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

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ve Equit y Deri vatives Strategy

New York London Tokyo

C C C SFB Equity Derivatives Strategy

Global Market Commentary October, 6, 2004

Alpha Pains

Mika Toikka (212) 325-5798 Ed Tom (212) 325-3584

Martin Boldt-Christmas 44 20 7888 8696

Stanislas Bourgois 44-20-7888-0459

Why It’s a Tough Market

S S F F B B E E q q u u i it ty y D D e e r r i iv va a t t i iv ve e s s S St tr ra a t t e eg gy y

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.

CSFB Quantitati 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

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

-0.04 -0.02 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14

Hedge Fund In dex

Convertible Arbitrage Dedicated Short

Emerging M arkets

Equity Mkt Neu tral

Event Drive n

Distressed E.D

. Multi-Strategy Risk Arbitrage

Fixed Incom e Arb

Glo bal Macro

Long/Short Equity Managed Futures

Multi-St rategy

Average Return

Rising Falling

Source: CSFB Derivatives Strategy.

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The Year of the Trading Range

The S&P 500 has spent all of 2004 in a narrow 10% trading range (i.e. less than 100 S&P 500 points). See Exhibit 2.

Narrow trading ranges of the duration that we have seen thus far in 2004 are a highly unusual phenomenon. Since the late 1970’s there have been three instances where we have

experienced a trading range this narrow that has lasted longer than the current 191 business days. See Exhibit 3 where we graph distributions of trading ranges.

A natural consequence of the extended narrow trading range has been a collapse in both implied and realized volatility.

Three month implied volatility on the S&P 500 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), volatilities on the S&P 500 are fast approaching the extreme lows that we experienced in the middle of the 1990’s. Note that the last two instances of trading ranges as narrow as what we are currently experiencing occurred in 1992 and 1993.

Exhibit 2: S&P 500: Current Trading Range

700 800 900 1000 1100 1200 1300 1400 1500 1600

1/3/00 7/3/00 1/3/01 7/3/01 1/3/02 7/3/02 1/3/03 7/3/03 1/3/04 7/3/04 1/3/05

Exhibit 3: Distribution of Trading Ranges Frequency

0 10 20 30 40 50 60 70

20 40 60 80 100 120 140 160 180 200 220 240 Trading Range Days

In st an ce s

Consequences of Low Volatility

In Exhibit 5 we show the relative returns of single stocks versus the overall market in absolute terms. It’s clear that we have had a significant contraction in market relative returns as overall equity volatilities have declined. Naturally, this contraction in relative returns makes

outperforming benchmarks by picking stocks a more difficult exercise.

However, what really makes the current environment exceptional and very different from other low volatility environments such as the early 1990’s is that not only have volatilities collapsed but also stock return correlations

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

0 1 0 2 0 3 0 4 0 5 0 6 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 8 7 C r a s h

1 9 9 0 I r a q i I n v a s i o n O f K u w a i t

A s i a C r i s i s L T C M

S e p 1 1 M a r k e t B o t t o m 2 0 0 2

2^{n d} I r a q W a r

0 1 0 2 0 3 0 4 0 5 0 6 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 8 7 C r a s h

1 9 9 0 I r a q i I n v a s i o n O f K u w a i t

A s i a C r i s i s L T C M

S e p 1 1 M a r k e t B o t t o m 2 0 0 2

2^{n d} I r a q W a r

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have increased (i.e. cross sectional stock returns).

This is the first time in 25 years that we are seeing an environment where correlations and volatility have decoupled in a meaningful way.

That is, correlation and volatility have moved in opposite directions. Please see Exhibit 6.

Note how there is a general tendency for volatility and correlation to move together (as one would expect). However, the recent environment clearly stands out as an exception.

The Role of Correlation

A market environment with high stock return correlations implies that stock returns are being driven by “big picture” (macro) related issues and stocks have a tendency to move in unison (at least more so than traditionally).

In other words, during these high correlation environments systematic risk dominates over

idiosyncratic (stock specific) risk.

Alpha Pains

Exhibit 5: Relative Returns (Absolute)

0 5 10 15 20 25 30

1/23/00 3/23/01 5/23/02 7/23/03 9/23/04

Naturally if stock returns are moving in unison (high correlation environment), it is more difficult to pick stocks. Even though one picks the “right” stocks so to speak, the market is not rewarding one (at least not to the degree that it would in a low correlation environment) for picking these “right” stocks.

In Exhibit 7 we display cross sectional returns for a large U.S. equity universe. As the Exhibit 7 clearly shows since 2000, we have a significant contraction in single stock cross sectional variation.

During these environments of high stock return correlations, adding value at the single stock level becomes much more difficult and the bigger picture “asset allocation” decisions tend to dominate.

Exhibit 7: Cross Sectional Return Variation

-22 -17 -12 -7 -2 3 8 13 18

9/23/99 9/23/00 9/23/01 9/23/02 9/23/03 9/23/04

Returns

10% 50% 90%

Hence, the current environment with both low volatility and high correlation is “the worst of all worlds” for stock pickers.

Exhibit 6: Significant Divergence in Correlation and Volatility

0 % 1 0 % 2 0 % 3 0 % 4 0 % 5 0 % 6 0 % 7 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

S i x M o n t h A v e r a g e C o r r e l a t i o n 6 M R e a l i z e d V o l a t i l i t y

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Implicit Correlation Bets

Correlation permeates most equity trading strategies because implicitly any strategy that has a portfolio of stocks in it is taking on correlation risk.

To empirically show the impact of correlation, we divide the past into increasing and

decreasing correlation environments. We use 6- month realized correlations on the S&P 500 going back to 1979 for our analysis. See Exhibit 8.

Observe how the lowest levels of stock return correlations were reached back in the early 1990’s (when volatility was also exceptionally low) and the top of the bubble in 2000. In 2000, correlation was low as there was a high degree of dispersions in returns. That is, the “new

economy” stocks were going in one direction and the “old economy” stocks were going in another. During this period volatility was also exceptionally high, making for a stock pickers market.

The last several years have been a period of relatively high correlation as the market has

been driven by macro issues, for example, Sep 11, the war with Iraq, market bottom of 2002 and more recently terrorism fears, oil shocks, etc.

Exhibit 8: Correlation Environments

0%

10%

20%

30%

40%

50%

60%

70%

9/24/79 9/24/84 9/24/89 9/24/94 9/24/99 9/24/04

Note the sharp decline in correlation following the initial war with Iraq back in March of 2003.

However, since then correlations have refused to decline back to “normalized” levels as macro concerns have continued to dominate.

The Impact of Correlation on Equity Strategies

First we explore the impact of market direction on correlation. As Exhibit 10 indicates, there is a clear tendency to see more positive returns in decreasing correlation environments. In other words when stock specific risk dominates (high degree of return dispersion), the market tends to be higher. However, during periods of increasing correlation (i.e. increasing macro fear), there is more of a negative bias to the market (correlations between stock returns tend to increase in down markets). That said, there are still more positive return instances than negative ones in our sample of increasing correlation environments

¹

. See Exhibit 10.

Next, we explore the impact of these increasing and decreasing correlation

environments on various investment strategies.

We examine the 14 sub investment categories of the CSFB Tremont hedge fund index going back to 1994.

As Exhibit 1 shows, there tends to be a strong relationship between a fund’s style

performance and the correlation environment.

Although by no means perfect, strategies such as Long/Short, Event Driven, Risk Arbitrage and

an r o n r e h e

Exhibit 10: Impact of Correlation on Market Direction

1

However keep in mind that our samples of increasing d decreasing cor elati n e vi onm nts av unequal lengths.

^{2 /} ^{9 /} ^/ ^/ ^{8 /} ^{2 /} ²^/¹

8 /1 99

/ / 27

5 /

2 / 9 / / / 8 / 2 / 2/18 /1 99

/ / 27

5 / - 3 0

- 2 0 - 1 0 0 1 0 2 0 3 0 4 0 5 0

3 /2 5/ 19 81 2 /2 4/ 19 82

6 /2 9/ 19 82 2 /1 5/ 19 83

1 1/29 /1 98 4 4 /2 0/ 19 88

2 /1 4/ 19 91 1 2/15 /1 99 4

9 /9 /1 99 6 3 /1 2/ 19 98

1 0/2/19 98 6 /2 2/ 20 00

7 /2 4/ 20 03 8 /1 1/ 19 81

8 /1 7/ 19 82 8 /1 98 4

1 9/ 19 85 32 7/ 19 86

32 0/ 19 87 3 /1 99 0

3 /1 99 4 1

5

21 2/ 19 97 72 3/ 19 98

1// 20 00 3 /2 00 2

Return

D e c l i n i n g

C o r r e l a t i o n R i s i n g

C o r r e l a t i o n

- 3 0 - 2 0 - 1 0 0 1 0 2 0 3 0 4 0 5 0

3 /2 5/ 19 81 2 /2 4/ 19 82

6 /2 9/ 19 82 2 /1 5/ 19 83

1 1/29 /1 98 4 4 /2 0/ 19 88

2 /1 4/ 19 91 1 2/15 /1 99 4

9 /9 /1 99 6 3 /1 2/ 19 98

1 0/2/19 98 6 /2 2/ 20 00

7 /2 4/ 20 03 8 /1 1/ 19 81

8 /1 7/ 19 82 8 /1 98 4

1 9/ 19 85 32 7/ 19 86

32 0/ 19 87 3 /1 99 0

3 /1 99 4 1

5

21 2/ 19 97 72 3/ 19 98

1// 20 00 3 /2 00 2

Return

D e c l i n i n g

C o r r e l a t i o n R i s i n g

C o r r e l a t i o n

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The Ebb and Flow of Macro Risk

Distressed Securities clearly seem to do better in environments where correlation is

decreasing. These strategies are highly stock specific in their focus and hence it makes sense that managers of these strategies are adding the most value in environments that favour stock picking.

Ultimately, correlation, just like volatility, tends to be a mean reverting process. That is historically, periods of abnormally low or high correlation environments do not tend to last.

As we have shown, if correlations do start to decrease from their current relative high levels (i.e. macro issues begin to wane), it is likely going to be a positive for the market overall and especially for market strategies that focus on stock picking.

²

On the other hand strategies such as Managed Futures and Emerging Markets do the best in environments that are macro driven (i.e. during increasing correlation environments).

What to Expect Going Forward

For Derivatives Users

To get a sense as to what the market is

currently expecting with regards to correlation risk (macro risk), we turn to the derivatives markets. By comparing the relative price of index versus single stock options, we can compute implied correlation. Implied

correlation is similar to implied volatility in that it is forward looking and incorporates the markets expectations. However, instead of volatility, implied correlation is the market forecast of pairwise stock return correlations (i.e. macro risk).

The high spread between implied versus realized correlation, although it has narrowed recently, still remains a potential source of trading opportunities. Short correlation trades have remained one of our favourite trades for the past two years, and we continue to recommend these trades especially if implied correlations spike due to market shocks.

The market is obsessed with macro fears and the option markets continue to price in a premium for macro risk. By selling correlation to the market, one is a supplier of “macro

insurance” and the market seems to be willing to pay an excessive premiums for this type of insurance. Call us for details.

In Exhibit 11, we graph three month implied versus realized correlation for the S&P 500. Note that there is a tendency for implied correlation to lead the market. This can be most clearly 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 vast majority of equity risk going forward was going to be macro focused. This also turned out to be the case as can be seen by the lagging realized correlations series.

Exhibit 11: S&P 500: Current Trading Range

0.1 0.2 0.3 0.4 0.5 0.6 0.7

3/24/01 9/24/01 3/24/02 9/24/02 3/24/03 9/24/03 3/24/04 9/24/04

Avg.Correlation Implied.Correlation

However, since approximately mid 2003, we have seen a significant divergence between what the market has expected versus what has actually been realized. That is, for the last 18 months, the option markets have continuously priced in excess macro risk. Macro fear has dominated.

After the Olympics and political conventions earlier this summer, implied correlations have started to decline. However, they still remain above current historically high realized correlations. This suggests that the market continues to emphasize macro risk.

2

Other potential structured developments in the market

(besides macro risk) could be contributing to increased

correlation levels, namely increased usage of ETFs and

program trading. Although, in our view, the impact on

overall stock return correlations from these products is

minor.

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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

[email protected] [email protected] [email protected]

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

[email protected] [email protected] [email protected]

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

[email protected] [email protected] [email protected]

Cem Hocaoglu, Ph.D Colin Goldin

Portfolio Trading Strategist Portfolio Trading Strategist

212-325-0722 +44 20 7888 9637

[email protected] [email protected]

Phil Mackintosh Portfolio Trading Strategist 212-325-5263

[email protected] Ryan Nolan Renicker, CFA Relative Value

212-325-1621 [email protected] Victor Lin

Portfolio Trading Strategist 212-325-5362

[email protected]

North America Europe Asia

CSFB Quantitative Equity Derivatives Strategy

Mika Toikka, Global Head, 212-325-5798, [email protected]

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"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."

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