Outperformance Options Catley Lakeman Winter Offsite – January 2014

Introduction 2  Country/region specific views can be implemented via outperformance options.  Within regions, general equity sub-sectors can be included - e.g. Mid Cap versus Large Cap  Examples of Outperformance Notes include; Europe over US (or vice-versa) EM over DM (or vice-versa) Mid cap over Large cap (or vice-versa)  Exposure to the performance of one index over another (including in the case of both indices falling)  “Relative Allocation”

Description 3  Outperformance is the difference in relative performance of one asset over another.  This is defined as the percentage change since the initial level which is set at the outset of the trade.  I.e. Day 1 both indices are at 100% of their initial level, by definition.

Pricing Factors of Outperformance Options 4 These are the main factors which the price of an outperformance option can be attributed to, there are others.  The Forwards of the two Indices - the difference between the two forwards is an important factor.  Volatility  Correlation

Forwards 5  Remember: Rates minus Dividends  The Forward of the S&P 500 is greater (5.83%) than that of FTSE 100.  Locking in current forward levels!  Price of an outperformance option of FTSE100 over S&P 500 will be cheaper than that of S&P over FTSE 100 FTSE % S&P % Vanilla Call premiums (in local crncy)?

Volatility of the Underlyings 6  Most circumstances: an increase in Implied Volatility for either of the underlyings results in an increase in the value of an outperformance option Why? → Remember we have a call option on the spread of the performance between two indices, the increase in the volatility of that spread will cause the value of the option to also increase (most cases) → “Positive Vega” The blue line shows an increasing volatility regime, this results in the spread between the indices increasing in volatility

Volatility of the Underlyings 7  Other circumstance: High correlation, volatility collapse of one of the indices can lead to an increase in the value of an outperformance option Why? → again, the result here is an increase in the volatility of that spread. Example given below Both indices move in sympathy (high correlation) but with differing volatility, volatility of the spread is higher.

Correlation of the Underlyings 8  Investors are “short” Implied Correlation between the two indices – i.e. investors benefit from the fall in the implied correlation of the performance of the two indices. Why? → again, the result here is an increase in the volatility of the spread. Example given below Fall in Correlation

Correlation of the Underlyings 9  Investors are “short” Implied Correlation between the two indices – i.e. investors benefit from the fall in the implied correlation of the performance of the two indices. Why? → again, the result here is an increase in the volatility of the spread. Example given below ©Tom May

Outperformance Note Indicative Prices – UK and US 10 5Yr UBS FTSE over S&P Outperformance Note GBP quanto 262% Participation in any outperformance of FTSE over S&P after 5 year term Soft capital protection, 60% knock-in, worst-of. [Cap protected version: 115% participation] 5Yr UBS S&P over FTSE Outperformance Note GBP quanto 145% Participation in any outperformance of S&P over FTSE after 5 year term Soft capital protection, 60% knock-in, worst-of. [Cap protected version: 56% participation]

Initial Sensitivities 11  Initial sensitivities of the trade (version with soft capital protection): 5Yr UBS FTSE over S&P Outperformance Note GBP quanto 262% Participation in any outperformance of FTSE over S&P after 5 year term Soft capital protection, 60% knock-in, worst-of. [Cap protected version: 115% participation] Sensitivity...to the underlying Spot movesFTSE 100: 138.1% note positive S&P 500: -77.4% note negative Net Delta: 60.7%...to the change in implied VolatilityFTSE 100: -0.29% S&P 500: 0.39% Net Vega: 0.1%

Initial Sensitivities 12  Initial sensitivities of the trade (version with soft capital protection): 5Yr UBS FTSE over S&P Outperformance Note GBP quanto 262% Participation in any outperformance of FTSE over S&P after 5 year term Soft capital protection, 60% knock-in, worst-of. [Cap protected version: 115% participation] Sensitivity...to the Correlation between the underlyings Outperformance options: -0.77% per correlation point Worst-of KI Put option: +0.17% per correlation point Net = -0.60% per correlation point Sensitivity to correlation is at a maximum when both index volatilities are equal

Initial Sensitivities 13  Initial sensitivities of the trade (version with soft capital protection): 5Yr UBS FTSE over S&P Outperformance Note GBP quanto 262% Participation in any outperformance of FTSE over S&P after 5 year term Soft capital protection, 60% knock-in, worst-of. [Cap protected version: 115% participation] Sensitivity...to the change in interest ratesAssuming a 1% move in both USD and GBP rates -2.6% per +1% rate move

Outperformance Note Indicative Prices – EM and DM 14 5Yr UBS EEM UP over S&P 500 Outperformance Note GBP quanto 112% Participation in any outperformance of EEM UP over S&P 500 after 5 year term Soft capital protection, 60% knock-in, worst-of. 5Yr UBS S&P 500 over EEM UP Outperformance Note GBP quanto 135% Participation in any outperformance of S&P 500 over EEM UP after 5 year term Soft capital protection, 60% knock-in, worst-of.

Outperformance Note Indicative Prices – Mid and Large Cap 15 5Yr UBS S&P 400 Midcap over S&P 500 Outperformance Note GBP quanto 160% Participation in any outperformance of S&P 400 Midcap over S&P 500 after 5 year term Soft capital protection, 60% knock-in, worst-of. 5Yr UBS S&P 500 over S&P 400 Midcap Outperformance Note GBP quanto 234% Participation in any outperformance of S&P 500 over S&P 400 Midcap after 5 year term Soft capital protection, 60% knock-in, worst-of.

Summary 16  Forwards are very important – The benefit of locking in current forward levels is seen in the large headline rate of FTSE 100 over S&P 500  Correlation and Volatility of each underlying combine to give the spread volatility  Allocation tailored to differing prospects between two indices (region-region, sector- sector, etc.)  Gain increased exposure to performance of one index over another, with defined downside

Summary 17  Summary of sensitivities (generalised)  Delta: Positive the “out-performer”, negative the “under-performer”  Long volatility on the Outperformance Options, with the Knock-in, day 1 sensitivity ~neutral  Short correlation  The long vol exposure is likely to be dominant over the short correlation exposure.

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