cross asset derivatives strategy - ieor.columbia.edu · upside buy dec11 1x2 (140x120) receiver...

October 5, 2011

M O R G A N S T A N L E Y R E S E A R C HGlobal

Morgan Stanley & Co. LLCSivan MahadevanRonald LevenHussein AllidinaChristopher MetliAshley MusfeldtPeter MallikChris CordaAdam LongsonAnkur Shah

Morgan Stanley & Co. International plc+Phanikiran NaraparajuCorentin RordorfPraveen Singh

Morgan Stanley Asia Limited+Viktor HjortGaurav Rastogi

In the United States, portions of this report regarding non-US options are intended for Morgan Stanley’s Institutional Clients only.

Portions of this report regarding non-US options are not intended for US clients, other than Institutional Clients. Investing in options is not suitable for all investors. Please see the disclosures at the end of this report and discuss whether this or any particular options strategy is suitable with your Morgan Stanley representative. Please direct all market-specific questions to the coverage analysts and all options-specific questions Sivan Mahadevan, Derivative Research Strategist.Morgan Stanley 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. For analyst certification and other important disclosures, refer to Disclosure Section, located at the end of this report.

Cross Asset Derivatives StrategyA Tale of Two Tails

Note: Ronald Leven, Ankur Shah, CorentinRordorf, Ashley Musfeldt, and Phanikiran Naraparaju are Fixed Income Research Analysts and they are not opining on equity securities. Their views are clearly delineated.

Downside or Upside Risk? Weakness in global markets owing both to European sovereign and global growth concerns leaves many market participants with disappointing YTD performance and continued defensive positioning. Both the downside and upside tails are a risk at this point, and we offer our thoughts on cross-asset derivatives positioning going forward.

What Is in the Price? Credit volatility is the highest among major asset classes, and downside tails in both credit and equities remain very expensive while continued steep skew points to relatively attractive upside tail plays. USD rates are an exception, with more balanced volatility and skew.

Cross-Asset Themes: With high market correlations, we prefer equity hedges that are funded by monetizing credit volatility, equity options linked to USD 10-year forward rates, and EURUSD hedges funded by credit volatility.

Credit and Equity: Within both markets we prefer shorter expiries for hedging and consider calendar strategies to position for medium-term market healing.

USD Rates: We advocate buying volatility in the 10-year sector as history suggests that both implied and realized can increase on any risky asset healing. We also find front-end receivers attractive.

FX & Commodities: In FX, we suggest strategies that favor safe-haven currencies over pro-cyclical ones. Given our lower forecast for oil, we like longer-dated put-spread and put-spread-collar hedges.

+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

M O R G A N S T A N L E Y R E S E A R C H

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Cross-Asset Derivatives StrategyOctober 5, 2011

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SP500 EURUSD Correl SP500 Oil Correl

SP500 10y Rates Correl SP500 CDX IG Correl

Source: Morgan Stanley Research, Quantitative and Derivative Strategies, Bloomberg.

Risk premiums high compared to real interest rates

Cross asset correlations (6m) are high

With Markets Priced for Crisis, Measure and Compare the Tails

Markets are pricing in high convexity

Volatility at crisis levels across assets, save rates: Due to global macro risks, volatility and skew have spiked, while term structures have inverted. Equity, credit, FX, and commodity markets are priced in a range for a May 2010-type crisis to a Nov 2008 systemic event.

Protection is expensive: Given our bearish, but non-recessionary view on growth in DM, and cautious but constructive view in EM, owning the medium tail is our preference. With both the upside and downside tails substantial, we continue to favor funded or structured (through selling the tails or cross asset correlation) approaches to protection buying. Additionally, we like selling excessive credit risk premiums to fund equity and FX puts.

Outlier is rates: USD rates volatility is more muted and skew is more balanced than other asset classes, reflecting the Fed’s intention to push down medium-term rates and spark a portfolio rebalancing into risky assets.

Both tails warrant consideration: We focus on tail risk hedges in FX, credit and equities globally and even though the market is less focused on it, we find attractive re-risking trades through simple OTM call and call spread strategies.

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Cross Asset Volatility: Uncertainty Remains High, Except in RatesEquity vol and skew remain at crisis levels: In the US, growth and European contagion concerns outweigh monetary stimulus as equity volatility and skew remain high and the term structure inverted. The volatility, skew, and term structure story is similar globally, as weaker global growth seems more likely. To play for downside, we favor funded and capped strategies.

Credit widens to compensate for market volatility: The move wider in global credit spreads and volatility has been severe in comparison to other risk assets over the two months. Credit index options continue to price in the highest risk premium across asset classes, and consequently offer less value as a volatility long, even though we continue to see demand for further downside hedges.

US Rates: Past experience has shown that QE has driven both realized and implied volatility higher, which we attribute to the subsequent risky assets rally.

FX: Volatilities are near post-crisis highs, while skew is extreme and favors safe haven currencies over pro-cyclical ones.

Note: Rate volatility is in normalized basis points, credit volatility is volatility of spreads, and all others are price return volatility . Data as of Oct 4, 2011* Pre-Crisis Average is the average level from 7/1/06 through 6/30/07Source: Morgan Stanley Research, Morgan Stanley Quantitative and Derivative Strategies, Bloomberg

Asset Class Asset Current Vol2006-2007 Average

Change in 3m Vol since Jul 08 2011

3m Imp Vol 3y Percentile

Change in Skew since Jul 08

2011

3m Skew (90-110) 3y Percentile

Equities SPX 34% 13% 19% 84% 2% 89% -18%SX5E 42% 15% 21% 94% 0% 71% -23%

IBOV 36% 27% 17% 82% 4% 99% -17%MSCI EM 50% 28% 27% 86% 5% 100% -28%

FX EURUSD 17% 7% 5% 87% 1% 99% -6%USDJPY 11% 7% 2% 19% 1% 38% -5%

Commodities Oil 53% 29% 24% 85% 16% 100% -23%Gold 33% 19% 18% 86% 2% 97% 5%

Rates 1y US Rates 60 bps 61 bps 19 bps 41% 7 bps 86% 19 bps10y US Rates 114 bps 67 bps 14 bps 48% 5 bps 54% -119 bps

Credit

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Jul 08 2011

HSI 43% 17% 26% 8% -28%

CDX IG 80% NA 39% -3% 48 bpsiTraxx 96% NA 43% -1% 90 bps


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Our Recommended Cross Asset StrategiesAsset Class Region

Rates / Equity US

Buy a S&P 1y ATMF put spread (20% OTM) knocking-out at 10y CMS lower than 1.9% for 3.7%

Buy a S&P 1y 105% call knocking-in at 10y CMS below 2.25% at expiry indicatively offered at 2.7%

Credit / Equity US CDX HY S&P 500 Buy a Dec11 97.5% S&P put and fund by selling a Dec11 CDX HY 80 payer for a near zero cost

EuropeFX / Credit EUR / USD iTraxx Main Buy a Dec11 97.5% EUR / USD put funded by selling a Dec11 150-240 iTraxx Main strangle for less than 1% of spot

Asset 1 Asset 2

10y Rates S&P 500 Buy 6m10y rate cap with KO on S&P above 1150 costing 15.5 bps

Trade Description


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Our Recommended Single-Asset StrategiesAsset Class

Region Asset Trade Type

Equities Global S&P 500 / KOSPI Volatility Buy Dec11 S&P variance and sell Dec11 KOSPI variance to fund at a spread of 4 var points

USD / MXN Volatility Sell a 3m USD / MXN volatility swap at 24% or add a 40% cap to lower the strike on the swap to 22.5%

Rates US 1y rates Upside Buy 3y1y ATMF receivers costing 44 bps

Protection

Upside

Correlation Sell Jan13 correlation (index versus top 50 varswap) at or above a high 60’s handle

Credit Global Protection Buy Nov11 payer spreads and payer spread collars for 11-47 bps

FX Global CNY / USD Protection Buy a 3m CNY 25d (CNY6.3308) USD put for 0.35%

AUD / USD Protection Buy a 3m AUD ATMF/25d USD put spread for 2.01%

USD / SGD Upside Buy a 1y ATMF (SGD 1.302) USD call with 3m window barriers at (SGD1.235) and (SGD1.410) for 1.9%

10y rates Volatility Buy a 6m10y variance swap at 123 norm vol points and keep for 3m

CDX IG & iTraxx Main

Upside Buy Dec11 1x2 (140x120) receiver spreads for 19 bps

US CDX IG Protection Buy CDX IG9 5y or 7y 3-100% tranche for 43-94 bps

Upside Buy Mar11 120 receivers funded by selling Dec 120 receivers for 20 bps

Buy CDX IG9 0-7% PO’s for 32 pts

Europe iTraxx Main Protection Buy iTraxx S9 5y 3-100% tranche for 90 bps or buy iTraxx S9 6-9% tranche for 870 bps (with light delta)

Upside Buy iTraxx S9 0-6% PO’s for 24 pts

VIX Volatility Buy Dec11 26 VIX puts costing 0.85 volatility points

Europe EuroStoxx Protection Buy 3m 95/85% put spreads for 2.9% of spot

Upside Buy 3m 85/105/115% call spread collars for near zero cost

Buy 2012/13 dividend futures

Protection

S&P 500

Buy Dec11 – Mar12 1375-1425 calls costing less than 1% of spot to play for targeted rallies

Sell 3m 1300 calls to fund 6m 1300 calls for 1.4%

Commodity Global Oil (Brent) Buy Jul12 $65/80 put spreads for 4.2% or buy Jul12 $65/80/130 put spread collars for 1% of the Jun12 future

US Buy Nov11 1000 puts and sell Jan12 1300 calls (bearish RR) for 2% or additionally sell Nov11 900 puts (PSC) for less than 1% of spot

Trade Description

Cross Asset Trading Strategies


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Rates vs. Equities: Too Quick, Too Fast?

Source: Morgan Stanley Research, MS Quotient, Bloomberg.

Attractive to sell rich rate/stocks correlation

Rates rally has overshot other risky assets

We analyzed the relationship between the Financial Condition Index (MSFCI Index) and the 10 year yield.Over past cycles, from bottom to peak, each 1 sigma rise of FCI drove rates 25 to 35 bps lower. This time rates have rallied 63bps for each unit of FCI. We believe this relationship should normalize, and like to position via hybrids for a fall in stock prices at constant rates or a rise in rates at constant stock prices (lower stock prices will put downward pressure on FCI).

Two trades for normalization in FCI/Stocks relationship

Buy 6m10y rate cap knocking-out on S&P above 1150:Price is 15.5 bps, which represents a 55% discount to vanilla. Investors who want to position for a back up in rates while remaining bearish or neutral; stocks can buy caps at interesting discount. The max loss is the premium paid.Buy an S&P 1y ATMF put spread (20% OTM) knocking-out at 10y CMS lower than 1.90%: Price is 3.7% which represents a 40% discount to vanilla. Investors who want to position for depressed stock market while thinking that rates reached a bottom can buy SPX hybrid puts at interesting discount to vanilla. The max loss is the premium paid.Both structures take advantage of selling rich stocks versus rate correlation.

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Historically monetary easing reduces volatility…

…and rallies spot markets

Rates vs. Equities: Play for Monetary Stimulus Fueled US Equities Rally

Notes: First chart is ratio of 3m realized vol 6m after rate cut or hike since 1980 divided by 1m before. Second chart is spot returns indexed to easing announcement date. For QE2, Irish Rescue, and EMU Summit dates are Aug 2, 2010, Nov 29, 2010, and Mar 14, 2011. QE2 spot is S&P, the others are SX5E.Source: Morgan Stanley Research, Bloomberg.

Equities may rally further if incremental Fed action is more powerful than expected

Fed still has some options: In addition to pushing medium-term rates lower through a larger “Operation Torque” program, the Fed can also cut interest on reserves and relax FX swap conditions to spur economic growth.

Monetary policy impact takes time: The immediate market selloff after the Fed’s September announcement may have as much to do with Europe as with the US, suggesting that if incremental progress is made by the ECB, existing monetary stimulus may take effect buoying markets.

Rates markets may be pricing in growth: Despite steep skews towards lower equities, commodities, and credit prices, rates skews are pricing in higher rates (payers) and subsequently US growth over the medium-term.

Trade Idea: Buy 1y OTM call KI on lower 10y rates

Rates lower for longer: Strong monetary policy may indeed be focused on keeping longer-term rates lower for longer. We favor buying 12m S&P 500 OTM calls that knock-in on 10-year rates staying below 2.25% offered indicatively at 2.7%. The max loss is the premium paid.

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Credit vs. Equities: Fund Equity Hedges in Credit by Selling High Yield Puts

Credit story is more positive this cycle, but it’s underperforming

Equities more sensitive to growth slowdown: While credit is more reactive to systemic events (at least initially), equities are heavily impacted by the growth outlook, which in our base case will drive performance going forward.

Deleveraging underway: With companies hoarding cash and reducing leverage, our HY strategists do not expect a default cycle similar to 2008-2009, which should support valuations if we have another leg down.

Credit volatility is expensive: Credit volatility is pricing in a high “fear premium”, given downside risks and large recent daily spread moves. Although we think it will normalize over time, we prefer using credit volatility to fund cross asset hedges as outright short volatility positions do not mark well.

Sell HY credit vol to fund equity protection

Sell CDX HY (S17) payers to buy S&P puts: We like selling Dec11 CDX HY 80 payers (ref 85) bringing in 3.2% of premium to fund a 97.5% Dec11 S&P put costing 6.1%. Scaling the notionals by the historical beta of 2:1 credit:equitymeans the trade would cost near zero. The key risk to this trade is that spreads widen, without a compensating move lower in equities.

HY volatility elevated relative to S&P

Leverage trending lower in aggregate

Notes: All pricing is indicative. Source: Morgan Stanley Research, Quantitative and Derivative Strategies, Bloomberg

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FX vs. Credit: Sell December iTraxx Main Strangles to Fund EURUSD Hedges

Hedge currency risk in Europe by selling credit volatility

iTraxx Main and EURUSD decoupling: Since the start of the credit crisis, iTraxx Main and EURUSD have been closely correlated, due to their sensitivity to the macroeconomic picture and broader market sentiment.

EURUSD resilience: This correlation has broken down in recent months, with iTraxx Main underperforming EURUSD. In spot markets, EURUSD is flat YTD, which goes against the trend of other risky assets (down 10-20%). We believe that this disconnect is not sustainable and should reverse with a more bearish credit valuation.

Trade idea: We like selling Dec11 150 – 240 strangles in iTraxx Main for 1.6% of spot to fund the purchase of a Dec11 2.5% OTMF EUR / USD put for a net cost less than 1% of spot to take advantage of this recent divergence as well as expensive credit volatility. The max loss on the short strangle is unlimited.

iTraxx Main versus EUR/USD: 2008 - present

iTraxx Main vs EURUSD Implied Volatility

Source: , Morgan Stanley Research

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Single Asset Trading Strategies


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Note: 2008 peak to trough dates are Nov 1, 2007 to Mar 11, 2009. Current Peak to trough is Jul 21, 2011 to current date.Source: Morgan Stanley Research, Quantitative and Derivatives Strategy, Bloomberg.

EM spot drop more like US than Europe

EM vol and skew rising relative to DM

Global Equities: EM Risks Catching up to DM, although EM Upside is Higher

Spot markets indicate EM risks catching up to DM

EM markets react strongly to global risks: The recent EM selloff was similar to Europe’s and sharper than the US selloff, indicating that EM may be vulnerable to European contagion, a growth slowdown, and funding concerns, as well as region specific risks such as policymaker missteps in confronting growth, growing debt and deficits, and still high inflation. Europe has fallen nearly 40% of the 2008 selloff while the US and EM has fallen only 25% of that selloff.

China easing is key: China has already announced a reduction in household tax, but further social funding to boost consumption are not guaranteed.

Options markets agree

Systemic event may impact EM more than US: If Greece were to default and funding tightness spreads, there may be a flight to safety (USD denominated debt) at the expense of EM. Already bond outflows and short currency positions are leading the fundamentals, raising the risks.

As a result, EM vol and EM skew (indicating downside protection cost) have risen relative to DM. In fact, EM skew is now historically close to DM, which is extreme considering the S&P is typically investor’s index of choice for hedging.

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Kospi variance still high relative to S&P

Global Equities: Buy DM / EM Variance Spread to Play for EM Strength

Still favor EM upside

Unlike DM, EM policymakers have options: EM policy makers can still ease rates, banking reserve requirements, or FX reserves to prevent disruption in currency markets. On the fiscal side, most EM economies have leeway to spend should they keep monetary policy tight to prevent further inflation.

EM fundamentals still cheap: EM equity P/B ratios are near 20 year lows given outflows despite EM equities being historically cheap versus UST yields. Going forward, our EM Equity Strategy team projects a 11% increase in EPS YoY as a base case.

Trade Idea: Buy Dec11 US variance and sell Kospivariance to fund

Near-term there are plenty of risks in the US: With fiscal stimulus wrangling likely to take us into the New Year and internal dissension at the Fed, there may be only limited government action for the rest of 2011.

Kospi preferred EM variance short: Korea is one of the least exposed countries to Eurozone exports and derives 7% of equity index member revenue from developed Europe. With Dec11 volatility / variance still high versus the US (at 4 variance point premium), we favor a spread trade to play for EM outperformance. The key risk is if the Kospi implied-realized spread shrinks while the S&P spread expands.


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US Equities: US Markets Cautious as Growth Risks Rise


Despite selloff, S&P fundamentals still strong

Current earnings not pricing in recession: 2011 earnings (expected to come in at $96 per share) seem far above the last 3 recession EPS’s which average in the high 50’s / low 60’s. With 2012 consensus EPS in the mid-80’s, this indicates a benign, demand related drop-off is more likely than a steep decline.

Bear case is 2008: Our Equity Strategy team estimates that a powerful global slowdown may push EPS to $60, which is still above, but close to 2008 level of 54.

Options markets are more bearish

Options markets reacting to Greece: Options markets appear to be pricing the possibility that Greece becomes insolvent, as risk metrics are similar to May 2010.

Term structure indicates a modest improvement in 2012:With term structure more inverted than in May 2010, longer-dated volatility is lower, suggesting that conditions may improve in 2012.

Delta convexity high: Peaking convexity indicates the wings are thick, suggesting that both upside and downside tails are substantial.

Vol metrics pricing in May 2010, not Nov 2008

Spot market catching up to options market

Metric 4-Oct-11 20-May-10 26-Nov-082m Spot Move -6% -9% -20%3m Implied Vol 34% 34% 48%12m Implied Vol 31% 32% 41%Skew 11.6% 13.6% 9.9%Term Structure 2.9% 2.6% 7.2%1y Implied Correlation 71% 75% 57%

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Note: All pricing is indicative.Source: Morgan Stanley Research, Bloomberg.

Cash market rarely higher after an inversion

US Equities: Buy Near-Term US Protection

Near-term risks are high

Incremental stimulus must raise the bar: With unprecedented internal dissension, fewer and more incremental policy options, a shifting political focus, and the market’s negative reaction to the Operation Torque announcement, policy impact on markets may be muted near term unless the Fed delivers a larger program than expected.

Europe risks remain high: With several European hurdles, including debate over EFSF leverage and the 2nd Greek bailout, reaching a PSI target, and further austerity measures, short-term risk may gap sharply higher, while longer-term seems more supported.

Trade Idea: Sell upside or downside tail to fund protection

Buy bearish risk-reversals or put spread collars: Buy Nov11 1000 calls and sell Jan12 1300 calls to fund for a net cost of 2%. We like this trade as a direction hedge over longs to cover risks of near-term policy failure. Or additionally sell Nov11 900 puts for a put spread collar costing 0.8%. The max loss on the short-call is unlimited.

US credit spreads have surpassed May 2010

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Notes: Correlation is for 500 constituents in S&P.Source: Morgan Stanley Research, Bloomberg.

Term structure pricing in modest healing medium-term

Realized correlation peaking

US Equities: Don’t Ignore the Upside Tail

With investor sentiment bearish, an upside snapback or short squeeze is possible

Fiscal policy may be catalyst: Passage of a fiscal stimulus with its continuation of unemployment benefits and payroll tax cuts could spark a rally, although timing and the final form of the legislation are uncertain. At the earliest, it may be passed at the beginning of next year.Realized correlation may fall relative to implied: With macro risk factors in the driver’s seat, both implied and realized correlation are near all-time highs, pushing the spread to negative territory. An equity rally may normalize realized correlation while implied remains bid.

Trade Ideas: Buy call calendars, OTM calls, or sell long-dated correlation

Buy call calendars or far OTM calls: Sell 3m and buy 6m 1300 calls for 1.4% of spot. Buy Dec11-Mar12 1375-1425 strike calls for <1% of spot to play for a year-end rally. The max loss is unlimited on a short call.Buy VIX Dec11 26 puts costing 0.85 vol points: Instead of selling vol outright, we favor buying VIX puts to play for a VIX decline due to a partial resolution in Europe, clarity of US fiscal stimulus, and an uneventful holiday season.Sell Jan 13 S&P implied correlation at or above high 60’s: With this trade currently negative carry, we prefer legging into it over time. The key risk is if the implied realized spread shrinks.

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SX5E variance convexity is near its peakSX5E term structure remains inverted

European Equities: Volatility and Convexity Remain High

Source: Morgan Stanley Research, Quantitative & Derivatives Strategy

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Fixed strike volatility is increasing, especially for DAX and FTSE. Since May 2010 spike in volatility, fixed strike volatility has largely remained in a range. However, over the last 3 months, fixed strike volatility has been gradually increasing, especially for DAX and FTSE. Fixed strike volatility for DAX and FTSE is current trading above May 2010 levels.

12m-3m term structure remains inverted; convexity is near its peak. Variance convexity in Europe is high and near its peak across indices and maturities. Longer dated convexity is relatively higher. Given the uncertainty about the European sovereign crisis, term structure has materially inverted over the last 3 months.


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b-10

Jan-

10N

ov-0

9O

ct-0

9S

ep-0

9Ju

l-09 1M

Rea

lized

Vol

- 1M

Impl

ied

Vol 1

M A

go

0%

10%

20%

30%

40%

50%

60%

1M R

ealiz

ed V

ol

1M Realized - 1M ATM Implied 1M Ago 1M Realized

Implied volatility vs. subsequent realized volatility

Note: All pricing is indicative only.Source: Morgan Stanley Research, Quantitative & Derivatives Strategy, Bloomberg

Indicative trade diagram for a put spread

Volatility is likely to remain high Implied volatility may remain sticky at higher levels.We remain concerned about weaker global growth, potentially supported by a weaker earnings season, and the sovereign crisis in Europe.

Trade: Buy near-term put spreads and call spread collars

Shorter dated options offer value: 1m realized may remain above 1m implied volatility, suggesting that expensive near-term options still have value.

Buy OTC 3m SX5E 95/85% put spreads for 2.9% to hedge downside risks (ref 2120, Delta 15) offering max leverage of ~3.4x at expiry. Given the relatively high volatility and skew, we prefer put spreads for hedging downside risk with the short put strike close to 2009 lows. The max loss on a put spread is the premium paid.

Buy OTC 3m SX5E 105/115% call spreads funded by selling 3m 85% puts (ref 2120, Delta 43). Investors looking to play a policy response induced year end rally, should consider buying a call-spread collar with short puts struck around 2009 lows. Such a strategy can be initiated at ~0 premium cost. The max loss for a short call is unlimited.

European Equities: Shorter-Dated Options Offers Value in an Uncertain Environment

Long Put Strike

Short Put Strike

1500

1700

1900

2100

2300

2500

2700

2900

3100

3300

Sep

-08

Nov

-08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep

-09

Nov

-09

Jan-

10

Mar

-10

May

-10

Jul-1

0

Sep

-10

Nov

-10

Jan-

11

Mar

-11

May

-11

Jul-1

1

Sep

-11


19


European Equities: SX5E Dividends – Recession in the Price, Prefer Curve Front-End

Source: Morgan Stanley Research, DataStream, Bloomberg

What is in the price? SX5E dividends are pricing inmaterial cuts to consensus earnings estimates and sequential double-digit earnings declines in 2011 and 2012. Furthermore, dividends from 2013 onwards are implying ~0 dividends from Financials and the MS bear case for other sectors.

We prefer front end (2012/2013) of the curve. While dividends across the term structure are attractive from a fundamental valuation perspective, we prefer the front end of the curve as these maturities offer the right combination of high base case upside, limited bear case downside, and improving earnings visibility.

2 6 2 2 7 32 9 4

3 1 9

2 2 4

1 7 5 1 7 2

-4 6 .0 %

-4 0 .6 %

-1 7 .7 %

P e a k to F in a l E P S - 2 0 0 8 -3 2 %

P e a k to F in a l E P S - 2 0 0 9 -5 1 %

-5 5

-5

4 5

9 5

1 4 5

1 9 5

2 4 5

2 9 5

3 4 5

2 0 1 0 2 0 1 1 2 0 1 2 2 0 1 3

SX5E

EP

S (E

ur)

-6 0 %

-5 0 %

-4 0 %

-3 0 %

-2 0 %

-1 0 %

0 %

Div

iden

d Im

plie

d C

onse

nsus

EP

S C

ut (%

)

C o n s e n s u s E P S E P S (D iv id e n d im p lie d ) D iv id e n d Im p lie d C o n s e n s u s E P S C u t

5.0% 4.1%

-14.3%

-6.0%

8.0%

-22.0%-25%

-20%

-15%

-10%

-5%

0%

5%

10%

M S forecast for Europe Consensus-SX5E D ividend Im plied-SX 5E

YoY

Ear

ning

s G

row

th

2011 2012

127.

6 138.

0 144.

4 153.

1

95.6 10

1.1

105.

4 112.

2

99.4 101.

9

106.

0 115.

5

82.2

83.0 86

.2 91.2

112

90.3

85.5

81.9

75

85

95

105

115

125

135

145

155

165

2012 2013 2014 2015

M S Base Case MS Base Case+Zero Financials DivsM S Bear Case MS Bear Case+ Zero Financials DivsCurrent Im plied

Dividends from 2013 onwards are already implying MS Bear case for all sectors and zero dividends from Financials

Dividend implied cuts to consensus earnings

Dividend futures are implying double-digit earnings decline in 2011 and 2012

Dividends from 2013 onwards are implying ~0 dividends from Financials, bear case for other sectors


20


0123456789

May-07 May-08 May-09 May-10 May-11

Daily Price Change

Implied 1SD Change

Source: Morgan Stanley Research

Volatility Remains High Amid Macro Concerns

Credit volatility is pricing in a lot, both relative to history and other asset classes. European credit volatility in particular ishighly elevated and close to 2008 highs. Downside skew has steepened, given the still prevalent bid for further tail hedges.

Realized volatility is higher in line with implied, although thevolatility carry still remains positive in most indices. CDX HY is an exception and has seen large daily spread moves in recent weeks making the volatility carry close to zero.

CDX IG: Implied and Realized Volatility

iTraxx Main: Implied and Realized Volatility

Global Credit: Volatility Overview – Volatility and Skew Elevated

CDX IG Vol

-3%

0%

3%

6%

9%

12%

Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11

Vol CarryRealized VolATM implied Vol

iTraxx Main

-3%

0%

3%

6%

9%

12%


Vol CarryRealized VolATM implied Vol

CDX HY: Realizing More Than Other Credit Indices




21


Global Credit: Short Dated Options for Hedging


Hedge Short Term Risk Using Options

Although credit valuations appear increasingly cheap at current levels, there is significant headline risk in the near term. This is reflected in the magnitude of daily spread moves, along with high levels of implied volatility and steep skew.

For hedging, we prefer short-term strategies that monetize the steep skew, with a relatively neutral view on volatility.

Buy Short Dated Payer Spreads/Payer Spread Collars

Payer spreads: We like buying November expiry payer spreads in CDX IG and iTraxx Main. The maximum leverage on this strategy is below 3.0x, which is lower than what we are used to, but arguably well justified in today’s environment. The max loss to this trade is limited to the premium paid.

Payer spread collars: Investors comfortable with selling away market upside may also want to consider payer spread collars, which can lower the overall cost of this trade significantly. The key risk to this trade is a sharp tightening in credit spreads, in which case there is no cap on downside.

November Expiry Payer Spreads

CDX IG Hedging MenuCDX IG November @ 141bps

Strategy Strike Price totalMax

DownsideUpside @

200bpsLeverage @

200bps

Payers 150 -0.75% -0.75% 1.45% 1.9x

Payers 170 -0.50% -0.50% 0.81% 1.6x

Payer Spread 150/190 -0.47% -0.47% 1.30% 2.8x

Payer Spread 150/180 -0.40% -0.40% 0.92% 2.3x

Payer Spread Collar 140/190/120 -0.43% unlimited 1.78% 4.2x



Bear Risk Reversal 160/120 -0.40% unlimited 1.36% 3.4x

Bear Risk Reversal 170/130 -0.09% unlimited 1.22% 13.6x

(150)

(100)

(50)

-

50

100

150

200

130 140 150 160 170 180 190 200 210 220

Buy 1 CDX IG Nov-11 @ 150 PayerSell 1 CDX IG Nov-11 @ 190 PayerNet Position



22


Spread change since vix peak

-80

-60

-40

-20

0

20

40

60

80

0 22 44 66 88Business days after spike

Max Min Current Median

Source: Morgan Stanley Research .


Buy 1x2 Receiver Spreads

Spreads After Volatility Peaks (Excluding 2008)

Global Credit: 1x2 Receiver Spreads For UpsideVolatility and Spreads Should Normalize Over Time

Credit priced for extreme outcomes: Credit spreads are currently pricing in default scenarios never seen before, especially in Europe. Despite poor technicals, our strategists remain fundamentally positive on IG credit in a below par growth environment, without a full-blown recession.

Spreads gap wider, grind tighter: Credit spreads and volatility tend to gap wider, but the normalization takes time. As such, we find strategies that benefit from tighter spreads, without much downside in a move wider particularly valuable today.

Buy 1x2 Receiver Spreads Across Indices

Trade idea: We like buying 1x2 receiver spreads across indices and prefer these strategies to outright longs. Selling the extreme upside tail makes this trade less expensive, but with an attractive break-even range that would benefit from a moderate move tighter in spreads. The main risk to this trade is a significant snap back in spreads to low levels, in which case downside could be unlimited.

(150)

(100)

(50)

-

50

100

150

80 90 100 110 120 130 140 150 160 170 180 190

Buy 1 CDX IG Dec-11 @ 140 Receiver

Sell 2 CDX IG Dec-11 @ 120 Receiver

Net Position

Max Profit +68bp

Cost if index stays above 140bp is -19bp



23


Global Credit: Calendar Trades For Long Term Upside

Source: Morgan Stanley Research, .

Inverted Volatility Term Structure Offers Upside Opportunity

Position for tighter spreads over time: Given cheap valuations, significant macro uncertainty and lack of conviction in the near term, we like trades that position for a gradual tightening of credit spreads over time. We find the volatility term structure a good place to express this view, given the current entry-point and low cost.

Buy IG17 March receivers funded by selling December receivers: We like buying March expiry 120 receivers in IG17, funded by selling Dec expiry receivers at the same strike. The inverted volatility term structure makes this a relatively cheap bet at 20 bp, with a possible leverage of greater than 4x if spreads tighten to 100 post December. The key risk to this trade is that spreads tighten sharply before December, although term structure steepening should cushion the mark-to-market in that scenario.

CDX IG: Volatility Term Structure Is Inverted

70%

75%

80%

85%

90%

Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12

110 120 130



24


iTraxx and CDX Equity Tranche PO Scenarios

Global Credit: Equity PO Economics and Preferred Ideas


•We have liked long-dated POs based on curve shape and the better asymmetry profile. However, recent spread curve flattening and correlation moves have made this relative value less attractive.

•For legacy indices, we continue to like longer-dated equity POs, but now prefer a thicker tranche, made by combining equity and mezzanine risk.

• Considering greater risk of defaults, we like the lower dollar price, defensive nature of iTraxx S9 0-6% and CDX IG9 0-7%, both of which can withstand 5+ defaults and hit a 10% IRR.

• At wider spread levels, thicker tranches provide better upside convexity without much additional downside relative to standard equity tranches.

•In newer series (S15 and IG15) we think shorter-dated POs should be appealing due to the better visibility on fundamentals.

•Key risk to the equity POs is dispersion (underperformance of tails) and defaults. However, the high yield of POs can pay for a variety of hedges in credit (macro and single-name) as well as in stocks.

Preferred PO ideas

IRR (at different numbers of defaults in the portfolio)0 1 2 3 4 5 6 7 8 9 10 11 12 13

Legacy Equity POsIG9 5y Dec-12 0-3% 54 62% 35% 6% -26% -62% FL FL FL FL FL FL FL FL FLIG9 7y Dec-14 0-3% 31 43% 33% 21% 6% -18% FL FL FL FL FL FL FL FL FLIG9 10y Dec-17 0-3% 16 34% 29% 23% 14% 0% FL FL FL FL FL FL FL FL FLLegacy Thick Equity POsIG9 5y Dec-12 0-7% 77 23% 15% 8% 0% -8% -16% -24% -33% -42% -51% -61% -71% -83% -98%IG9 7y Dec-14 0-7% 54 21% 18% 15% 12% 8% 4% 0% -4% -10% -15% -22% -31% -44% -74%IG9 10y Dec-17 0-7% 32 20% 18% 17% 15% 13% 11% 9% 6% 3% 0% -5% -10% -19% -46%New Equity POsIG15 3y Dec-13 0-3% 64 22% 13% 3% -9% -22% -40% -70% FL FL FL FL FL FL FLIG15 5y Dec-15 0-3% 43 22% 17% 11% 5% -4% -16% -43% FL FL FL FL FL FL FLIG15 7y Dec-17 0-3% 32 20% 17% 13% 8% 2% -7% -28% FL FL FL FL FL FL FLNew Thick Equity POsIG15 3y Dec-13 0-7% 78 12% 8% 5% 1% -3% -7% -12% -16% -21% -27% -33% -40% -48% -58%IG15 5y Dec-15 0-7% 60 13% 11% 9% 7% 4% 2% -1% -3% -6% -10% -14% -19% -25% -33%IG15 7y Dec-17 0-7% 45 14% 12% 11% 9% 8% 6% 4% 2% 0% -3% -6% -9% -14% -20%

Index Mty Tranche Price

IRR (at different numbers of defaults in the portfolio)0 1 2 3 4 5 6 7 8 9 10 11 12 13

Legacy Equity POsS9 5y Jun-13 0-3% 45 57% 42% 26% 9% -12% -37% -75% FL FL FL FL FL FL FLS9 7y Jun-15 0-3% 24 46% 39% 32% 23% 11% -5% -38% FL FL FL FL FL FL FLS9 10y Jun-18 0-3% 14 34% 30% 26% 21% 15% 5% -17% FL FL FL FL FL FL FLLegacy Thick Equity POsS9 5y Jun-13 0-6% 62 31% 25% 19% 12% 5% -2% -9% -18% -26% -36% -47% -60% -79% FLS9 7y Jun-15 0-6% 40 28% 25% 22% 19% 15% 12% 8% 3% -2% -9% -17% -27% -46% FLS9 10y Jun-18 0-6% 24 24% 22% 21% 19% 17% 15% 12% 10% 7% 3% -2% -9% -23% FLNew Equity POsS15 3y Jun-14 0-3% 38 42% 33% 23% 12% -2% -21% -56% FL FL FL FL FL FL FLS15 5y Jun-16 0-3% 24 35% 30% 24% 18% 9% -4% -31% FL FL FL FL FL FL FLS15 7y Jun-18 0-3% 17 30% 27% 23% 18% 12% 2% -19% FL FL FL FL FL FL FLNew Thick Equity POsS15 3y Jun-14 0-6% 54 25% 21% 17% 13% 9% 4% -1% -7% -14% -21% -30% -42% -61% FLS15 5y Jun-16 0-6% 38 23% 21% 18% 16% 13% 10% 7% 3% -1% -6% -12% -21% -37% FLS15 7y Jun-18 0-6% 28 21% 20% 18% 16% 14% 12% 10% 7% 4% 0% -5% -12% -25% FL

Index Mty Tranche Price


25


0

50

100

150

200

250

300

Nov-06 Jul-07 Mar-08 Nov-08 Jul-09 Mar-10 Nov-10 Jul-11

IG9 5yIG9 5y 3-100% Duration of 5y IG9

roughly the same as today's IG9 7y index.

Source: Morgan Stanley Research, .

IG9 3-100% Historical Spread

iTraxx Main X-100% Historical Spread

Global Credit: Hedge Against Systemic Risk Using X-100% TranchesCheap Convex Hedges

Rising systemic concerns and higher correlation should lead to risk moving up the structured credit capital structure in theindex tranche market.

We like buying protection on x-100% tranches in IG 9 5Y and 7Y, as a way to position for rising systemic risk, without the guess work of which tranche absorbs this risk. These shorts are positively convex, with an increasing delta as spreads widen. Rising correlation is also a positive from a MTM perspective.

Buy Protection on IG9 5Y and 7Y 3-100%: This trade has a running premium cost of 43 bp at the 5Y point and 94 bp at the 7Y point. These tranches trade significantly tighter than the IG9 or IG17 index, with exposure to quite a few HY names.

In Europe, we like this trade at the iTraxx S9 5Y point, with a spread of 90 bp and maturity of June 2013. If spreads tighten, the maximum downside to this trade is limited to the premium paid.

0

20

40

60

80

100

120

140

160

180

200

Nov-06 Jul-07 Mar-08 Nov-08 Jul-09 Mar-10 Nov-10 Jul-11

iTraxx Main Index

iTraxx S9 6-100%

iTraxx S9 3-100%



26


FX: Market Recap

Source: Morgan Stanley Research, Bloomberg.

Volatility at post crisis highs

Global Market Downturn Sparked Surge in FX Vols: The selloff in global equity markets and concerns about the future of the Euro set off sharp moves in FX rates. In particular, vols for the high-beta EM and commodity currencies went well into the top 15th percentile (red in the chart) but vols are relatively high for most currencies.

SNB adds to market volatility: The Swiss National Bank engineered a surprise 10% devaluation of the CHF. With the CHF now effectively pegged to the EUR, implied vol is sharply lower following an initial surge.

As vol moved higher skew also became extreme

Skew is also at post-crisis highs: Heavy demand for protection for tail risk has pushed up the price of low-delta options. Skew for USD strength is at highest levels since the crisis. And, on a vol-adjusted basis skew is actually at or near all-time highs for many currencies.

EUR not the main place of concern: EUR down skew vsUSD is at an extreme, in part, reflecting the sovereign debt problems in Europe. The prospects for increasing the EFSF effective capacity remains problematic and even under best assumptions capacity will not be expanded enough to calm the markets. Nevertheless, EUR skew vs some EM currencies – LATAM shown in chart – is for EUR strength.

Implied Volatility Heat Map

Implied Volatility Skew Heat Map


27


FX: Trades for a Return to Positive Risk Sentiment


Attractive time to buy CNY

CNY net rates have done a flip so that NDF implied carry favours CNY longs – albeit modestly – for the first time since the financial crisis. As shown in the first chart the risk reversal has also flipped and is now mildly skewed for USD calls. We remain structurally bullish on CNY, especially if risksentiment recovers, and see the vol and RR flip as an opportunity to buy cheap puts.

Specifically, with spot at CNY6.3984 we recommend buying a 3M CNY 25-delta CNY6.3308 USD put for 0.35%.The breakeven for this is CNY6.309, or 2% above the year-end forecast. The risk is that CNY fails to rally but the loss cannot exceed the up front premium

USDMXN implied vol is at post crisis highs

USDMXN 6M implied vol is currently trading well above 20%. As shown in the second chart, this is near the post –crisis high for implied vol and is well above the 13.5% maximum for realized vol outside of the crisis period. If investor confidence returns to the market, implied vol is likelyto quickly mean revert back towards the 11-12% range. So we recommend selling a 6M USDMXN vol swap at 24.0%.Alternatively, for investors uncomfortable with the unlimited risk of a vol swap a cap at 40% can be added which lowers the strike on the swap to 22.5%, which still leaves ample room for profit if the market mean reverts.

USDCNY Implied Carry and 25D Risk Skew

USDMXN Volatility


28


FX: Trades for a Return to Deteriorating Risk Sentiment


Skew favors AUD put spreads

The AUD has consistently been one of the most sensitive currencies to global risk sentiment. The risk reversal skew is almost 7% points in favor of AUD puts. So we recommend buying a 3M ATMF vs 25-delta put spread for 2.01% a roughly half the cost of the plain vanilla. The spread has potential for a gain of 7.58% and the risk is restricted to losing the up front premium, which would occur if the AUD rebounds. We can further exploit the skew by utilizing a reverse knock-in on the short lower-delta put at 0.8545 – a level that last traded in Julyr of 2010 – the price increases to 2.72% but the profit potential is now just under 12%. The max loss is the premium paid.

Inverted USDSGD vol favors window barriers

As vols have picked some curves have inverted. USDSGD is the most inverted vol curve and skew is extreme for EUR calls. While we are fundamentally constructive on SGD we would expect it to continue weakening in a distressed global environment. We take advantage of the inverted curve by purchasing a 1Y ATMF SGD1.302 USD call and putting in 3M window barriers at SGD1.235 and SGD1.410 for a cost of 1.90% - vs 5.0% for the P.V.. The skew is reflected in the upside – more vulnerable – strike being roughly twice as far from the spot rate. The max loss is the premium paid.

AUDUSD 3M Implied Vol and 25D Skew

USDSGD Implied Vol Curve


29


US Rates: Volatility and Rates Snapshot


Front end anchored, volatile long end

Stable 2y: Front end rates have remained fairly stable over past months. This is a consequence of the commitment of the Fed to keep rates on hold for an extended period of time.

Volatile 10y: Realized volatility in the long end has spiked recently. 10 year yields have reached record low levels after the launch of Operation Torque.

What is in the Price

While implied volatility on front end rates are trading at extremely low levels, front end rates have been realizing even lower. Investor should consider buying 3y1y ATMF receivers for 44bps. By positioning in the steep part of the curve investor can earn carry via options. Over 6 month the carry more than covers the theta of the trade. Hence in an unchanged environment the option value will increase with time. The max loss is the premium paid.

Long tail gamma, while relatively high against short tail gamma, still looks attractive vs. realized. We like to own 10y gamma during Fed long end operations.

Rates reached historical lows

Implied vol is rich in front end, cheap in back end


30


US Rates: Trade Idea, Buy 6m10y Variance Swap

Source: Morgan Stanley Research.

QE and US volatility

In the US we find that quantitative easing has been supportive for volatility (both implied and realized), especially in the sectors where the Fed concentrated its operations.

Trade: Buy 6m10y variance swap at 123 Norm, keep for 3 months. The key risk is the implied realized spread widens.

Why 6m10y variance swap

The Fed will concentrate 32% of its purchases in the 10y sector, which in turn should keep volatility elevated.

Although we think Fed policy will also be positive for 30y tails, 6m30y volatility trades historically rich to 6m10y.

The trade has high positive carry due to a combination of inverted curve roll and high ratio of implied to realized volatility.

We like the convexity of variance swaps in the current environment as we want to be extra exposed to the possibility of large daily move.

QE should support 6m10y vol


31


Average Year Price ($/bbl) New PriorCrude Oil (Brent) 100 130

Forward Curve 103Bull 115 140Bear 75 70

2012Revised MS Forecasts and Forward Curve

Commodities: Risk-reward Unappealing, but Oil Likely More Resilient in This Cycle

Sources: Bloomberg, IEA, Morgan Stanley Commodity Research estimates

Risks increasingly skewed to the downside.

We have long argued that higher oil prices are needed to ration demand so that equilibrium can be found, given limited supply. Our constructive long-term view on oil is unchanged: growing supply is still challenging, at best. However, we expect ~800 kb/d of supply to come online into year-end from both shut-in production and new projects (with Libyan production alone likely to recover to between 400-500 kb/d).

We anticipate rapid supply growth amidst a challenging macro environment suggesting prices do not need to work as aggressively in the near-term to ration demand. Thus, we see oil prices capped for now with the bias skewed to the downside.

Our year-end 2011 target for Brent is $100/bbl. For 2012, we are using a tepid global GDP growth est. of 3.1% and see crude averaging near $100/bbl (down from our prior estimate of $130/bbl) – but in a tale of two halves, 1H should be significantly weaker than 2H.

Supply Growth to Outpace Demand into 1H12

(3.5)

(2.5)

(1.5)

(0.5)

0.5

1.5

2.5

3.5

1Q10 3Q10 1Q11 3Q11 1Q12 3Q124.15

4.19

4.23

4.27

4.31

4.35

Demand (LHS) Total Capacity (LHS)Avg OECD Inventory (RHS)

(left axis: YoY change, mmb/d; right axis: average OECD inventories, bln bbls)


32


25%

30%

35%

40%

45%

50%

55%

60%

65%

25%OTMPut

20%OTMPut

15%OTMPut

10%OTMPut

5%OTMPut

ATM 5%OTMCall

10%OTMCall

15%OTMCall

20%OTMCall

25%OTMCall

30-Sep 23-Sep 2-Sep 1-Jul

Sources: IEA, Morgan Stanley Commodity Research estimates

Market Positioned for A Sell-off

Commodities: Tight Balances Today; But Likely to Soften into Year-end

Physical Markets Tight; Relief On The Way

Over the course of the last few months, disappointing supply has more than offset slowing demand, drawing inventories and strengthening spreads. The latest available data for the 3Q shows total inventories drawing by 377 kb/d, well-above normal, and slightly above our estimates.

While we see inventories drawing into year-end, we expect draws to be below-normal as demand softens (on a YoY basis) and more importantly, production from Libya, Canada and the North Sea start to recover. We are modeling a 4Q inventory draw of 90 kb/d, less than the 400 kb/d normal.

Oil Market Participants Positioned for Weakness into 2012

A grim economic outlook, especially in the OECD, has prompted traders to buy downside protection into year-end. In addition, a faster than anticipated resumption in Libyan supply should mitigate inventory draws through 4Q11.

OECD Inventories Are Lean and Continue to Draw

(80)

(60)

(40)

(20)

-

20

40

60

Jan Feb Mar Apr May Jun Jul Aug Sep2011 5-yr average

(MoM change in OECD inventory, mmb)

(Brent Dec ’11 volatility skew)


33


Commodities: 1H12 Looks Increasingly Challenging for Brent Prices

Sources: IEA, Morgan Stanley Commodity Research estimates

A tale of two halvesEven though structural supply challenges are an issue in the medium-term, softening demand and the return of shut-in production will challenge prices into year-end and 1H12, in our view. We see the potential for significant supply increases (Libya restarts, returning North Sea and Canadian production, new projects in Angola, etc) and slowing in demand over the next few quarters that could all coalesce around 2Q12.OPEC will likely need to reduce production by at least 1.4 mmb/d through 2Q12 in response to eroding fundamentals –by definition, lifting spare capacity.

Trade Idea: Buy put spreads on BrentDepending on the size of the GDP slowdown and the pace of the Libyan recovery, we see the potential for prices to fall well below our full year average (towards $85-90/bbl) In fact, the average Brent peak to trough decline during the past 3recessions have averaged 50% bringing the price to ~$60/bbl.With skew flat and volatility high, we favor Jul12 Brent $65/80 put spreads costing 4.2% of Jun12 futures indicatively (3.8x reward to risk, Jun12 future ref 96). Or for investors with a more bearish viewpoint, we like Jul12 $65/80/130 put spread collars costing 1% of spot. The max loss on the put spread is the premium paid and the max loss on the short call is unlimited.

OPEC Spare Capacity Set to Rise Again in 2012

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 1Q12 3Q122,500

3,000

3,500

4,000

4,500

5,000

5,500

6,000

YoY Change OPEC Spare Capacity

Forecasts

(YoY change in OPEC spare capacity, kb/d; right axis: OPEC spare capacity, kb/d)


34


Appendix: Strategy Risk Factors Long Puts/Payors: Overlaid on a long position, the position is protected below the strike at expiration. The maximum potential loss in isolation is the premium paid.

Long Calls/Receivers: Overlaid on a short position, the position is protected above the strike at expiration. The maximum potential loss in isolation is the premium paid.

Short Puts/Payors: The maximum loss is the strike less the premium.

Short Calls/Payors: The maximum loss is unlimited.

Buy-writing / Overwriting (selling calls over long stock): At expiry the risk is that the stock rallies through the short call strike, with the stock called away at the strike price, limiting participation in further upside. Buy- and over-writers retain downside exposure to the stock. The maximum potential loss is the stock purchase price less the premium.

Put/Payor Spreads: Overlaid on a long position, the position is protected between the strikes (but not below) at expiration. The maximum potential loss in isolation is the premium paid.

Call/Receiver Spreads: Overlaid on a stock position, the position is protected between the strikes (but not above) at expiration. The maximum potential loss in isolation is the premium paid.

Ratio Put/Payor Spreads: Overlaid on a long position, the position is protected between the higher strike and the lower breakeven point (but not above or below) at expiration. The lower breakeven is the lesser strike less the put ratio range divided by the difference in quantities, plus or minus the premium paid. Therefore the maximum potential loss for the option position alone is the lower breakeven.

Ratio Call/Receiver Spreads: Overlaid on a short position, the position is protected above the lower strike and the higher breakeven point (but not above or below) at expiration. The higher breakeven is the higher strike plus the call ratio range divided by the difference in quantities, plus or minus the premium paid. The maximum potential loss for the option position alone is unlimited due to the net short call position at higher levels.

Put/Payor Spread Collars: Overlaid on a long position, the position is protected between the strikes at expiration. If the asset rallies through the short call strike, investors could be forced to sell the asset and upside will capped. The maximum loss on the option position alone is unlimited due to the short call.

Call/Receiver Spread Collars (Call Spread + Short Put): Overlaid on a short position, the position is protected between the strikes (but not above) at expiration, while profit is capped below the strike of the put sold. The maximum potential loss in isolation is the level of the put strike plus/minus the initial premium.

Strangles: The maximum potential loss on a long strangle is the premium paid. The maximum potential loss on a short strangle is unlimited.

Barrier or conditional options: These are options that can only be exercised if the barrier condition is met and they are in the money. We reference both European-style and daily close barriers in this piece. For European-style the barrier (which decides if the underlying option activates or knocks-in) is evaluated only at expiry. On the other hand, the daily close barrier is evaluated at each day’s closing price, and once active it remains so and behaves like a vanilla European option. For knock-in barrier options the maximum potential loss is the premium paid.

Risks to Dividend Futures/Swaps: Investors long dividend futures/swaps participate 1:1 in movements on the underlying dividend levels. If the dividend index rises the position will show a profit and a loss if the index falls below the entry price. Eligible investors can gain long or short synthetic exposure to the return on the basket through a swap. Typically, the party gaining long exposure via swap will be required to make financing payments to the swap provider. Such payments will be based on various factors, including, credit, liquidity, and borrowability at the time of the transaction. With all swaps, this type of basket swap offers customized exposure based on clients' interest in a given investment strategy and weighting profile. Please contact your Morgan Stanley sales representative for more details. The information contained herein has been prepared solely for informational purposes and is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Swaps may not be appropriate for every investor. Please consult with your legal and tax advisors before making any investment decision.

Variance/Volatility Swaps: At expiry, an investor long/short a variance/volatility swap will be paid the difference between the volatility (squared for variance) and the strike price (or vice-versa for short variance positions) that is realized over the term of the contract. If realized volatility is above the strike price, there will be a gain/loss, and if realized volatility is below the strike price, there will be a loss/gain


35


Options are not for everyone. Before engaging in the purchasing or writing of options, investors should understand the nature and extent of their rights and obligations and be aware of the risks involved, including the risks pertaining to the business and financial condition of the issuer and the underlying stock. A secondary market may not exist for these securities. For customers of Morgan Stanley & Co. Incorporated who are purchasing or writing exchange-traded options, your attention is called to the publication “Characteristics and Risks of Standardized Options;” in particular, the statement entitled “Risks of Option Writers.” That publication, which you should have read and understood prior to investing in options, can be viewed on the Web at the following address: http://www.optionsclearing.com/about/publications/character-risks.jsp. Spreading may also entail substantial commissions, because it involves at least twice the number of contracts as a long or short position and because spreads are almost invariably closed out prior to expiration. Potential investors should be advised that the tax treatment applicable to spread transactions should be carefully reviewed prior to entering into any transaction. Also, it should be pointed out that while the investor who engages in spread transactions may be reducing risk, he is also reducing his profit potential. The risk/ reward ratio, hence, is an important consideration.

The risk of exercise in a spread position is the same as that in a short position. Certain investors may be able to anticipate exercise and execute a "rollover" transaction. However, should exercise occur, it would clearly mark the end of the spread position and thereby change the risk/reward ratio. Due to early assignments of the short side of the spread, what appears to be a limited risk spread may have more risk than initially perceived. An investor with a spread position in index options that is assigned an exercise is at risk for any adverse movement in the current level between the time the settlement value is determined on the date when the exercise notice is filed with OCC and the time when such investor sells or exercises the long leg of the spread. Other multiple-option strategies involving cash settled options, including combinations and straddles, present similar risk.

Important Information:• Examples within are indicative only, please call your local Morgan Stanley Sales representative for current levels.• By selling an option, the seller receives a premium from the option purchaser, and the purchase receives the right to exercise the option at the strike price. If the option

purchaser elects to exercise the option, the option seller is obligated to deliver/purchase the underlying shares to/from the option buyer at the strike price. If the option seller does not own the underlying security while maintaining the short option position (naked), the option seller is exposed to unlimited market risk.

• Spreading may entail substantial commissions, because it involves at least twice the number of contracts as a long or short position and because spreads are almost invariably closed out prior to expiration. Potential investors should carefully review tax treatment applicable to spread transactions prior to entering into any transactions.

• Multi-legged strategies are only effective if all components of a suggested trade are implemented.• Investors in long option strategies are at risk of losing all of their option premiums. Investors in short option strategies are at risk of unlimited losses.• There are special risks associated with uncovered option writing which expose the investor to potentially significant loss. Therefore, this type of strategy may not be suitable for

all customers approved for options transactions. The potential loss of uncovered call writing is unlimited. The writer of an uncovered call is in an extremely risky position, and may incur large losses if the value of the underlying instrument increases above the exercise price.

• As with writing uncovered calls, the risk of writing uncovered put options is substantial. The writer of an uncovered put option bears a risk of loss if the value of the underlying instrument declines below the exercise price. Such loss could be substantial if there is a significant decline in the value of the underlying instrument.

• Uncovered option writing is thus suitable only for the knowledgeable investor who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements. In this regard, if the value of the underlying instrument moves against an uncovered writer’s options position, the investor’s broker may request significant additional margin payments. If an investor does not make such margin payments, the broker may liquidate stock or options positions in the investor’s account, with little or no prior notice in accordance with the investor’s margin agreement.

• For combination writing, where the investor writes both a put and a call on the same underlying instrument, the potential risk is unlimited. • If a secondary market in options were to become unavailable, investors could not engage in closing transactions, and an option writer would remain obligated until expiration or

assignment. • The writer of an American-style option is subject to being assigned an exercise at any time after he has written the option until the option expires. By contrast, the writer of a

European-style option is subject to exercise assignment only during the exercise period.

Options Disclosure

http://www.optionsclearing.com/about/publications/character-risks.jsp


36


The information and opinions in Morgan Stanley Research were prepared or are disseminated by Morgan Stanley & Co. LLC and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley Mexico, Casa de Bolsa, S.A. de C.V. and/or Morgan Stanley & Co. International plc and/or RMB Morgan Stanley (Proprietary) Limited and/or Morgan Stanley MUFG Securities Co., Ltd. and/or Morgan Stanley Capital Group Japan Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H), regulated by the Monetary Authority of Singapore (which accepts legal responsibility for its contents and should be contacted with respect to any matters arising from, or in connection with, Morgan Stanley Research) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services license No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley Smith Barney Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley").For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA.Analyst CertificationThe following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Sivan Mahadevan.Unless otherwise stated, the individuals listed on the cover page of this report are research analysts.Global Research Conflict Management PolicyMorgan Stanley Research has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies.Important US Regulatory Disclosures on Subject CompaniesThe equity research analysts or strategists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.The following analyst or strategist (or a household member) owns securities (or related derivatives) in a company that he or she covers or recommends in Morgan Stanley Research: Sivan Mahadevan - SPDR S&P 500 ETF (common or preferred stock); Christopher Metli - Short S&P500 ProShares (common or preferred stock). Morgan Stanley policy prohibits research analysts, strategists and research associates from investing in securities in their sub industry as defined by the Global Industry Classification Standard ("GICS," which was developed by and is the exclusive property of MSCI and S&P). Analysts may nevertheless own such securities to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition.Morgan Stanley and its affiliates do business that relates to companies/instruments covered in Morgan Stanley Research, including market making, providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, commercial banking, extension of credit, investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in Morgan Stanley Research on a principal basis. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report.Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions.STOCK RATINGSMorgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations.

Disclosures


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Global Stock Ratings Distribution(as of September 30, 2011)For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively. Coverage Universe

Disclosures

Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months.Analyst Stock RatingsOverweight (O or Over) - The stock's total return is expected to exceed the total return of the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis over the next 12-18 months.Equal-weight (E or Equal) - The stock's total return is expected to be in line with the total return of the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis over the next 12-18 months.Not-Rated (NR) - Currently the analyst does not have adequate conviction about the stock's total return relative to the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.Underweight (U or Under) - The stock's total return is expected to be below the total return of the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.Analyst Industry ViewsAttractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below.In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below.Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below.Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.

Investment Banking Clients (IBC)

Stock Rating Category Count% of Total Count

% of Total IBC

% of Rating Category

Overweight/Buy 1130 40% 457 46% 40%Equal-weight/Hold 1168 42% 419 42% 36%Not-Rated/Hold 112 4% 23 2% 21%Underweight/Sell 400 14% 104 10% 26%Total 2,810 1003


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Ask your Financial Advisor or use Research Center to view any available CIRA research reports in addition to Morgan Stanley research reports.Important disclosures regarding the relationship between the companies that are the subject of Morgan Stanley Research and Morgan Stanley Smith Barney LLC, Morgan Stanley and Citigroup Global Markets Inc. or any of their affiliates, are available on the Morgan Stanley Smith Barney disclosure website at www.morganstanleysmithbarney.com/researchdisclosures.For Morgan Stanley and Citigroup Global Markets, Inc. specific disclosures, you may refer to www.morganstanley.com/researchdisclosures and https://www.citigroupgeo.com/geopublic/Disclosures/index_a.html.Each Morgan Stanley Equity Research report is reviewed and approved on behalf of Morgan Stanley Smith Barney LLC. This review and approval is conducted by the same person who reviews the Equity Research report on behalf of Morgan Stanley. 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The trademarks and service marks contained in Morgan Stanley Research are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. The Global Industry Classification Standard ("GICS") was developed by and is the exclusive property of MSCI and S&P.Morgan Stanley has based its projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on publicly available information. MSCI has not reviewed, approved or endorsed the projections, opinions, forecasts and trading strategies contained herein. Morgan Stanley has no influence on or control over MSCI's index compilation decisions.Morgan Stanley Research, or any portion thereof may not be reprinted, sold or redistributed without the written consent of Morgan Stanley.Morgan Stanley Research is disseminated and available primarily electronically, and, in some cases, in printed form.Additional information on recommended securities/instruments is available on request.

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©2011 Morgan Stanley

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Credit Derivatives Strategy A Guide to Credit Hedging

M O R G A N S T A N L E Y R E S E A R C HGlobal

Morgan Stanley & Co. Incorporated

Sivan [email protected]+1 (1)212 761 1349

Ashley [email protected]+1 (1)212 761 1727

Vishwas [email protected]+1 (1)212 761 8041

Morgan Stanley & Co. International plc+

Phanikiran [email protected]+(44 207) 677-5065

November 2, 2011

Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

All sources Morgan Stanley unless otherwise noted.


2

Credit Derivatives ResearchNovember 2, 2011

Credit Hedging Landscape: Who Are Credit Hedgers?Small Tail Focused Hedgers (Size = Large)Investors who focus on small tails in investment grade and high yield credit in both the US and Europe perhaps comprise the largest segment of the market. This community is opportunistic and will hedge when it feels it necessary or when it sees value. Some take more of a buy-and-hold approach, while others can manage their options portfolios very actively. We have seen more focus of late on tranches in this community, especially at times when credit volatility becomes high and investors look for further convexity opportunities through rises in market correlation or actual idiosyncratic events.

Natural and Systematic Hedgers (Size = Medium)Natural hedgers generally have business models that demand regular hedging, including the management of risks from loan books and counterparty exposures over both short- and long-term periods, and they tend to take very systematic approaches as well. There is also a medium-sized community of banks who engage in first-loss protection hedging that can provide important regulatory capital relief to lending portfolios.

Long-Term and Large Tail Hedgers (Size = Medium)Many investors in this category are looking for a lock-in-the-drawer type long-term hedge that costs little and doesn’t require much day-to-day management. This is also a community that is more likely to invest in third-party tail risk funds. While they use credit options, the lack of a well-developed longer maturity market is a deterrent, as is high volatility which has impacted their equity hedges as well. Within credit options, this community will focus on far OTM strikes, thereby owning skew. The longer-duration and far OTM nature of tranche hedges are appealing as well, and are in many ways a more natural fit, and activity here has increased.

Yield Generators (Size = Medium)This community of participants are not hedgers and are generally not inclined to spend premium on option or tranche strategies, as they tend to focus on relative return versus benchmarks and their peer groups. Instead, they look for opportunities to monetize excessive market volatility through the sale of options and have effectively translated their capabilities in rates, FX and equities into credit. Flows from this community are important to balance the large community of hedgers, and the market would welcome more yield generators for this reason.

Cross-Asset Hedgers (Size = Small)This growing community of investors is increasingly active in options, and to some degree tranches, to identify the cheapest hedge or yield idea across equities, credit, rates, currencies, and commodities. They can play an important role in balancing the technicals between markets, and have often engaged in credit vs. equity hedging themes (i.e., selling options in one market to fund the purchase of options in another).


3


The Credit Hedging Budget: How Much to Pay?Having a hedging budget can be helpful when narrowing down the range of hedging strategies. Deciding a hedging budget is an iterative process – a function of the portfolio being hedged and its yield, how much of a contribution is desired from the hedges and the current cost of sourcing hedges.

• We generally target payout ratios of 3.5x or higher for hedging strategies in normal environments. Thus for every $1 spent on hedging, we would expect a payoff of about $3-6 if the hedged scenario materializes.

• During market dislocations we drop this target payout to 2.0x-2.5x.

• With IG portfolios yielding between 4-5% today and HY credit yielding 10% today, we believe an IG hedging budget of 0.5%-0.75% of AUM and a HY hedging budget of 1.5-2.5% of AUMshould be typical.

• Increasing the budget can facilitate the purchase of hedges withunlimited upside, whereas with a more limited budget investors may have to settle for strategies with capped upside.

• Assuming the hedges are successful and the hedging budget generates 3.0x leverage, that can translate into 2% in hedge P&Lfor IG portfolio and 4.5-.7.5% for HY portfolios. We emphasize setting guidelines on constructing a hedging budget, and remaining adaptable as the market changes.

©2011 Morgan Stanley


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The Hedging Instruments: Single Name CDS, Indices, Options and Tranches

Hedger’s Liquidity Pyramid – Typical Trade Sizes

Three things drive the choice of instrument:

•Liquidity

•Correlation to hedged assets

•Cost vs. convexity

Indices 1Bn+ for IG indices

100-500Mn for HY/SOVX/Financials

Single name CDS Baskets

2-10Mn per name

Cycle Turn hedges Mezzanine Tranches

25-50Mn

Contagion hedges X-100% Tranches

250-750Mn

Index Options500Mn+ for IG indices


Indices 1Bn+ for IG indices


Single name CDS Baskets

2-10Mn per name

Cycle Turn hedges Mezzanine Tranches

25-50Mn

Contagion hedges X-100% Tranches

250-750Mn

Index Options500Mn+ for IG indices


Credit indices: CDS indices, of which there are over 20 globally, remain the most liquid way to express a portfolio view in credit. The drawback is that the exposure is linear, meaning that the investor can lose money if the market improves, and hedging can be expensive if risk premium is already in the price.

Index options: Increasing liquidity, asymmetric payoffs and the ability to customize payouts define maximum costs at trade inception all have attracted investors to options for hedging. However, these are still very short dated instruments, with expiries in the 3m–6m range.

Credit tranches: Tranches are designed to express a view on defaults and risk premiums separately. Their long-dated nature makes them ideal when uncertain about the time-frame of events being hedged. These are also relatively liquid, and can vary in cost depending on the strategy. Unlike options these do have more than capped downside if the market improves.

Single-name CDS and baskets: Individual single name CDS and baskets are less liquid than the indices, but more “customized”. We like using this strategy to hedge exposure to highly specific exposures or risks.


5


Beyond Delta One: Options vs Tranches As HedgesOptions as a hedge

• An investor who buys a put or payer is long the “option” to buy protection at a pre-determined price (strike). The probability of this option being in the money at expiry is between 0% and 100%, which is roughly equivalent to the option’s delta.

• The investor also owns protection from any defaults that occurred up through the option expiry.

• Time decay is a big factor in an option hedge, and an OTM option loses value at an accelerating rate as expiry approaches.

Tranches as a hedge• An investor who buys tranche protection is short the market with 100% certainty, much like simply owning CDX protection.

• The tranching defines the payoff for scenarios where there are actual losses from default, and the delta of the tranche estimates how much the tranche price will move with respect to small price changes in the underlying index/portfolio. A tranche that is ATM in terms of expected defaults will have the highest delta.

• The biggest concern for tranches is the ongoing carry involved, unlike an option strategy where the payment occurs only once upfront.

• In tranches, while the time decay is less severe (unless maturity is less than a year or so), the longer the investor waits for the market widening, the more expensive the hedge.

If we think of an option in the context of a tranche, then the put buyer’s best case scenario is being long 0-100% protection at an attractive price (at expiry) relative to the then market price of that protection. There is no additional leverage to the market in the form of default exposure.


6


Options vs. Tranches: A Comparison

ATM Put OTM Put ATM Put Spread Put Spread Collar* Bearish Risk Reversal**Absolute Cost High Medium Medium Low MediumDownside Limited Limited Limited Unlimited UnlimitedUpside Unlimited Unlimited Limited Limited UnlimitedMTM Impact of..Spread Direction (Delta) High Medium Medium High HighMagnitude of Spread Change (Gamma) High Medium Medium Low HighImplied Volatility (Vega) High High Low Medium LowVolatility Skew Low Medium High High HighTime Decay (Theta) High Medium Medium Low High

Equity Tranche Junior Mezzanine Senior Super Senior X-100Absolute Cost High High Medium Low MediumDownside High Medium Medium Low LowUpside Full Writedown Full Writedown Medium Low MediumMTM Impact of..Increase in Systemic Risk Low Low Medium High HighIncrease in Tail Risk High Medium Low Low MediumImplied Correlation High n/a n/a n/a HighCorrelation Skew n/a High High High n/aTime Decay (Theta) High High Medium Medium Low

Tranches and options each have their merits and drawbacks, including:

• the impact of time decay

• the timing of the scenario hedged

• the cost involved

• the delta to the underlying index if the hedged scenario does materialize

• how much negative MTM an investor is willing to tolerate should the market actually improve

Options Hedges

Tranches Hedges

Notes: *Buy ATM Payer, Sell OTM Payer and OTM Receiver**Buy OTM Payer, Sell OTM Receiver“n/a” implies that the correlation impact on tranche performance depends on other factors


7


The First Step: Defining Hedge Scenarios

Historical Examples of IG Large Tail Moves

Hedging for a Large Tail Scenario

We find it useful to look at past credit sell-offs to assess the extent and pace of bear market credit spread deterioration. For the moment, we ignore the basis between cash and CDS. For CDS indices specifically, we have a more limited history than the broader credit market, but the examples we have show roughly the same intensity and trajectory as the underlying credit market for various market declines.

For investment grade indices a large tail scenario seems to be about 130bp of widening over five months from trough to peak, with the bulk of this in the two months preceding the peak (illustrated below).

In high yield indices, the equivalent move is around 400-600bp over a five month period with nearly 300bp of that in the 4-8 weeks before the peak.

An Average Large Tail Widening in IG

(160)

(140)

(120)

(100)

(80)

(60)

(40)

(20)

-

(110 (88) (66) (44) (22) - 22 44 66 88

iTraxx Main (Mar-08)iTraxx Main (Dec-08)iTraxx Main (Oct-11)CDX IG (Mar-08)CDX IG (Dec-08)

18 18 2137

72

316

35

57

-

20

40

60

80

100

120

140

1m 2m 3m 4m 5m


8


The First Step: Defining Hedge Scenarios

Start End Time Months Spread Move3/7/2005 5/17/2005 2.37 326/4/2007 7/30/2007 1.87 46

10/11/2007 11/21/2007 1.37 355/19/2008 7/8/2008 1.67 452/9/2009 3/9/2009 0.93 631/11/2010 2/8/2010 0.93 293/17/2010 6/8/2010 2.77 66

1.70 45

Start End Time Months Spread Move3/8/2005 5/17/2005 2.33 366/5/2007 8/3/2007 1.97 474/15/2010 6/9/2010 1.83 507/4/2011 10/3/2011 3.03 61

2.29 49

iTraxx Main Small Tail Moves

CDX IG Small Tail Moves

Hedging for a Small Tail Scenario

In investment grade indices, smaller tail scenarios are more frequent and involve 30-65bp move in a 1-3 month timeframe with the bulk of this occurring in the 4-6 weeks prior to the peak.

In high yield indices, a small tail is a move of about 150-300bp with a similar timeframe.

Small Tail Hedging: Options work better

The easiest way to hedge a small tail is by using options, which would involve buying a rather expensive ATM or close to ATM payer, coupled with a short call for a risk reversal, or OTM put to make a put spread, to cheapen the cost.

Hedging for small tail scenarios is more challenging in tranches, as spread impact on individual tranches is less clear in smaller spread widening scenarios, and the cheapest hedges can have little convexity in a moderate sell-off.


9


The Second Step: Choosing a Hedging StrategyOption Hedging Strategies

-200

-150

-100

-50

0

50

100

150

200

120 140 160 180 200 220 240 260 280

Buy PayerBuy Bearish Risk ReversalBuy Payer Spread CollarBuy Payer Spread Buy 1x2 Payer Spread

In options, the simplest strategy (but most expensive) is the outright payer, a trade with capped downside and unlimited upside if spreads widen dramatically.

One way to cheapen the cost of an outright payer is by selling afurther OTM payer to make a payer spread. These are cheaper than payers, but don’t have the unlimited upside.

Another way to cheapen a payer is to sell an OTM receiver in a bearish risk reversal. These have the advantage of unlimited upside when spreads widen, but also have unlimited downside in a rally.

Payer spread collars are the cheapest in a range-bound market, capping the upside if spreads widen but also taking the risk of a significant tightening of spreads.

Tranche Hedging StrategiesFor tranches, the investor can think of hedges as falling into one of two broad categories.

Systemic tranche hedges

These should protect the underlying portfolio when the market widens rapidly due to systemic risk concerns but not individual corporate issues. These include the standard super senior tranche, or X-100% tranches which combine the super senior with any number of the tranches beneath it.

These all performed well going into the credit crisis, when systemic risk was rising. These trades are generally done outright (no-delta) with an annualized cost of under 100bps, depending on the attachment used and when the trade was implemented. These tranches usually have a delta of less than one, which rises as markets widen.

Cyclical tranche hedges

These should protect the portfolio from more idiosyncratic risk, or actual corporate defaults, and include buying protection on equity tranches. Because equity protection is very expensive, most investors prefer mezzanine tranches, which can widen considerably with a default, given the loss of subordination. Typically these types of hedges are paired with a light delta long on the index to reduce cost. These trades work best when there is an expectation of actual defaults and the underlying index has some risky tail names.


10


The Third Step: Monitoring the Hedge – A Guide to Our MethodologyTo evaluate various hedging strategies across options and tranches, we evaluated each as though they were implemented on a systematic basis. We then assessed their impact across three variables as follows:

P&L Impact

This metric shows the average monthly return of systematically using the hedging strategy. A negative number indicates that the hedging overlay had a cost to the hedging investor during the period evaluated. Conversely, a positive number implies, the hedging strategy added to the P&L on average over the period. This number is presented as a monthly cost (or revenue), averaged over the period.

Volatility Reduction

Here we show the % decline in volatility of the hedged portfolio when evaluated in comparison to the unhedged portfolio. Thus if the unhedged portfolio has an annualized volatility of 10% and the hedged portfolio has an annualized volatility of 5%, that is a 50% reduction in the portfolio volatility when a hedge is implemented.

Drawdown Reduction

In this metric, we show the % change in the performance of the worst month of the hedged portfolio over the worst month of the unhedged portfolio. So for example, if the worst month for the unhedged portfolio was March 2009 in which the unhedgedportfolio had a return of -3%, and the worst month for the hedged portfolio was June 2009 with -1.5% return, the drawdown reduction is 50%.


11


The Third Step: Monitoring the Hedge – Investment Grade OptionsSystematic Hedging with Options: Payers Consistently Reduce Volatility

iTraxx Main Volatility Max MonthlyJan-10 to Sep-11 P&L Impact Reduction Drawdown ReductionATM Payer 3 -66% -65% OTM Payer -1 -46% -54% OTM RR 1 -55% -59% PS -3 -17% -15% PSC -2 -26% -23% 1 X 2 payer -1 -27% -39%

CDX IG Options Volatility Max MonthlyJan-10 to Sep-11 P&L Impact Reduction Drawdown ReductionATM Payer -4 -27% -47% OTM Payer -6 -23% -35% OTM RR -8 -21% -33% PS -9 -15% -12% PSC -11 -14% -14% 1 X 2 payer -2 -11% -23%

In our analysis, we assume the investor rolls the option hedges a month before expiry, rather than holding them to expiry. We can conclude that systematically hedging with options has been cost effective, volatility reducing, and loss protecting, across a variety of options strategies.

Cost: The cost of implementing the systematic hedge program has been less than 15bp over the course of two years

Volatility reduction: Any of the options hedging strategies helped significantly reduce the volatility of the underlying portfolio by as much as 15% to 60%

Drawdown reduction: Furthermore, the hedged portfolio experienced a similar 15% to 60% reduction in the max drawdown (difference of max monthly loss with a hedge in place vs without).

We can further parse the results and conclude that for investment grade, "expensive" strategies such as ATM payers look better than most other strategies in terms of both volatility reduction and drawdown reduction

iTraxx Main Volatility Max MonthlyJan-08 to Dec-09 P&L Impact Reduction Drawdown ReductionATM Payer -15 -43% -35% OTM Payer -15 -32% -25% OTM RR -18 -46% -41% PS -13 -15% -6% PSC -16 -34% -24% 1 X 2 payer -8 -19% -17%


12


-2.5-2.0-1.5-1.0-0.50.00.51.01.52.02.53.0

2007 2008 2009 2010 2011

Outright XOCollared XOXO With Put Spread Collar

The Third Step: Monitoring the Hedge – High Yield OptionsInvestment Grade: Use Systematic ATM Payers

(2.5%)

(2.0%)(1.5%)

(1.0%)

(0.5%)

0.0%0.5%

1.0%

1.5%

2.0%2.5%

3.0%


iTraxx Main (OTR) ATM Payer Net P&L

(10.0%)

(8.0%)

(6.0%)

(4.0%)

(2.0%)

0.0%

2.0%

4.0%

6.0%

Jan-10 Jul-10 Jan-11 Jul-11

CDX HY HY PSC Net P&L

US High Yield: Collared Strategies Have Worked WellEuropean High Yield: Collared Strategies Have Resulted in Superior Sharpe Ratios

High Yield: Collared Strategies. While outright payers perform best for investment grade, in high yield, strategies that sell away upside have performed well, though we caution that this analysis was performed in a post credit crisis period, in which valuations and volatility have been dislocated. With implied volatility generally trading at a significant premium to realized, outright payers have not performed as well.

Put spread collars and risk reversals that do not take an outright long volatility view have worked well. From a MTM perspective, put spread collars benefit from lower volatility and time decay as expiry approaches.

Collared strategies are popular as systematic hedges in equity markets for the same reasons. Given HY market pricing today this congruence in the two markets makes sense to us.


13


The Third Step: Monitoring the Hedge – CDX IG Tranches

CDX Tranches Volatility Max MonthlyJan-06 to Sep-07 P&L Impact Reduction Drawdown Reduction7-100% (No Delta) 1 -39% -55% 30-100% (No Delta) 0 -33% -37% 15-30% (No Delta) 2 -49% -79% 3-7% (Delta Scaled) 1 -59% -73% 7-10% (Delta Scaled) 3 -39% -49% 10-15% (Delta Scaled) -3 38% 34% 15-30% (Delta Scaled) 9 49% -70%

CDX Tranches Volatility Max MonthlyJan-08 to Dec-09 P&L Impact Reduction Drawdown Reduction7-100% (No Delta) -3 -37% -45% 30-100% (No Delta) -2 -27% -41% 15-30% (No Delta) -8 -33% -44% 3-7% (Delta Scaled) 12 77% 75% 7-10% (Delta Scaled) 14 27% 21% 10-15% (Delta Scaled) 16 22% -20% 15-30% (Delta Scaled) 1 -24% -44%

CDX Tranches Volatility Max MonthlyJan-10 to Sep-11 P&L Impact Reduction Drawdown Reduction7-100% (No Delta) -1 -39% -45% 30-100% (No Delta) -1 -16% -16% 15-30% (No Delta) 3 -51% -61% 3-7% (Delta Scaled) -4 3% -37% 7-10% (Delta Scaled) 0 -29% -63% 10-15% (Delta Scaled) -2 -30% -51% 15-30% (Delta Scaled) -1 -45% -49%

Systematic Hedging with CDX Tranches: Senior and X-100% Strategies Consistently Reduce Volatility

Tranches can be used to fine tune views to account for default correlation, portfolio dispersion and tail risk.

Index tranches are an important liquidity point in the corporate credit landscape in part due to their potential for outsized returns at different points in the cycle, but also because they are among the few “lock-in-the drawer” longer duration instruments available in the credit markets.

We look at tranches purely from a hedging perspective to examine how different parts of the capital structure would have performed as hedges during the last several years.

For systematic hedging, very senior tranches, as well as some X-100% tranches with mid-level attachment points can be cost effective, portfolio volatility reducing and loss protecting hedges.

Intuitively this makes a great deal of sense to us, because these tranches are very much akin to puts (OTM would be 30-100% or 22-100%, ATM would be the lower attaching X-100% tranches) and put spreads (15-30%, 12-22%,etc.)


14


The Third Step: Monitoring the Hedge – iTraxx Main Tranches

iTraxx Tranches Volatility Max MonthlyJan-06 to Sep-07 P&L Impact Reduction Drawdown Reduction6-100% (No Delta) 1 -32% -43% 22-100% (no Delta) 0 -22% -27% 12-22% (No Delta) 2 -59% -79% 3-6% (Delta Scaled) -3 -54% -58% 6-9% (Delta Scaled) 1 -55% -80% 9-12% (Delta Scaled) 4 -37% -87% 12-22% (Delta Scaled) 7 1% -90%

iTraxx Main Volatility Max MonthlyJan-08 to Dec-09 P&L Impact Reduction Drawdown Reduction6-100% (No Delta) 0 -55% -61% 22-100% (no Delta) -1 -41% -50% 12-22% (No Delta) 0 -44% -41% 3-6% (Delta Scaled) 3 -19% -35% 6-9% (Delta Scaled) 8 -50% -64% 9-12% (Delta Scaled) 3 -50% -72% 12-22% (Delta Scaled) -2 -36% -19%

iTraxx Tranches Volatility Max MonthlyJan-10 to Sep-11 P&L Impact Reduction Drawdown Reduction6-100% (No Delta) 10 -57% -56% 22-100% (no Delta) 4 -34% -30% 12-22% (No Delta) 25 -50% -76% 3-6% (Delta Scaled) 17 -60% -69% 6-9% (Delta Scaled) 17 -63% -76% 9-12% (Delta Scaled) 18 -69% -77% 12-22% (Delta Scaled) 18 -61% -74%

Systematic Hedging with CDX Tranches: Senior and X-100% Strategies Consistently Reduce Volatility

In iTraxx, like CDX IG, super senior tranches would have performed very well as part of a broader systematic hedging program prior to 2010.

In other trades however, tranche hedges in iTraxxperformed rather differently from CDX IG. In CDX IG, junior tranches would have added considerable cost if not implemented on a very strategic basis, while in iTraxx, they would have still been volatility reducing and with relatively low impact on overall P&L

Interestingly, many iTraxx tranche hedges would have been volatility reducing and loss reducing throughout the more recent European stress. This would have come at varying levels of cost however.


15


-15%

-10%

-5%

0%

5%

10%

15%

20%

Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11

CDX IG Equity Tranche Hedges

Correlation falls after US Autos downgraded, equity hedges outperform

IG starts to widen on back of early subprime fears; high delta equity tranches bear the brunt of this early widening

IG defaults pick up, and equity becomes a levered play on portfolio losses. However, equity return volatility is extremely high

X-100% Credit Hedging Has Good Performance

The Third Step: Monitoring the Hedge – Tranche Strategies

-3%

-2%

-1%

0%

1%

2%

3%


CDX IG7-100% (No Delta)3-100% (No Delta)

Equity Tranche Hedge Performance

Senior tranche shorts: Systematic hedging

When hedging for systemic or contagion risk, senior and super senior tranches can be ideal, given the cost and convexity profile. These tranches are more “option like” in their return profile, and can be thought of as deep OTM puts, but on defaults rather than spreads.

On an annualized basis, a super senior tranche usually costs much less than most OTM puts, yet can offer decent payoffs if systemic fears manage to push risk up the capital structure, as we saw in late 2008.

If the systemic scenario does not materialize, these usually have limited downside, both in terms of carry and MTM.

Junior tranche shorts: Tactical hedging

For environments where systemic risk is expected to be low, spreads are generally low, yet there is risk of a few names widening dramatically or even defaulting, junior tranches are appealing tools for hedging.

To illustrate, we look at tranche performance in mid-2005, when the US autos were downgraded, causing fears of potential defaults in names from that sector, despite an overall robust credit market.

They key is determining the ATM tranche, and then shorting it on a delta adjusted basis to reduce the cost, since the cost of being wrong for too long can be a drag on eventual returns

We also like these shorts for turns in the cycle. When it appears that credit may be headed for a downturn, but before defaults happen, the junior mezzanine tranche can be an effective hedge.


16


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18


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