
OMX
AEX INDU KOSPI2
(1) 3M 95% Put Implied

Volatility
12.7% 13.1% 15.9% 14.8% 16.5% 15.5% 17.1% 16.1% 16.0%
NDX SX5E HSCEI XU030 FTSEM RTY MSCI CECEE MSCI IBEX RDXU
IB
Mexico
UR Brazil
SD
16.8% 18.1% 17.2% 18.2% 18.8% 19.1% 19.3% 20.3% 21.0% 21.1% 20.5% 20.5% 22.2% 23.6% 22.4% 27.0%
(2) 3M 95% Put Premium
0.76% 0.84% 0.96% 1.23% 1.29% 1.32% 1.36% 1.37% 1.41%
1.47% 1.55% 1.59% 1.62% 1.80% 1.84% 1.87% 1.89% 1.90% 2.06% 2.13% 2.30% 2.31% 2.54% 2.71% 3.11%
DAX
SPX
NKY
CAC
Cheap premium
Rich premium
(3) Median 3M Return w/ -10.5% -11.0% -8.6% -9.9% -13.7% -13.9% -12.9% -14.5% -8.7% -12.5% -12.0% -9.4% -12.1% -13.8% -7.8% -14.3% -16.9% -8.6% -17.1% -10.9% -10.7% -16.0% -14.7% -15.5% -16.7%
MXWD Falling >5%
(4) % of Times of 3M 95%
Put Being ITM
82%
87%
64%
88%
88%
76%
73%
88%
79%
75%
84%
85%
88%
96%
63%
96%
85%
62%
99%
76%
79%
91%
78%
96%
84%
(5) Median 3M 95% Put

Return on Premium
6.2X
6.0X
2.7X
3.0X
5.7X
5.8X
4.8X
5.9X
1.6X
4.1X
3.5X
1.8X
3.4X
3.9X
0.5X
4.0X
5.3X
0.9X
4.8X
1.8X
1.5X
3.8X
2.8X
2.9X
2.8X

* (3) Median 3M return with MXWD falling >5%: median of 3m rolling returns when MXWD fell more than 5% over the past 5 years. (5) Median 3M 95%
put return on premium = {ABS(Median 3M Return w/ MXWD Falling > 5%) -5% - (3M 95% Put Premium)}/ (3M 95% Put Premium)
34

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Buy Jan VIX calls spread funded by selling Jan puts

As discussed in the Outlook for Volatility section, the current level of VIX looks cheap relative to virtually every
macroeconomic indicator across the globe. All 81 US macro series indicate that the VIX should be ~7.2 points higher on
average. In addition, it is not clear how the US fiscal cliff will be resolved, but we do know that it can have significant
implications on equity markets and indirectly on the VIX. In our view, the risk for market volatility is skewed to the upside.
In light of this view, we recommend buying the Jan 2013 17-22 VIX call spreads and selling the 16 strike put to fund it
partially as an inexpensive hedge against lawmakers failure to agree to a fiscal cliff solution. This trade can be entered into
for a net cost of ~$0.30. The maximum profit on the trade is 4.7 vegas. Investors would realize the maximum profit if at
expiry VIX opens above 22. The investor would lose one for one below 16 owing to the short put leg. But it must be noted
that over the past five years VIX has opened below 16 only 7% of the time.
We back-tested this strategy since 2006 where the investor buys VIX ATM and ATM+5 call spreads and funds it by selling
a put with a strike that would make the trade as close to cashless as possible. Note that obtaining exactly cashless is difficult
as we back-tested with listed options. In Figure 69 below we show the average profit-loss of this strategy by the level of
VIX at inception. For example, an investor who would have entered into this strategy when VIX was between 20 and 22
would have lost on average -3.5 vegas historically.
We believe that the current level of the VIX makes this trade attractive. It can be seen from Figure 69 that an investor
entering into this trade when the VIX is between 14 and 16 would make on average 1.8 vegas. The maximum profit would
have been 3.1 vegas in July 2007 when VIX was 16. In order to determine which strikes are optimal for the call spread we
back tested ATM ATM+5, ATM+1 ATM+6, and ATM+2 ATM+7 call spreads and found that the ATM ATM+5
call spread has the highest average profit when VIX is between 14 and 16 at trade inception. In terms of the maturity, we
like the second month better than the front month as an investor entering into a similar strategy with second month maturity
when VIX is between 14 and 16 would have made ~1.8 vegas on average vs. 0.1 vegas for the front month maturity.
Additionally, the current steep VIX upside skew makes call spreads attractive relative to outright calls as the 2M 25-50 delta
VIX skew is in its 97th percentile relative to the last five years of data.
Figure 69: Back-test results of rolling VIX call spreads and funding it
by selling put. Horizontal axis shows the VIX level at inception
Figure 70: VIX call skew is near record steepness, cheapening VIX
call spreads significantly vs. outright calls
Vega Profit/Loss
2M 25-50 delta VIX call skew
3.0
25
1.8
2.0
1.0
20
0.3
0.1
0.0
-1.0
1.6
1.0
10
-0.1
12
14
16
18
20
22
-2.0
26
15
10
5
-3.0
-4.0
24
0.0
-3.5
-3.1
2008
2009
2010
2011
2012
35

10 December 2012
Marko Kolanovic
(1-212) 272-1438
Japan Armageddon Put Buy 1Y 90% Nikkei 225 Put Contingent on 10Y JPY Swap Rate
As the worlds third largest economy, Japan remains an economic powerhouse that can influence the global economy and its
growth outlook. However, Japans debt-to-GDP ratio remains one of the highest in the world (Figure 71), and its trade
deficit may continue to deteriorate on the back of a struggling economy and shrinking population. Furthermore, the
outstanding amount of JGBs continues to grow, and next year over 216trn of bonds are expected to mature. If the trade
deficit continues to worsen, the nation may have to depend on foreign investors for fundingtoday, ~91% is funded
domestically.
While we are not bearish on Japan, investors who are looking to hedge tail risk for Japanese equities may consider an equity
put contingent on rates rising to take advantage of the current level of cross-asset correlation. Specifically, we recommend a
1Y 90% Nikkei 225 put option contingent on 10Y JPY swap rate (JYISDP10) above 1.2% at maturity, indicatively
available for 0.40%, which is a ~90% discount compared to a 1Y 90% vanilla put (3.9% prem). The 10Y JPY swap
rate is currently at a multi-year low of 0.68%, with the five-year average standing at ~1.26% (above the contingent strike
level) and rose as high as ~2.15% in mid 2008.
Figure 71: Global comparison of debt-to-GDP ratio (2011 est.)
Figure 72: FTSE/GBP correlation has been well supported during

2012, but we see signs of it breaking down
Debt-to-GDP Ratio
6M Correlation between FTSE 100 & GBP
250%
70%
206%
200%
165%
150%
100%
UKX Index / GBPUSD Curncy
60%
50%
129%
40%
120% 118%
108% 108%
30%
87% 86% 85%

81%
50%
20%
69% 68%
44%
10%
0%
0%
-10%
-20%
Jun06
Source: J.P. Morgan Equity Derivatives Strategy, Central Intelligence Agency.
Jun07
Jun08
Jun09
Jun10
Jun11
Jun12
British ProtectionBuy 95% UKX and 102.50% GBPUSD Jun-13 Dual Digital @ 10%
If UKX index performance is below 95% at maturity and GBPUSD performance is above 102.50 %, the structure will pay
10 times the premium invested. We are suggesting the structure for several reasons:
Our equity strategist, Mislav Matejka, remains cautious on the outlook for UK equities, and the JPM GDP forecast for 2013
was reduced by 0.50% recently. Although one could argue that UK equities are not expensive, they are heavily weighted to
Energy and Materials (30%), sectors that we believe will struggle into next year.
In the meantime, the GBP FX market should remain attractive relative to USD. For 2013, our Asset Allocation team
believes there will be a major step-up in QE buying, mainly from the Fed ($1tr of bond purchases), and we dont think the
Bank of England will be sidelined. This would be supportive for the GBP versus USD. Furthermore, our FX Strategy
teams 2013 year-end target for GBP is 1.63.
The BOEs actions in 2012 (i.e., additional QE) increased equity/FX correlation. We see this correlation softening in 2013.
This trade idea takes advantage of the high level in implied correlation between UKX index and GBPUSD as the Dual
Digital is net short correlation (Figure 72).
36
Marko Kolanovic
(1-212) 272-1438

10 December 2012
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 covered
call 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.
37
Marko Kolanovic
(1-212) 272-1438

10 December 2012
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
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.
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analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document
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J.P. Morgan Equity Research Ratings Distribution, as of September 28, 2012
J.P. Morgan Global Equity Research Coverage

IB clients*
JPMS Equity Research Coverage
IB clients*
Overweight
(buy)
44%
52%
42%
69%
Neutral
(hold)
44%
46%
48%
61%
Underweight
(sell)
12%
34%
10%
53%
*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. Please note that stocks with an NR designation are not included in the table
above.
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38
Marko Kolanovic
(1-212) 272-1438

10 December 2012
Conflict of Interest
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10 December 2012
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Global Equity Derivatives &

Delta One Strategy

Global Derivatives Themes

In 2013 the prevailing macro uncertainty should provide a floor to

Buoyed by central bank actions and macro uncertainty, assets

Equity Derivatives Strategy Team

In the second part of this report, we recommend a number of trade ideas

Davide Silvestrini (EMEA)

Tony Lee (Asia Pacific)

J.P.Morgan Securities (Asia Pacific) Limited

Ruy Ribeiro (Rule-based)

Global Equity Derivatives & Delta One Strategy

Derivatives Ideas for 2013 .....................................................23

Global Equity Derivatives & Delta One Strategy

Outlook for Macro Volatility and Correlations

Source: J.P. Morgan Equity Derivatives Strategy.

Short Sale Ban

Source: J.P. Morgan Equity Derivatives Strategy.

6M realized volatility of S&P 500 daily returns.

Global Equity Derivatives & Delta One Strategy

Figure 4: Equity share volumes are currently near record lows.

S&P 500 Volatility

Figure 3: What appears to be a benign environment of moderate

Total US Equity Volume

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

Global Equity Derivatives & Delta One Strategy

Figure 5: ECB and FED announcements were key drivers of market

Figure 6: US Elections were key drivers of market performance and

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

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

Global Equity Derivatives & Delta One Strategy

Figure 7: Debt and Deficit (as % of GDP) for 10 developed world

Figure 8: Based on the past 10 years of historical data,

10Y Regression of VIX

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

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

S&P 500 Volatility

Figure 9: Over the past 20 years, correlation between stocks

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

Global Equity Derivatives & Delta One Strategy

S&P 500 (Left)

Source: J.P. Morgan Equity Derivatives Strategy.

Global Equity Derivatives & Delta One Strategy

Figure 14: Ratio of options implied to historical realized tail event

Global Equity Derivatives & Delta One Strategy

Figure 16: Implied and realized correlations across global indices

Source: J.P. Morgan Equity Derivatives Strategy.

Source: J.P. Morgan Equity Derivatives Strategy.

Global Equity Derivatives & Delta One Strategy

Figure 17: Dispersion of realized correlation levels doubled post

Source: J.P. Morgan Equity Derivatives Strategy.

Global Equity Derivatives & Delta One Strategy

1Y ATM vol spread avg

TPCX30 (vs. NKY)

Source: J.P. Morgan Equity Derivatives Strategy.

Global Equity Derivatives & Delta One Strategy

Skew and Convexity

Source: J.P. Morgan Equity Derivatives Strategy.

See US Equity Strategy FLASH, 29-Nov-2012

Global Equity Derivatives & Delta One Strategy

Put/call open interest ratio

Rolling 6M beta of VIX to S&P 500