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					                                                                                                               CSFB Equity Derivatives Strategy
                                                                                                               CSFB Equity Derivatives Strategy
CSFB Quantitative Equity Derivatives Strategy


                                                    Global                                                                                   Market Commentary                                                                                                   October, 6, 2004
                                                    Mika Toikka
                                                    (212) 325-5798
                                                    Ed Tom                                                                                                           Alpha Pains
                                                    (212) 325-3584
                                                    Martin Boldt-Christmas
                                                    44 20 7888 8696
                                                    Stanislas Bourgois                                                                       Why It’s a Tough Market
                                                    44-20-7888-0459


                                                Ø   The recent market environment has turned out to be a tough one for stock pickers. Not only is equity
                                                    market volatility at very low levels but also correlation among stock returns is at historically high levels.
                                                    This is the first time in 25 years that we are seeing an environment where correlations and volatility
                                                    have been moving in opposite directions in a meaningful way. See Exhibit 6.
                                                Ø   Low volatility environments make it difficult to generate differentiated returns but this is made much
                                                    worse when there is a tendency for stock returns to be highly correlated. High stock return correlations
                                                    imply that stock returns are being pushed around in unison by “big picture” related issues (macro) and
                                                    that single stock related issues (idiosyncratic risks) on aggregate are having less of an impact on
                                                    returns than usual.
                                                Ø   We show historically how the correlation environment makes a big difference in the expected
                                                    performance of various investment styles. We examine the 14 sub investment categories of the CSFB
                                                    Tremont hedge fund index during increasing and decreasing correlation environments. As Exhibit 1
                                                    shows, there tends to be a strong relationship between a fund’s style performance and the correlation
                                                    environment. Funds that are focused on idiosyncratic risk (stock pickers) tend to do much better in
                                                    decreasing correlation environments (e.g. long short strategies). Funds that focus on bigger picture
                                                    macro issues (e.g. emerging markets and managed futures) historically tend to do much better in
                                                    increasing correlation environments. Many funds have inherent and often substantial correlation
                                                    exposure without fully realizing it.
                                                Ø   The derivatives markets are currently pricing in a decrease in correlation going forward although levels
                                                    on an absolute basis are still expected to remain high. Bigger picture (macro) related issues are most
                                                    likely going to continue to dominate market concern, which implies that it might not be the best of
                                                    environments for stock pickers. One of our favourite trades continues to be the selling of correlation
                                                    especially during market shocks where macro fears surge. Call us for details.

                                                    Exhibit 1: Hedge Fund Style Returns During Increasing and Decreasing Correlation Environments
                                                                              0.14
                                                                                                                                        Rising
                                                                              0.12

                                                                               0.1                                                      Falling
                                                                              0.08
                                                      Average Return




                                                                              0.06

                                                                              0.04

                                                                              0.02

                                                                                0

                                                                             -0.02

                                                                             -0.04
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                                                    Source: CSFB Derivatives Strategy.

                                                    New York                                                                     London                                                                      Tokyo
                                                    Mika Toikka                                  (212) 325-5798                 Sri Moorthy                         +44-20-7888- 8053                        Stephen Chadwick +81-3-5777-7183
                                                    Peter Tannenbaum                             (212) 325- 6255                Martin Boldt-Christmas              +44-20-7888- 8696                        Edmund Ching +852 2101 7296
                                                    Edward K. Tom                                (212) 325- 3584                Hon Wai Lai                         +44-20-7888- 9637                        Ken Feng +81-3-5777-7183
                                                    Cem Hocaoglu                                 (212) 325- 0722                Stanislaus Bourgois                 +44-20-7888- 0459
                                                    Ryan Renicker                                (212) 325- 1621                Colin Goldin                        +44 20 7888-9637
Quantitative Equity Derivatives Strategy

                                                                                                             (Exhibit 4), volatilities on the S&P 500 are fast
                                                                                                             approaching the extreme lows that we
Exhibit 2: S&P 500: Current Trading Range
                                                                                                             experienced in the middle of the 1990’s. Note
1600
                                                                                                             that the last two instances of trading ranges as
1500
                                                                                                             narrow as what we are currently experiencing
1400
                                                                                                             occurred in 1992 and 1993.
1300
1200
1100                                                                                               Exhibit 3: Distribution of Trading Ranges
1000
                                                                                                                 70
 900                                                                                                                                         Frequency
                                                                                                                 60
 800                                                                                                             50




                                                                                                     Instances
 700                                                                                                             40
   1/3/00 7/3/00     1/3/01 7/3/01   1/3/02 7/3/02   1/3/0 7/3
                                                          3   /03    1/3/04   7/3/04   1/3/05                    30
                                                                                                                 20
Source: CSFB Derivatives Strategy.                                                                               10
                                                                                                                  0
                                                                                                                      20    40       60    80 100 120 140 160 180 200 220 240
The Year of the Trading Range                                                                                                                  Trading Range Days

The S&P 500 has spent all of 2004 in a narrow
10% trading range (i.e. less than 100 S&P 500                                                      Source: CSFB Derivatives Strategy.

points). See Exhibit 2.
Narrow trading ranges of the duration that we                                                                Consequences of Low Volatility
have seen thus far in 2004 are a highly unusual
                                                                                                             In Exhibit 5 we show the relative returns of single
phenomenon. Since the late 1970’s there have
                                                                                                             stocks versus the overall market in absolute
been three instances where we have
                                                                                                             terms. It’s clear that we have had a significant
experienced a trading range this narrow that
                                                                                                             contraction in market relative returns as overall
has lasted longer than the current 191 business
                                                                                                             equity volatilities have declined. Naturally, this
days. See Exhibit 3 where we graph distributions
                                                                                                             contraction in relative returns makes
of trading ranges.
                                                                                                             outperforming benchmarks by picking stocks a
                                                                                                             more difficult exercise.
A natural consequence of the extended narrow                                                                 However, what really makes the current
trading range has been a collapse in both                                                                    environment exceptional and very different
implied and realized volatility.                                                                             from other low volatility environments such as
                                                                                                             the early 1990’s is that not only have volatilities
Three month implied volatility on the S&P 500
                                                                                                             collapsed but also stock return correlations
has fallen 16 points whereas realized volatility
has declined almost 5 points since the start of
the year. If we take a longer-term perspective

Exhibit 4: Three Month S&P 500 Volatility is Close to the Lows Last Seen in Early 1990’s

   60
                                                8 7 C ra s h                                                                    L TC M                  M a rk e t
                                                                                                                                                    B o tto m 2 0 0 2
   50                                                                                                                                                                     2   n d   Ira q W a r
                                                                                                             A s ia C r is is
                                                                1 9 9 0 Ir a q i In v a s io n                                                        S ep 11
   40                                                                  O f K u w a it


   30

   20

   10

       0
 1 2 /3 0 /1 9 8 3        1 2 /3 0 /1 9 8 6      1 2 /3 0 /1 9 8 9       1 2 /3 0 /1 9 9 2       1 2 /3 0 /1 9 9 5              1 2 /3 0 /1 9 9 8     1 2 /3 0 /2 0 0 1   1 2 /3 0 /2 0 0 4


Source: CSFB Derivatives Strategy.



                                                                                                –2–
Quantitative Equity Derivatives Strategy

                                                                                      idiosyncratic (stock specific) risk.

                                                                                      Alpha Pains
Exhibit 5: Relative Returns (Absolute)
    30
                                                                                      Naturally if stock returns are moving in unison
                                                                                      (high correlation environment), it is more
    25
                                                                                      difficult to pick stocks. Even though one picks
    20                                                                                the “right” stocks so to speak, the market is not
                                                                                      rewarding one (at least not to the degree that
    15
                                                                                      it would in a low correlation environment) for
    10                                                                                picking these “right” stocks.
     5                                                                                In Exhibit 7 we display cross sectional returns for
     0
                                                                                      a large U.S. equity universe. As the Exhibit 7
    1/23/00           3/23/01           5/23/02    7/23/03           9/23/04          clearly shows since 2000, we have a significant
                                                                                      contraction in single stock cross sectional
Source: CSFB Derivatives Strategy.                                                    variation.
have increased (i.e. cross sectional stock
returns).                                                                            Exhibit 7: Cross Sectional Return Variation
                                                                                                                                      10%       50%         90%
This is the first time in 25 years that we are                                           18
seeing an environment where correlations and                                             13
volatility have decoupled in a meaningful way.                                              8
That is, correlation and volatility have moved in
                                                                                      Returns



                                                                                            3
opposite directions. Please see Exhibit 6.
                                                                                           -2

Note how there is a general tendency for                                                   -7
volatility and correlation to move together (as                                         -12
one would expect). However, the recent                                                  -17
environment clearly stands out as an                                                    -22
exception.                                                                               9/23/99                9/23/00             9/23/01               9/23/02   9/23/03          9/23/04


The Role of Correlation                                                              Source: CSFB Derivatives Strategy.
                                                                                      During these environments of high stock return
A market environment with high stock return                                           correlations, adding value at the single stock
correlations implies that stock returns are being                                     level becomes much more difficult and the
driven by “big picture” (macro) related issues                                        bigger picture “asset allocation” decisions tend
and stocks have a tendency to move in unison                                          to dominate.
(at least more so than traditionally).                                                Hence, the current environment with both low
In other words, during these high correlation                                         volatility and high correlation is “the worst of all
environments systematic risk dominates over                                           worlds” for stock pickers.


Exhibit 6: Significant Divergence in Correlation and Volatility
   7 0 %



   6 0 %
                                                                                                       S ix   M o n t h A v e r a g e C o r r e la t io n
                                                                                                       6 M    R e a liz e d V o la t ilit y

   5 0 %



   4 0 %



   3 0 %



   2 0 %



   1 0 %



    0 %
      9 /2 4 /7 9                    9 /2 4 /8 4             9 /2 4 /8 9                        9 /2 4 /9 4                                 9 /2 4 /9 9                       9 /2 4 /0 4


Source: CSFB Derivatives Strategy.


                                                                               –3–
Quantitative Equity Derivatives Strategy


Exhibit 8: Correlation Environments
                                                                                                                                                                                                                                                                                                                                         been driven by macro issues, for example, Sep
70%                                                                                                                                                                                                                                                                                                                                      11, the war with Iraq, market bottom of 2002
                                                                                                                                                                                                                                                                                                                                         and more recently terrorism fears, oil shocks,
                                                                                                                                                                                                                                                                                                                                         etc.
60%




                                                                                                                                                                                                                                                                                                                                         Note the sharp decline in correlation following
50%




40%
                                                                                                                                                                                                                                                                                                                                         the initial war with Iraq back in March of 2003.
30%
                                                                                                                                                                                                                                                                                                                                         However, since then correlations have refused
                                                                                                                                                                                                                                                                                                                                         to decline back to “normalized” levels as
20%
                                                                                                                                                                                                                                                                                                                                         macro concerns have continued to dominate.

                                                                                                                                                                                                                                                                                                                                         The Impact of Correlation on
10%




                                                                                                                                                                                                                                                                                                                                         Equity Strategies
 0%
  9/24/79                                          9/24/84                                                9/24/89                                              9/24/94                                               9/24/99                                                  9/24/04




Source: CSFB Derivatives Strategy.
                                                                                                                                                                                                                                                                                                                                         First we explore the impact of market direction
Implicit Correlation Bets                                                                                                                                                                                                                                                                                                                on correlation. As Exhibit 10 indicates, there is a
Correlation permeates most equity trading                                                                                                                                                                                                                                                                                                clear tendency to see more positive returns in
strategies because implicitly any strategy that                                                                                                                                                                                                                                                                                          decreasing correlation environments. In other
has a portfolio of stocks in it is taking on                                                                                                                                                                                                                                                                                             words when stock specific risk dominates (high
correlation risk.                                                                                                                                                                                                                                                                                                                        degree of return dispersion), the market tends
                                                                                                                                                                                                                                                                                                                                         to be higher. However, during periods of
To empirically show the impact of correlation,                                                                                                                                                                                                                                                                                           increasing correlation (i.e. increasing macro
we divide the past into increasing and                                                                                                                                                                                                                                                                                                   fear), there is more of a negative bias to the
decreasing correlation environments. We use 6-                                                                                                                                                                                                                                                                                           market (correlations between stock returns
month realized correlations on the S&P 500                                                                                                                                                                                                                                                                                               tend to increase in down markets). That said,
going back to 1979 for our analysis. See Exhibit                                                                                                                                                                                                                                                                                         there are still more positive return instances
8.                                                                                                                                                                                                                                                                                                                                       than negative ones in our sample of increasing
Observe how the lowest levels of stock return                                                                                                                                                                                                                                                                                            correlation environments1. See Exhibit 10.
correlations were reached back in the early                                                                                                                                                                                                                                                                                              Next, we explore the impact of these
1990’s (when volatility was also exceptionally                                                                                                                                                                                                                                                                                           increasing and decreasing correlation
low) and the top of the bubble in 2000. In 2000,                                                                                                                                                                                                                                                                                         environments on various investment strategies.
correlation was low as there was a high degree                                                                                                                                                                                                                                                                                           We examine the 14 sub investment categories
of dispersions in returns. That is, the “new                                                                                                                                                                                                                                                                                             of the CSFB Tremont hedge fund index going
economy” stocks were going in one direction                                                                                                                                                                                                                                                                                              back to 1994.
and the “old economy” stocks were going in
another. During this period volatility was also                                                                                                                                                                                                                                                                                          As Exhibit 1 shows, there tends to be a strong
exceptionally high, making for a stock pickers                                                                                                                                                                                                                                                                                           relationship between a fund’s style
market.                                                                                                                                                                                                                                                                                                                                  performance and the correlation environment.

The last several years have been a period of                                                                                                                                                                                                                                                                                             Although by no means perfect, strategies such
relatively high correlation as the market has                                                                                                                                                                                                                                                                                            as Long/Short, Event Driven, Risk Arbitrage and

Exhibit 10: Impact of Correlation on Market Direction
                                                                                                                                D e c lin in g                                                                                                                                                                                                                                                                                                                  R is in g
                  5 0
                                                                                                                               C o r r e la tio n                                                                                                                                                                                                                                                                                                            C o r r e la tio n
                  4 0



                  3 0


                  2 0
      Return




                  1 0



                     0



                -1 0


                -2 0
                                                                                                                                                                                                                                                                                                                                         1
                -3 0
                                                                                                                                                                                                                                                                                                                                           However keep in mind that our samples of increasing
                                                                                                                                                                                                                                                                                                                                         and decreasing correlation environments have unequal
                        1                      2                      2                      3                   4                      8                      1                       4                                           8                      8                      0                      3                      1                       2                                           5                       6                       7                                                           95                       7                       8                       0
                     98                     98                     98                     98                  98                     98                     99                      99                     96                   99                     99                     00                     00                     98                    98                      84                  98                      98                      98                      90                  94                                       99                      99                      00                      02
                  /1                    1                      1                      1                   1                      1                      1                       1                      9                    1                      1                      2                      2                      1                    /1                      19                  /1                      /1                      /1                      19                  19                   19                  /1                      /1                      /2                      20
                                     4/                     9/                     5/                  9/                     0/                     4/                      5/                 9/
                                                                                                                                                                                                   1
                                                                                                                                                                                                                         2/                     2/                     2/                     4/                     1/                                         8/                                                                                          3/                  3/                   8/                                                                                          3/
               25                2                      2                      1                  /2                      2                      1                      /1                 9/                        1                      /                      2                      2                      1                      17                 2/                       19                      27                      20                 8/                  2/                   /1                       12                      23                      /7
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            5/
        3/                  2/                     6/                     2/                 11                      4/                     2/                     12                                           3/                     10                     6/                     7/                     8/                     8/                                          9/                      3/                      3/                                                          12                       2/                      7/                      12
                                                                                                                                                                                                                                                                                                                                         lengths.
Source: CSFB Derivatives Strategy.


                                                                                                                                                                                                                                                                                                      –4–
Quantitative Equity Derivatives Strategy

Distressed Securities clearly seem to do better                  The Ebb and Flow of Macro Risk
in environments where correlation is
decreasing. These strategies are highly stock                    Ultimately, correlation, just like volatility, tends
specific in their focus and hence it makes sense                 to be a mean reverting process. That is
that managers of these strategies are adding                     historically, periods of abnormally low or high
the most value in environments that favour                       correlation environments do not tend to last.
stock picking.                                                   As we have shown, if correlations do start to
On the other hand strategies such as Managed                     decrease from their current relative high levels
Futures and Emerging Markets do the best in                      (i.e. macro issues begin to wane), it is likely
environments that are macro driven (i.e. during                  going to be a positive for the market overall
increasing correlation environments).                            and especially for market strategies that focus
                                                                 on stock picking.2
What to Expect Going Forward
                                                                 For Derivatives Users
To get a sense as to what the market is
currently expecting with regards to correlation                  The high spread between implied versus
risk (macro risk), we turn to the derivatives                    realized correlation, although it has narrowed
markets. By comparing the relative price of                      recently, still remains a potential source of
index versus single stock options, we can                        trading opportunities. Short correlation trades
compute implied correlation. Implied                             have remained one of our favourite trades for
correlation is similar to implied volatility in that it          the past two years, and we continue to
is forward looking and incorporates the markets                  recommend these trades especially if implied
expectations. However, instead of volatility,                    correlations spike due to market shocks.
implied correlation is the market forecast of                    The market is obsessed with macro fears and
pairwise stock return correlations (i.e. macro                   the option markets continue to price in a
risk).                                                           premium for macro risk. By selling correlation to
In Exhibit 11, we graph three month implied                      the market, one is a supplier of “macro
versus realized correlation for the S&P 500. Note                insurance” and the market seems to be willing
that there is a tendency for implied correlation                 to pay an excessive premiums for this type of
to lead the market. This can be most clearly                     insurance. Call us for details.
seen in the period immediately prior to the war
with Iraq in early 2003 (middle of the chart). At
this point the market was assuming that the                     Exhibit 11: S&P 500: Current Trading Range
vast majority of equity risk going forward was                       0.7


going to be macro focused. This also turned                                        Avg.Correlation


out to be the case as can be seen by the
                                                                                   Implied.Correlation
                                                                     0.6



lagging realized correlations series.                                0.5


However, since approximately mid 2003, we
have seen a significant divergence between
                                                                     0.4




what the market has expected versus what has                         0.3

actually been realized. That is, for the last 18
months, the option markets have continuously                         0.2



priced in excess macro risk. Macro fear has
                                                                     0.1
dominated.                                                            3/24/01   9/24/01         3/24/02   9/24/02   3/24/03   9/24/03   3/24/04   9/24/04




After the Olympics and political conventions                    Source: CSFB Derivatives Strategy.

earlier this summer, implied correlations have
started to decline. However, they still remain
                                                                 2
above current historically high realized                           Other potential structured developments in the market
correlations. This suggests that the market                      (besides macro risk) could be contributing to increased
                                                                 correlation levels, namely increased usage of ETFs and
continues to emphasize macro risk.
                                                                 program trading. Although, in our view, the impact on
                                                                 overall stock return correlations from these products is
                                                                 minor.


                                                          –5–
Quantitative Equity Derivatives Strategy

                                CSFB Quantitative Equity Derivatives Strategy
                                     Mika Toikka, Global Head, 212-325-5798, mika.toikka@csfb.com

    North America                                                Europe                                                  Asia

Mika Toikka                                             Sri Moorthy, Ph.D                                     Stephen Chadwick
Global Head, Quantitative Equity Derivatives Strategy   Head, Portfolio Trading Strategy                      Derivatives Strategist
212-325-5798                                            44 207 888 8053                                       81 3 4550 7183
mika.toikka@csfb.com                                    sri.moorthy@csfb.com                                  stephen.chadwick@csfb.com

Peter Tannenbaum                                        Martin Boldt-Christmas                                Edmund Ching
Head, Equity Trading Strategy                           Derivatives Strategist                                Portfolio Trading Strategist
212-325-6255                                            44-20-7888-8696                                       852 2101 7296
peter.tannenbaum@csfb.com                               martin.boldt-christmas@csfb.com                       edmund.ching@csfb.com

Edward K. Tom                                           Stanislas Bourgois                                    Ken Feng
Derivatives Strategist                                  Portfolio Trading Strategist                          Derivatives Strategist
212-325-3594                                            44 20 7888 0459                                       81 3 4550 7189
ed.tom@csfb.com                                         stanislas.bourgois@csfb.com                           ken.feng@csfb.com

Cem Hocaoglu, Ph.D                                      Colin Goldin
Portfolio Trading Strategist                            Portfolio Trading Strategist
212-325-0722                                            +44 20 7888 9637
cem.hocaoglu@csfb.com                                   colin.goldin@csfb.com

Phil Mackintosh
Portfolio Trading Strategist
212-325-5263
phil.mackintosh@csfb.com

Ryan Nolan Renicker, CFA
Relative Value
212-325-1621
ryan.renicker@csfb.com

Victor Lin
Portfolio Trading Strategist
212-325-5362
victor.lin@csfb.com


Options involve risk and are not suitable for all investors. Prior to investing in options, you should have read and understand the
"Characteristics and Risks of Standardized Options" publication, which can be viewed on the Web by going to the following link:
http://www.optionsclearing.com/publications/risks/riskstoc.pdf
Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax
advisor as to how taxes affect the outcome of contemplated options transactions.
Strategies involving the purchase of calls or puts have a risk of loss of the entire amount of the premium paid. Strategies that include selling
uncovered calls or uncovered puts have unlimited risk and may result in losses significantly greater than the premium received."

This material has been prepared by individual traders or sales personnel of Credit Suisse First Boston LLC (CSFB) and not by the
CSFB research department. It is provided for informational purposes, is intended for your use only and does not constitute an
invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to
provide a sufficient basis on which to make an investment decision. It is intended only to provide observations and views of
individual traders or sales personnel, which may be different from, or inconsistent with, the observations and views of CSFB
research department analysts, other CSFB traders or sales personnel, or the proprietary positions of CSFB. Observations and views
expressed herein may be changed by the trader or sales personnel at any time without notice. Past performance should not be
taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is made
regarding future performance. The information set forth above has been obtained from or based upon sources believed by the trader
or sales personnel to be reliable, but each of the trader or sales personnel and CSFB does not represent or warrant its accuracy or
completeness and is not responsible for losses or damages arising out of errors, omissions or changes in market factors. This
material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a limited view
of a particular market. CSFB may, from time to time, participate or invest in transactions with issuers of securities that participate in
the markets referred to herein, perform services for or solicit business from such issuers, and/or have a position or effect
transactions in the securities or derivatives thereof. The most recent CSFB research on any company mentioned is at
https://s.research-and-analytics.csfb.com/login.asp.




                                                                       –6–

				
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