ThinkingAhead Aug10

Infation: What lies ahead?
August | Issue 17
www.commerzbank.com
THINKING AHEAD, AUGUST 2010 | ISSUE 17
2
08 PeterDixon
This month
04 Whatyoushouldknowabout
monetarypolicy
Una Pjanic
08 Infationisalwaysandeverywhere
Peter Dixon
15 Whereareweinthecorporate
leveragecycle?
Bernd Meyer
19 Theneedforcompetitionamong
exchanges
Tommy Fransson
21 FIMScandinaviaTeam
22 Ourworld
24 Equityfash
Alexander Krmer
26 Equitystrategy
Gunnar Hamann
30 HybridProducts
Anton Hong & Thomas Etheve
32 GettingexposedtoInfation
Dr. Oliver Brockhaus
34 ViewsfromtheTradingFloor
Oliver Sultan
38 SowhatisVega?
40 Commodityspotlight
Eugen Weinberg
44 Aneffcientinfationhedge?
Dr Konstantinos Kalligeros
48 Fundsplatform
Huw Price
50 NewETFinthefunduniverse
Daniel Briesemann
53 FundWatchlist
Xavier Burkhard
56 Indicesplatform
Alicia Kerbrat
58 StrategiesUpdate
60 Asiafocus
Ashley Davies
63 Growthvs.Infation
San Tam
66 Contacts
Infation is always and everywhere...
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Editors letter
With a global economic recovery underway and the interest rates of the most important global economies at or near
historic record lows, the prospect of infation is beginning to occupy the minds of institutional investors, and central
bankers. While infation rates in both the US and the Euro zone are currently moving within very low levels, given the
aforementioned circumstances, infationary risks cannot be ruled out going forward. The Euro zone merits particular
consideration, where a prolonged weaker Euro relative to main trading currencies has the potential to diminish
purchasing power and demand for imported goods.
The US economy, despite some weaker economic data of late, is frmly entrenched in a virtuous cycle, with corporate
profts surging, employment stabilised and improving consumer sentiment. Interest rate increases are not likely in
the foreseeable future, and while core US infation is at a 40 plus year low, the loose monetary policy which will most
likely be unwound slowly, has the potential to tend consumer prices upwards.
In this issue, we discuss the contrasting historical experiences of Germany and the Anglo-Saxon economies.
We also discuss the effects of an infationary scenario from an asset allocation perspective.
What can one do to protect ones investment from infationary effects? Our product specialists propose a number
of products and solutions.
Wishing all our readers a pleasant summer,
Yours,
Jaime Uribe
Co-Head of Financial Institutions Marketing,
Equity Markets & Commodities
What you should know

about monetary policy
UNAPJANIC
FINANCIAL INSTITUTIONS MARKETING
Givingacentralbankaclearremitofmaintainingprice
stability,andholdingitaccountableforachievingthat,
isseenasasine qua nonofacrediblemonetarypolicy
regime.Thelanguageinwhichthatremitisembodied
variesfromcountrytocountry.Buttheviewthat
pricestabilityistheoverridingobjectiveofmonetary
policyisnowcommontobothindustrialisedcountries
andemergingmarkets.Italsorefectstheexperience
ofthepastwherehighandunstableinfationledto
greaterfuctuationsinoutputandemploymentthan
accompaniedperiodsoflowandstableinfation.
Acommitmenttopricestabilityisnowseenasthekey
toachievingbroadereconomicstability.
The way in which monetary policy infuences the economy can
be explained as follows. The central bank is the sole issuer
of banknotes and sole provider of bank reserves, ie it is the
monopoly supplier of the monetary base. By virtue of this
monopoly, the central bank is able to infuence money market
conditions and steer short-term interest rates.
In the short run, a change in money market interest rates
induced by the central bank sets in motion a number of
mechanisms and actions by economic agents, ultimately
infuencing developments in economic variables such as output
or prices. This process also known as the monetary policy
transmission mechanism is complex and, while its broad
features are understood, there is no unique and undisputed
view of all the aspects involved.
However, it is a widely accepted proposition in the economic
profession that, in the long run, ie after all adjustments in the
economy have worked through, a change in the quantity of
money in the economy (all other things being equal) will be
refected in a change in the general level of prices and will not
induce permanent changes in real variables such as real output
or unemployment. The explanation for this is straightforward:
A change in the quantity of money in circulation ultimately
represents a change in the unit of account, in much the same
way as changing the standard unit used to measure distance
(eg switching from kilometres to miles) would not alter the actual
distance between two locations.
THETrANSMISSIONMECHANISM
As the Governing Council of the ECB is responsible for taking
monetary policy decisions aimed at the maintenance of price
stability, it is crucial that the ECB develops a view about how
monetary policy affects developments in the price level. The
process through which monetary policy decisions affect the
economy in general, and the price level in particular, is known as
the transmission mechanism of monetary policy. The individual
links through which monetary policy impulses (typically) proceed
are known as transmission channels.
Astylisedillustrationofthetransmissionmechanismfrom
interestratestoprices
The transmission mechanism through which central banks
infuence prices is because of the numerous links and
interdependencies between different components of a developed
economy a complex process. The (long) chain of cause and
effect starts with a change in the offcial interest rates set by
the central bank on its own operations. In these operations, the
central bank typically provides funds to banks (base money).
Given its monopoly over the creation of base money, the central
bank can fully determine the interest rates on its operations.
Since the central bank thereby affects the funding cost of
liquidity for banks, banks need to pass on these costs when
lending to their customers. Through this process, the central
bank has a dominant infuence on money market conditions and
can thereby steer money market interest rates. Because of the
impact it has on fnancing conditions in the economy but also
because of its impact on expectations monetary policy can
affect other fnancial variables such as asset prices (eg stock
market prices) and exchange rates.
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For example, all other things being equal, higher interest rates
tend to make it less attractive for households or companies
to take out loans in order to fnance their consumption or
investment, thereby infuencing supply and demand in goods
markets. At the same time, the domestic currency is likely
to appreciate as Euro deposits and interest bearing assets
denominated in Euro become more attractive relative to
other currencies. Exchange rate movements, in turn, affect
the domestic price of imported goods. If the exchange rate
appreciates, the price of imported goods tends to fall, thus
helping to reduce infation directly, or, if these imports are
used as inputs into the production process, lower prices for
inputs might feed through into lower prices for fnal goods.
An appreciation of the exchange rate would thus tend to reduce
infationary pressures.
Other channels through which monetary policy can infuence
price developments work by infuencing the private sectors
longer term expectations. If a central bank enjoys a high degree
of credibility in pursuing its objective, monetary policy can exert
a powerful direct infuence on price developments by guiding
peoples expectations of future infation and thereby infuencing
their wage and price setting behaviour.
THEECBSqUANTITATIVEDEFINITIONOF
PrICESTABIlITy
The ECB has set itself an infation target of below but close to
2%. This defnition makes clear that not only infation above 2%
but also that defation (ie price level declines) is inconsistent with
price stability.
While defation implies similar costs to the economy as
infation, avoiding defation is also important because, once it
occurs, it may become entrenched as a result of the fact that
nominal interest rates cannot fall below zero. In a defationary
environment monetary policy may thus not be able to suffciently
stimulate aggregate demand by using its interest rate instrument.
Any attempt to bring the nominal interest rate below zero would
fail, as the public would prefer to hold cash rather than to lend
or hold deposits at a negative rate. Although various monetary
policy actions are possible even when nominal interest rates
are at zero, the effectiveness of these alternative policies is not
certain. This makes it more diffcult for monetary policy to fght
defation than to fght infation.
The ECB decided to publicly announce a quantitative defnition of
price stability for a number of reasons. First, the defnition helps
to make the monetary policy framework easier to understand
(ie it makes monetary policy more transparent). Second, the
defnition of price stability provides a clear and measurable
yardstick against which the public can hold the ECB accountable.
Deviations of price developments from the defnition of price
stability can be identifed, and the ECB would then be required to
Una Pjanic
provide an explanation for such deviations and to explain how it
intends to re-establish price stability within an acceptable period
of time. Finally, the defnition provides guidance to the public for
forming expectations of future price developments.
CONClUSION
Appreciation of the fact that our present understanding of the
economy is limited should be central to the policy-making
process. It is precisely that lack of knowledge that makes
mechanical policy rules incredible. Perhaps one of the strongest
arguments for delegating decisions on interest rates to an
independent central bank is that, whereas democratically elected
politicians do not often receive praise when they say I dont
know, those words should be ever present on the tongues of
central bankers. And it is important for the central bank to be
transparent about both what it thinks it understands and what
it knows it does not understand. In so doing, it may reduce the
scale of wasted resources devoted to discovering the secrets
of central bank thinking, and reduce the number of players in
fnancial markets who fear that others have inside information.
According to the Nobel Prize laureate Milton Friedman

infation is always and everywhere a monetary
phenomenon. Given that prices over history have had
a tendency to rise, it is certainly a permanent feature
of economic systems. Given the wide range of goods,
services and assets whose prices have risen, it is certainly
everywhere. But whilst central bankers appear to accept
that it is a monetary phenomenon, the workhorse infation
model adopted by Anglo-Saxon central banks allows no
role for money in the infation process, and assume that
it is determined by the amount of spare capacity in the
economy. But if we instead widen the defnition of infation
to include asset prices, rather than simply goods and
services, Friedmans assertion holds a lot more water.
Infation is always
and everywhere...
PETErDIxON
GLOBAL EqUITIES ECONOMIST

10
ABrIEFHISTOryOFINFlATIONDETErMINATION
Ask a German central banker about why we need low and
stable infation and they will simply point you in the direction
of a history book and suggest you read about the history of the
Weimar Republic. In 1923, the central bank was issuing notes
with a denomination of 100 trillion Marks and postage stamps
had a face value of 50 billion Marks. (However, even this is not
the worst infation on record: The rate of Hungarian infation in
1946 was so bad that prices doubled every 13.5 hours and the
annual infation rate in July 1946 reached 4.19 x 10
16
%).
The root cause of hyperinfations is a huge rise in the quantity
of currency in circulation which far outstrips output growth a
simple case of too much money chasing too few goods. Given the
experience of the 1920s, it was thus no surprise that following
its foundation in 1948, the Bundesbank paid close attention to
monetary developments. This was particularly the case from the
mid-1970s, when it successfully combated the great infation
following the 1973 oil price shock by strictly controlling the rate
of monetary aggregate growth in order to provide an anchor for
infation expectations a policy which has since been continued
by the ECB.
But the experience in the Anglo-Saxon world has been rather
different. Neither the US nor the UK has ever experienced
hyperinfation, and although both the Federal Reserve and Bank
of England experimented with a policy of controlling monetary
aggregate growth in the 1970s and 1980s, this was soon
abandoned. There were two main reasons for this change of heart.
For one thing, fnancial liberalisation in the US and UK meant
that it was very diffcult to defne the correct monetary aggregate
to be targeted. It was very clear that money could no longer
simply be defned as notes and coin but it was less clear what
other forms of near money should be included. Second,
monetary aggregates became subject to a phenomenon known
as Goodharts Law which states that any observed statistical
regularity will tend to collapse once pressure is placed upon
it for control purposes. Thus, the stable relationship between
money and output, which was a key determinant of the infation
process, broke down. As a consequence, both the Fed and BoE
came to the conclusion that it was impossible to target infation
via control of the monetary aggregates.
In recent years, the Anglo-Saxon approach has placed more
weight on the New Keynesian infation formation process, in
which the rate of price growth can be determined by the degree
of spare capacity in the economy (subject to certain caveats
which, for those who care, include the assumption of rational
expectations and the existence of price rigidities). The key point,
however, is that there is no role whatsoever for money or credit
in the infation process at least in the short-term which is
anathema to the thinking of the ECB.
What all this goes to show is that there is clearly no unanimity
amongst economists about what causes infation it remains a
subject as controversial today as at the height of the bitter debate
between Keynesians and monetarists in the 1970s. Moreover,
it is striking that even major central banks have big ideological
differences and the reason this matters is that much of the
debate on whether we are about to enter a period of rising
infation or disinfation/defation is conditioned by the school of
thought (if any) to which the protagonist subscribes.
SOWHICHISITTOBE:HIGHErOrlOWEr
INFlATION?
For those of us not frmly wedded to either of these ideologies,
both models of infation contain some merit. Most practical
macroeconomists take the view that a large injection of liquidity
into the economy will produce infation if it leads to an increase
in demand for goods and services beyond the economys
capacity to produce them. In other words, money matters when
the output gap is close to zero but it is not clear how much it
contributes to infation otherwise particularly if the monetary
transmission mechanism is impaired.
A good example of this is provided by Japan, whose policy of
quantitative easing between 2001 and 2006 produced a 50% rise
in the monetary base. However, broader monetary aggregates
did not pick up because the injection of liquidity remained in
the banking system and did not translate into a rise in demand.
Similarly, those concerned that the recent central bank liquidity
injection will inevitably lead to a rise in infation are assuming
explicitly or otherwise that the banking system is in a position
to pass it on to consumers. In the UK case, where asset purchases
relative to the size of the economy are largest (around 15% of
GDP) it is clear that the credit transmission mechanism remains
impaired, and there is also little evidence that banks in the US are
boosting their credit supply. As for the ECB, bond purchases will
be sterilised in order to prevent an increase in bank reserves, thus
sidestepping the issue of a monetary impulse to infation.
From the monetary side, there would appear to be little
immediate reason to worry that liquidity injections are about to
generate a huge boost to demand growth. In any event, higher
infation will only result if demand outstrips the capacity of
the economy to supply which may take some time to occur
given the extent of spare capacity in the global economy. We
are consequently fairly relaxed about the near-term prospects
for infation in the industrialised world. Core infation rates in
the euro zone and US continue to head downwards, and it only
remains elevated in the UK as a result of higher indirect taxes
once this effect is stripped out, infation here is also on a
downward trend.
In the medium-term, it is possible that infation might pick up
more quickly than desired unless central banks are able to rein
11
Peter Dixon
in their quantitative easing strategies before they get out of
hand. But to the extent that the growing importance of the Asian
economies will boost global supply capacity, we do not see any
major medium-term threat to goods and services price infation.
BUTBEWArEOTHErFACTOrS
Even though we may have a relatively sanguine attitude towards
infation, there are a whole range of other issues to consider.
We will, for example, skip over the issue of expectations in the
infation process and will leave this for another day. But suffce
to say that the way in which expectations are formed can have a
decisive impact on infation trends, as the 1973 oil shock proved.
Instead, we wish to focus on the question of what exactly do
we mean when we talk about price infation: Which prices do
we mean? Much of the standard economic literature focuses
on the threat posed by goods and services price infation, but
this is far from the whole story since asset prices can have a
decisive impact on household and corporate decision-making.
Whilst central banks have focused all their efforts into reining
in consumer price growth over the last decade, there is a strong
case to be made that they have taken their eye off the ball with
regard to asset prices.
From the early-1990s onwards, consumer price infation in
the developed world began to slow considerably promoting
talk of the great moderation during which growth was strong
but infation low. Central banks were quick to take credit for
their role in curbing infation, but it is perhaps no coincidence
that global infation slowed at a time when Asian economies
were ramping up output. In other words, the global output gap
widened as Asian supply growth more than matched the pace of
demand growth in the industrialised world. Central banks were
emboldened to believe that the infation bogey had been laid to
rest and responded by keeping interest rates low.
The consequence was to produce a huge build-up of global
liquidity based on cheap credit. This helped to fuel an equity
bubble in the late-1990s and also helped promote a sharp rise in
house prices in the Anglo-Saxon world. Moreover, the fact that
central banks maintained a lax monetary policy after the bursting
of the equity bubble, in the mistaken belief that defation was
a threat in 2003, served only to shift the bubble into credit
markets. As this bubble began to unravel spectacularly in 2007
it has helped cause a chain of events which have contributed
to our current economic and market predicament. It is perhaps
unfair to lay all the blame for the boom and bust on the doorstep
of the worlds central banks. However, a deeper truth is that
central banks failed miserably to account for the impact of their
monetary decisions on asset markets and it is not as if this is
a criticism which we are making after the event, as some of us
were pointing out that this was an issue way back in 2003.
The moral of the story is that although consumer price infation
is clearly a key mandate for central banks, they cannot ignore
asset price infation given their responsibility for maintaining the
stability of fnancial markets. Whilst central banks may debate
over the extent to which consumer price infation is caused by
real economy or monetary factors, when we look at infation in
a wider context to include a whole variety of goods, services
and assets, the experience of the last decade appears to support
the claims of those who believe infation is caused by monetary
factors. We should, perhaps, allow the last word to Milton
Friedman, the father of modern monetarism, who stated that
infation is always and everywhere a monetary phenomenon.
That is a lesson which students of German (and Hungarian)
economic history may not need to learn, but it is one which
Anglo-Saxon central bankers may periodically need to revisit.
Most practical macroeconomists take
the view that a large injection of liquidity
into the economy will produce infation
if it leads to an increase in demand
for goods and services beyond the
economys capacity to produce them.
12
GrossDomesticproductatconstantprices,
percentagechangeonyear
Consumerprices
percentagechangeonyear
Forecast Forecast
2009 2010 2011 2009 2010 2011
Euro zone -.1 1.2 1. 0. 1. 1.7
Germany -. 2. 1. 0. 0. 1.
France -2. 1. 1. 0.1 1. 1.
Italy -.1 0.7 1. 0.7 1. 1.
Spain -. -0. 0. -0. 1. 1.
Netherlands -. 1. 1.7 1.2 1. 1.
Belgium -.0 1.1 1. -0.1 1. 1.
Austria -. 0. 1. 0. 1. 1.
Greece -2.0 -.0 -.0 1.2 .0 1.
Finland -7. 0. 1. 0.0 1.0 1.
Portugal -2.7 1.0 0. -0. 1.1 1.
Ireland -7. 0. 1. -1.7 -1. 0.
United Kingdom -. 1.1 2.0 2.2 2. 2.
Sweden -.1 .0 2. -0. 1. 2.0
Denmark -. 1. 1. 1. 2.0 1.
Switzerland -1. 1.7 1. -0. 1. 1.2
Norway -1. 1. 2. 2.2 2. 2.0
USA -2. . . -0. 1.7 1.
Canada -2. . .0 0. 2.0 2.0
Japan -.2 .0 1. -1. -0. 0.
Australia 1. 2. .0 1. 2. 2.
New Zealand -1.7 2. 2. 2.1 2.7 .
Poland 1.7 . . . 2.7 .
Hungary -. 1.0 .2 .2 .7 .2
Czech Republic -.1 1. .7 1.0 2.2 2.
Slovakia -.7 2. .0 1.7 1. 2.
China .7 10. .2 -0.7 2. .1
South Africa -1. . . .7 .1 .
Source: Global Insight, Commerzbank Research
Growth and infation
Source: Economic and Market Monitor, July/August 2010
To order, please contact: economic.research@commerzbank.com
Credits to: Chief Economist: Dr. Jrg Krmer
1
Interest rates
Table in per cent pa
1
Forecasthorizon
land 12.7.10 Sep10 Dec10 Mar11 Jun11 Sep11
Eurozone 10 years
2
2.1 2.0 2.7 2.0 .10 .2
months 0.2 0. 1.00 1.1 1. 1.7
Minimum bid rate 1.00 1.00 1.00 1.00 1.00 1.2
UnitedKingdom 10 years . .0 .7 .20 . .0
months 0.7 0.7 0.0 1.10 1.0 2.00
Repo rate 0.0 0.0 0.0 0.0 1.00 1.0
Sweden 10 years 2.7 2.0 2.70 2.0 2.0 .1
months 0. 0.0 1. 1. 1.0 2.0
Repo rate 0.0 0.0 1.00 1.2 1.0 2.00
Switzerland 10 years 1.2 1.0 1. 1. 1.7 1.
months 0.12 0.0 0.0 0. 1.10 1.2
Target rate for mo.Libor 0.2 0.2 0.0 0.7 1.00 1.2
USA 10 years .0 .0 .70 . .10 .0
month (T-Bills) 0.1 0.20 0.0 0. 1.20 1.0
month Eurodollar 0. 0. 0.0 1. 1.70 2.0
Fed funds rate 0.2 0.2 0.2 0.7 1.2 1.7
Canada 10 years .2 .1 .0 . .00 .0
months 0. 1. 1.7 2. .0 .
Overnight rate target 0.0 0.7 1.2 1.7 2.2 .00
Japan 10 years 1.1 1.0 1.0 1.0 1.70 1.0
months 0.2 0.0 0.0 0.0 0.0 0.0
Overnight rate target 0.10 0.10 0.10 0.10 0.10 0.10
Australia 10 years .12 .0 . . . .10
months . .10 .2 . .70 .
Overnight rate target .0 .0 .7 .00 .2 .0
Poland 10 years . .0 .00 .0 .0 .7
months .7 .0 .2 .7 .0 .10
Intervention rate (7 days) .0 .0 .7 .2 .0 .00
Hungary 10 years 7. 7.00 .7 7.00 7.2 7.7
months .2 .2 .0 .0 .0 .00
2 weeks deposit rate .2 .00 .00 .00 .00 .00
Czechrepublic 10 years .10 .00 .2 .7 .00 .00
months 1.2 1.0 1.7 1.7 2.00 2.2
Repo rate (2 weeks) 0.7 0.7 1.00 1.2 1.0 2.0
SouthAfrica 10 years .2 .70 .7 .00 .00 .0
months . . 7.00 7.2 7.0 .00
Repo rate .0 .0 .0 7.00 7.00 7.0
Source: Bloomberg, Commerzbank Research
1
10 years government bond yields; months money market rates
2
Bunds
1
Exchange rates
Forecasthorizon
Currency 12.7.10 Sep10 Dec10 Mar11 Jun11 Sep11
Dollar USD per EUR 1.2 1.17 1.17 1.1 1.1 1.1
Japanese yen JPY per EUR 112 112 117 121 12 10
JPY per USD 100 10 110 11
British pound GBP per EUR 0. 0.2 0.1 0.1 0.0 0.0
USD per GBP 1.0 1. 1. 1.2 1.1 1.1
Swiss franc CHF per EUR 1. 1.1 1.2 1.2 1.0 1.2
CHF per USD 1.07 1.12 1.10 1.12 1.1 1.17
Swedish krona SEK per EUR .7 .2 .0 .7 . .2
SEK per USD 7. .1 .12 .2 . .
Norwegian krone NOK per EUR .0 7.0 7. 7.0 7.77 7.7
NOK per USD . .7 .71 .7 . .
Canadian dollar CAD per EUR 1.0 1.21 1.22 1.21 1.20 1.22
CAD per USD 1.0 1.0 1.0 1.0 1.0 1.0
Australian dollar AUD per EUR 1. 1. 1. 1. 1. 1.
USD per AUD 0.7 0. 0. 0. 0. 0.
New Zealand dollar NZD per EUR 1.77 1.70 1.70 1. 1. 1.71
USD per NZD 0.71 0. 0. 0. 0.7 0.
Polish zloty PLN per EUR .0 .0 .0 .7 .70 .
PLN per USD .2 . .2 .2 .27 .2
Hungarian forint HUF per EUR 20 2 2 2 20 20
HUF per USD 222 22 22 20 20 20
Czech koruna CZK per EUR 2.1 2.0 2.0 2.0 2.20 2.00
CZK per USD 20.1 22.0 21. 22.0 22.0 22.12
Romanian leu RON per EUR .2 .20 .10 .0 .0 .10
RON per USD .7 . .0 .2 . .
Russian rouble RUB per EUR .2 .1 .7 . .2 .2
RUB per USD 0.7 0. 0. 0.1 1.1 1.1
Ukrainian hryvnia UAH per EUR . . . .20 .0 .0
UAH per USD 7.0 .00 .00 .00 .00 .00
Turkish lira TRY per EUR 1. 1.0 1.2 1.1 1.0 1.1
TRY per USD 1. 1.2 1. 1. 1. 1.
South African rand ZAR per EUR .7 .7 . .1 .2 .1
ZAR per USD 7.1 7.0 7.0 7.0 7.0 7.20
Chinese Renminbi CNY per EUR .2 7.0 7. 7. 7. 7.0
CNY per USD .77 .7 .70 . .0 .
Source: Bloomberg, Commerzbank Research
1
During the past 12 months, corporate credit has been among the highest-yielding assets from
an investor point of view. However, our analysis of previous corporate leverage cycles reveals
that we are approaching a phase which, in the past, has tended to show fairly poor returns
on corporate bonds. Looking at various measures of fnancial leverage since 10, this article
identifes three phases of the leverage cycle, balance sheet repair, intentional re-leveraging
and blow-out. At present companies are in balance sheet repair mode. Assuming that double-
dip concerns which typically appear during this stage of the cycle are overcome, we believe the
leverage cycle will move into the phase of intentional re-leveraging over the next -12 months.
This tends to be the best phase for equity performance, while credit tends to move at best in-line
with government bonds.
Where are we in the
corporate leverage cycle?
BErNDMEyEr
HEAD OF CROSS ASSET STRATEGY
Corporate earnings have rebounded from their recession lows
and companies have started to repair their balance sheets. This
in turn leads to tighter credit spreads. This is typically a phase
in which credit tends to perform very well. This time around,
credit performance was additionally supported by declining
government bond yields. While in terms of absolute returns
credit performance did not keep pace with equity performance,
credit posted the highest risk-adjusted performance of all asset
classes over the last 12 months (see Chart 1). How will the credit
to equity performance progress going forward? To answer this
question, this article analyses the relationship between global
economic growth, the corporate fnancial leverage cycle and the
relative performance of credit, equity and government bonds.
THrEEPHASESOFTHECOrPOrATElEVErAGECyClE
Looking at various measures of corporate leverage, a clear
cyclical behaviour, related to global economic growth can
be observed. In our view the corporate leverage cycle can be
divided into in three phases.
Phase 1: Balance-sheet repair
Phase 1 follows a global recession or at least a strong
downturn in global economic growth. During this phase,
global growth bottoms out and recovers, to be followed by a
similar development in corporate proftability. Cash generation
picks up and earnings growth is strong, benefting from high
operational leverage at this stage of the cycle due to the typically
underutilised capacities. As balance sheets have suffered during
the recession/downturn and costs for debt fnancing are high,
companies now focus on debt reduction and healthy balance
sheets. As a consequence, Net debt/Equity and Net debt/EBITDA
ratios tend to decline (see Charts 2 and 3) and interest cover
rises. While return on equity and the net proft margin tend to
rise, the recovery of dividend growth tends to be limited due to
the debt reduction focus.
Phase 2: Intentional re-leveraging
Phase 2 of the leverage cycle is characterised by solid economic
growth. However, as growth momentum is fading and the
operational leverage is now limited due to already high capacity
utilisation, companies are looking to sustain solid earnings
momentum. As balance sheets look healthy, cash generation
is strong and debt fnancing costs have declined, companies
may try to keep earnings growth momentum high by expanding
their business organically, which requires CAPEX, or through
M&A. Alternatively, they may return excess cash to shareholders
1
Equly Volallly
REITS
Commodles
Credl
Inalonlnked Debl
Soveregn Debl
Equly
0
5
10
15
20
25
30
35
40
45
50
55
1
2
M

T
o
l
a
l

R
e
l
u
r
n

%
,

E
U
R
I
0 10 15 5 20 25 35 30 40
Volallly %, EURI
Cash
Eurodenomnaled lolal relurn and Sharpe ralo over lhe lasl 12 monlhs or assel classes
Chart1:Credithasthehighest12MEUrSharperatioofall
assetclassesbuttotalreturnonequityishigher
Source: Bloomberg, Markit, Datastream, Commerzbank Corporates & Markets, data as
at July 2010
1
0
1
2
3
4
5
6
180 183 186 18 12 15 18 2001 2004 2007 2010
0
10
20
30
40
50
60
Clobal real CDP growlh orecasls
or 2010 and 2011 rom IMl
1 2 3 1 2 3 1 2 3 1 3
O Clobal real CDP growlh %I
Nel debl/Equly %, rhsI

Medan or Sloxx600 comps. S global CDP growlh
Chart2:Netdebt/Equityratio
Source: IMF, Datastream, Commerzbank Corporates & Markets
1
0
1
2
3
4
5
6
180 183 186 18 12 15 18 2001 2004 2007 2010
0
20
40
60
80
100
120
140
160
Clobal real CDP growlh orecasls
or 2010 and 2011 rom IMl
1 2 3 1 2 3 1 2 3 1 3
O Clobal real CDP growlh %I
Nel debl/EBITDA %, rhsI

Medan or Sloxx600 comps. S global CDP growlh
Chart3:Netdebt/EBITDA
Source: IMF, Datastream, Commerzbank Corporates & Markets
by means of share-buybacks or higher dividends. Notice that
share-buybacks support EPS growth and RoE. Companies thus
intentionally increase fnancial leverage. As a consequence the
Net debt/Equity and Net debt/EBITDA ratios start to rise again
(see Charts 2 and 3) and interest cover stabilises, though at a
healthy level. Return on equity and the net margin continue to
rise and dividend growth is stable at a high level.
Phase 3: Unintentional rise in leverage (Blow-out)
Phase 2 continues with gradually increasing fnancial gearing
until economic growth weakens/collapses, triggering Phase 3.
As soon as this happens, the already higher geared companies
face a further unintentional rise in fnancial leverage as operating
profts plummet and losses eat into the existing equity. As a
consequence, the Net debt/EBITDA and the Net debt/Equity
ratios continue to rise (see Charts 2 and 3) while the interest
cover declines strongly. Return on equity, the net proft margin
and dividend growth all collapse.
ASSETClASSPErFOrMANCEDUrINGTHEPHASES
OFTHECOrPOrATElEVErAGECyClE
Phase 1: Investors should focus on credit and equity
Charts 4a and 4b depict the median performance for each of
the three asset classes in each phase of the corporate leverage
cycle in Europe and the US. As one would expect, Phase 1 of the
corporate leverage cycle tends to be the best for credit. Rising
corporate proftability and the focus on debt reduction result in
tightening credit spreads. Although credit performance cannot
fully keep pace with equity performance, the difference of the
average and median performance of credit and equity is limited
in Phase 1.
Phase 2: Investors should focus on equity
In Phase 2 credit is losing the support from tightening credit
spreads as (1) credits spreads tend to have come in substantially
already, and, (2) companies intentionally re-lever their balance
sheets which leads to gradually rising credit spreads. Corporate
focus thus clearly shifts from bondholder value to shareholder
value. Moreover, credit may start to suffer from another angle,
as tightening credit spreads no longer offset rising government
bond yields. Chart 3 shows that Phase 2 tends to be the weakest
phase of the corporate leverage cycle for credit. Median credit
performance is actually slightly weaker than government bond
performance during this phase.
Phase 2 of the corporate leverage cycle is clearly the best phase
for equity. Solid returns on invested capital coupled with higher
fnancial leverage tend to enhance RoE and EPS. As analysts
tend to underestimate the earnings impact from intentional
re-leveraging, they also tend to underestimate earnings growth
in Phase 2 of the leverage cycle. As re-leveraging occurs,
earnings forecasts need to be upgraded. This is one important
driver of continued earnings upgrades at this stage of the cycle.
17
Moreover, during this phase of the cycle, equities beneft
from solid net demand due to M&A, share buy-backs and the
necessary re-investment of solidly growing dividend payments.
The diverging development of credit and equity in Phase 1 and
Phase 2 of the corporate leverage cycle also becomes obvious
when looking at fund fow data in Chart 5. Despite the limited
available data history, we fnd that during the last occurrence
of Phase 2, credit funds faced redemptions while equity funds
enjoyed infows. In contrast, in Phase 1 since 2009, credit funds
have seen strong infows while infows into equity funds have
been limited. Note however, that the momentum of fows into
credit funds has started to weaken recently. In Phase 3, it is not
surprising to observe outfows for both equity and credit funds.
Phase 3: Investors should focus on government bonds
Phase 3 is obviously the best phase for government bonds.
As sales growth and earnings collapse with the deterioration
of economic growth, this is the weakest phase for equity.
Credit tends to perform worse than government bonds.
Though corporate debt enjoys the same decline of bond yields as
government bonds, part of this performance is eaten up by rising
credit spreads. During 2008 the latter effect more than offset
the beneft from declining government bond yields resulting in a
clearly negative performance of credit
FrOMBAlANCE-SHEETrEPAIrTOINTENTIONAl
rE-lEVErING
So, where are we in the current leverage cycle? Given the decline
of Net debt/Equity and Net debt/EBITDA in 2009 (see Charts 2
and 3), we have classifed 2009 as the frst year of the balance
sheet repair phase, despite interest cover, corporate proftability
and economic growth still declining. This classifcation though is
also suggested by the asset class performance observed during
2009. In 2010 economic growth recovers, earnings grow strongly
and balance sheet repair has so far remained in the focus of
companies. As can be seen in Chart 6, 2010 dividend growth is
expected to remain limited despite the solid growth of earnings.
Thereafter however, dividend growth is expected to reach
double digit territory in 2011 and 2012, while earnings growth
is levelling off.
If corporate proftability comes in as forecasted by analysts,
companies will likely start to intentionally re-lever from 2011
onwards, supporting EPS growth and ROE. This suggests
that within the next 6 -12 months corporate focus shifts from
bondholder value to shareholder value and the corporate
leverage cycle enters Phase 2. This in turn suggests that the
strong performance of credit observed over the last 12 months
should level off and equity should clearly move into investors
16.5
14.3
15.1
7.5
11.
4.7
7.1
6.6
5.8
6.6
.0
23.5
20
15
10
5
0
5
10
15
20
25
All Phase 1 Phase 2 Phase 3
(XURSH
0HGLDQ
O Equly O Credl O Covernmenl bonds
Chart4a: Medianannualtotalreturnofassetclassesinthe
differentphasesofthecorporateleveragecycle
Source: Bloomberg, Datastream, Commerzbank Corporates & Markets
20
15
10
5
0
5
10
15
20
25
All Phase 1 Phase 2 Phase 3
86
0HGLDQ
O Equly O Credl O Covernmenl bonds
14.6
10.1
16.3
3.1
.1 .3
8.7
.1
8.7
5.
.1
.
Chart4b: Medianannualtotalreturnofassetclassesinthe
differentphasesofthecorporateleveragecycle
Source: Bloomberg, Datastream, Commerzbank Corporates & Markets
13
11
7
5
3
1
1
3
5
7
11
13
1an 05 1ul 05 1an 06 1ul 06 1an 07 1ul 07 1an 08 1ul 08 1an 0 1ul 0 1an 10
30
20
10
0
10
20
30
2 3 1
12M Clobal equly und ows % o AuMI
12M HY bond und ows % o AuM, rhsI

Chart5:12Mfowsintoglobalequityfundsandglobal
Hybondfundsas%ofAuM
Source: EPFR, Commerzbank Corporates & Markets
1
focus. The currently attractive valuation of equities does indeed
allow solid equity market performance going forward as long
as the expected earnings and dividend development shown in
Chart 5 is realised. An obvious precondition for this to happen
is that the double dip worries currently dominating the markets
are overcome as predicted by our economists in their baseline
scenario. In this case we believe investors should in the next
6 -12 months use phases of tighter credit spreads (see Chart 7)
to reduce credit positions to the beneft of equity positions.
Bernd Meyer
In 2010 economic growth recovers,
earnings grow strongly and balance
sheet repair has so far remained in
the focus of companies.
Chart6a:Bottom-upconsensusearningsanddividend
growthexpectations
30
20
10
0
10
20
30
40
200 2010 2011 2012
O Sloxx 600 earnngs growlh %I
O SSP 500 earnngs growlh %I
Earnngs growlh or Sloxx 600 and SSP 500
Source: Thomson Financial IBES, Commerzbank Corporates & Markets
30
25
20
15
10
5
0
5
10
15
20
200 2010 2011 2012
O Sloxx 600 dvdend growlh %I
O SSP 500 dvdend growlh %I
Earnngs growlh or Sloxx 600 and SSP 500
Chart6b:Bottom-upconsensusearningsanddividend
growthexpectations
Source: Thomson Financial IBES, Commerzbank Corporates & Markets
0
50
100
150
200
250
300
1 2000 2001 2002 2003 2004 2005 2006 2007 2008 200 2010
70
0
110
130
150
170
10
210

Boxx Corp nonnancals Asselswap Spread bpI

Nel debl/EBITDA medan o nonnancal Sloxx 600 comps. %, rhsI

3 x Nel debl/Equly medan o nonnancal Sloxx 600 comps. %, rhsI
Corporale Nonnancal Asselswap Spreads and medan Nonnancal
Sloxx600 Nel debl/Equly and Nel debl/EBITDA
2 3 1 2 3 1
Chart7:CorporateleverageandcreditspreadsinEurope
Source: Markit, Datastream, WorldScope, Commerzbank Corporates & Markets
1
The infrastructure in Sweden for securitised derivatives in the early 200 was not
conducive to sound market development. The cost involved in bringing a product
to market was extremely high and the segment in general got little attention. It took
one week for issuers to reach the market with a product and the number of possible
listings was restricted. In addition to this, the general presentation of securities
by the exchange, brokers and information system as equities and other fnancial
instruments. There was a need for competition among exchanges!
The need for competition
among exchanges
TOMMyFrANSSON
HEAD OF NORDIC DERIVATIVES EXCHANGE
20
Tommy Fransson
THElAUNCHOFNDx
The situation encouraged issuers to contact Nordic Growth
Market NGM- at that time a small cap equity exchange to
discuss possibilities to list and trade securitised derivatives at
NGM. The Nordic Derivatives eXchange NDX was launched on
13 March 2003, as a business segment for securitised derivatives
at the NGM exchange. The business model of NDX was to offer
a fexible market with strong infuence by issuers and other
market participants. The prices were reduced for listing by up
to 90% and for trading by up to 30%. The cost for market data
was also drastically reduced as a step to develop the market. The
frst products to be listed at NDX were Hit warrants, issued by
the local bank Handelsbanken in March 2003. A Hit warrant was
a barrier warrant with a predefned possible payout of 10 SEK.
During the whole year 2003, there was only one issuer at NDX,
offering only Hit warrants. At the end of the year, 24 instruments
were listed at NDX and the total turnover for the year was SEK17m.
The development of NDX started to take off in December 2004,
when Carnegie Investment Bank and Socit Gnrale started
to list plain vanilla warrants. At the same time, NDX launched
a segment for capital protected certifcates NDX Bonds, with
Handelsbanken as issuer. At the end of the year, 85 instruments
were listed at NDX and the total turnover for the year was SEK20m.
NDxTODAy
Today NDX has 18 issuers, eg Commerzbank, RBS, Nordea,
Carnegie Investment Bank, UBS, Socit Gnrale and Deutsche
Bank. The total number of listed products is over 2,600 and
the turnover for June 2010 was over SEK1.4bn. The product
range has increased to include plain vanilla warrants, turbo
warrants, Mini Futures, Constant Leverage certifcates, Discount
certifcates, Tracker certifcates, Capital protected certifcates
and more. The ambition of NDX is to build and develop the
market together with market participants through promoting
transparency, conveying information and knowledge to private
investors and offering a powerful platform for marketing issuers
products. This shared business philosophy and the success of
NDX contributed to the Boerse Stuttgart acquisition of NGM in
November 2008.
THENEEDFOrEDUCATION
In the beginning of 2009, NDX launched the education platform
NDX Education. Flow providers, issuers and media use the
platform to give information and education about investment
products to their end clients. Today, the electronic platform has
over 10,000 members and has had over 45,000 unique visitors.
In addition to the electronic education platform, NDX has an
established cooperation with the leading newspaper in Sweden
Dagens Nyheter. In Dagens Nyheter, NDX produced educational
articles about the segment every Sunday, throughout 2010. The
third part of the education activities NDX conduct is seminars.
These are arranged with product specialists from the issuers,
describing different investment opportunities offered in the
market. During 2010, NDX has held over 40 seminars in cities all
over Sweden.
NDx2010
Elasticia In October 2010, NGM will launch a new trading

system Elasticia. A major reason for the development of
Elasticia is the increased demand from the product side.
Issuers want to be able to offer a much larger product range
and Elasticia is therefore built to handle all future capacity
required for facilitating this markets next phase of growth.
Also, a feature know as quote validation a function to verify
a correct transaction price and much improved market data
will ensure that NGM has a next generation trading system for
a dynamic and growing market.
Finland and Norway With the launch of Elasticia, NDX will

start to offer listing and trading for Finnish and Norwegian
end clients. This will enable issuers to have one exchange
for distribution of their products to greater parts of the
Scandinavian market. NDX will provide these markets with
education and tools to develop the market in the same way
as has been done in Sweden.
ETPs NDX is also in the process of launching a segment for

trading in Exchange Traded Products (ETPs). The interest
from investors in this investment form is continuously rising.
The combination of retail clients having easy access to
internet banking, sophisticated investors and a tradition of
investing in traditional funds, creates a good foundation for
Sweden as a ETPs market.
21
Financial Institutions Marketing
Scandinavia Team
We, the FIM Scandinavian Team, deliver investment and hedging solutions to fnancial
institutional clients in Sweden, Norway, Denmark, Finland and Iceland. Our clients include other
Banks, Asset Managers, Independent Financial Advisors and Insurance Companies. The level of
investor sophistication throughout the region is generally high and as a result we are involved in
a variety of projects which require bespoke and/or innovative solutions.
From left to right: Christian Malmberg, Per Ingvoldstad, Frederik Borreschmidt, Jakob Palmqvist, Karl-Fredrik Hansson
TEAMMEMBErS
Although based in London, we remain in constant contact
with our clients, travelling frequently for face-to-face
meetings. Thanks to this close contact we have built strong
relationships and gained a deep insight into client needs, market
developments and trends. Supported by Commerzbanks trading,
structuring, product specialists and research platforms, we strive
to deliver a high-quality, value-added service to our clients.
We have built our team around the following principles:
Client focus
Integrity
Commitment
Results focus
We wish all Thinking Ahead magazine readers every success in
H2 2010 and beyond.

Yours Sincerely
FIM Scandinavia
For further information contact:
Email: FIMscandi@commerzbank.com
Phone: +44 207 444 9389
22
FOREIGN BRANCHES
REPRESENTATIVE OFFICES
SUBSIDIARIES AND
HOLDINGS
NUMBER OF EMPLOYEES 2012
GREAT BRITAIN POLAND UKRAINE
> 1,000 EMPLOYEES:
LUXEMBOURG
SINGAPORE
CZECH REPUBLIC
USA
2501,000 EMPLOYEES:
BELGIUM
CHINA
FRANCE
HONG KONG
ITALY
JAPAN
NETHERLANDS
AUSTRIA
RUSSIA
SWITZERLAND
SPAIN
HUNGARY
25250 EMPLOYEES:
EGYPT
ETHIOPIA
ARGENTINA
AZERBAIJAN
AUSTRALIA
BRAZIL
CHILE
GREECE
INDIA
INDONESIA
IRAN
IRELAND
KAZAKHSTAN
CROATIA
LATVIA
LEBANON
LIBYA
MALAYSIA
NIGERIA
PANAMA
PORTUGAL
ROMANIA
SERBIA
SLOVAKIA
SOUTH AFRICA
SOUTH KOREA
TAIWAN
THAILAND
TURKEY
TURKMENISTAN
UZBEKISTAN
UAE
VENEZUELA
VIETNAM
BELARUS
< 25 EMPLOYEES:
NOVOSIBIRSK
ALMATY
ASHGABAT
TEHRAN
BEIRUT
CAIRO
TRIPOLI
DUBAI
LAGOS
ADDIS ABEBA
JOHANNESBURG
MUMBAI
BANGKOK
SINGAPORE
JAKARTA
MELBOURNE
HONG KONG
SHANGHAI
TAIPEI
TIANJIN
BEIJING
TOKYO
BAKU
SEOUL
KUALA LUMPUR
HO CHI MINH CITY
DUBLIN
LONDON
BRUSSELS
LUXEMBOURG
AMSTERDAM
PARIS
BARCELONA
MADRID
MILAN
ZAGREB
BUDAPEST
BRATISLAVA VIENNA
BRNO KOSICE
HRADEC KRLOV
OSTRAVA
WARSAW
PRAGUE
PLZE
BELGRADE
BUCHAREST
ISTANBUL
KIEV
MINSK
RIGA
MOSCOW
TASHKENT
NEW YORK
CARACAS
SO PAULO
BUENOS AIRES
SANTIAGO
DE CHILE
PANAMA CITY
ZURICH
Around 1,000 employees at 100 locations in countries did you
know how big Commerzbanks world really is? This map shows you
all the locations at which the new Commerzbank is represented.
It also offers you an insight into how many colleagues we have in
place to support our customers at these locations.
Our world
2
FOREIGN BRANCHES
REPRESENTATIVE OFFICES
SUBSIDIARIES AND
HOLDINGS
NUMBER OF EMPLOYEES 2012
GREAT BRITAIN POLAND UKRAINE
> 1,000 EMPLOYEES:
LUXEMBOURG
SINGAPORE
CZECH REPUBLIC
USA
2501,000 EMPLOYEES:
BELGIUM
CHINA
FRANCE
HONG KONG
ITALY
JAPAN
NETHERLANDS
AUSTRIA
RUSSIA
SWITZERLAND
SPAIN
HUNGARY
25250 EMPLOYEES:
EGYPT
ETHIOPIA
ARGENTINA
AZERBAIJAN
AUSTRALIA
BRAZIL
CHILE
GREECE
INDIA
INDONESIA
IRAN
IRELAND
KAZAKHSTAN
CROATIA
LATVIA
LEBANON
LIBYA
MALAYSIA
NIGERIA
PANAMA
PORTUGAL
ROMANIA
SERBIA
SLOVAKIA
SOUTH AFRICA
SOUTH KOREA
TAIWAN
THAILAND
TURKEY
TURKMENISTAN
UZBEKISTAN
UAE
VENEZUELA
VIETNAM
BELARUS
< 25 EMPLOYEES:
NOVOSIBIRSK
ALMATY
ASHGABAT
TEHRAN
BEIRUT
CAIRO
TRIPOLI
DUBAI
LAGOS
ADDIS ABEBA
JOHANNESBURG
MUMBAI
BANGKOK
SINGAPORE
JAKARTA
MELBOURNE
HONG KONG
SHANGHAI
TAIPEI
TIANJIN
BEIJING
TOKYO
BAKU
SEOUL
KUALA LUMPUR
HO CHI MINH CITY
DUBLIN
LONDON
BRUSSELS
LUXEMBOURG
AMSTERDAM
PARIS
BARCELONA
MADRID
MILAN
ZAGREB
BUDAPEST
BRATISLAVA VIENNA
BRNO KOSICE
HRADEC KRLOV
OSTRAVA
WARSAW
PRAGUE
PLZE
BELGRADE
BUCHAREST
ISTANBUL
KIEV
MINSK
RIGA
MOSCOW
TASHKENT
NEW YORK
CARACAS
SO PAULO
BUENOS AIRES
SANTIAGO
DE CHILE
PANAMA CITY
ZURICH
2
Equities
EURO STOXX Autos:
Technically ready for take-off
EURO STOXX Automobiles & Parts was experiencing a bear
market trend, the course of which was distorted by temporary
price fuctuation in Volkswagen ordinary shares, and fell to 143
index points. During the frst recovery period, the index freed itself
from its bearish trend and rose to 233. After a brief consolidation
(technical fag below 233) during which the recovery trend was
concluded as well, the index experienced another boost from 193
to 260 in July 2009. We have been seeing a medium-term, volatile,
Large blue-chip indices such as the S&P 00 and the DAX appear, from a technical point
of view, to be stuck in a medium-term, sideways pendulum movement (with positive touch
in some cases). While this is true for selected sector indices as well, eg the STOXX Europe
Telecommunications, which has entered a medium-term stabilisation phase, others, for example
the EURO STOXX Automobiles & Parts, where interest focuses on the resistance below 20, are
about to conclude their sideways movement.
sideways pendular movement that initially appears to have the
character of a moderate downward triangle (lower triangle line
currently at 200), but in the last few weeks has transitioned into
a consolidation below 248. In the wake of this consolidation the
index, which, as an export-led sector is benefting from the recent
weakness of the Euro, was able to build up relative strength
against the STOXX Europe 600. Since the end of February 2010
there has also been an upward trend (trend line currently at 228),
which has taken the future into the tiered resistance between 248
and 260. Therefore it would not be surprising if the index were
to come up with a new buy signal with medium-term potential at
least to test the (next) resistance at 280 to 285.
O N D M A M J J A S O N D M A M J J A S O N D M A M J J A S O N
200-day
m.a.
2008 2009 2010
B = Buy signal S = Sell signal TP = Take-prot signal
150
200
250
300
350
400
450
New all-time high
TP
425
S
S
VW price
movement
distorted
automobile sector
228
161
405
190
270
S
143
S
S
B
248
233
Recovery
trend
260
TP
193 200
Relative
strength
196
B
Support
262
228
280
Chart1:EUrOSTOxxAutomobiles&Parts
Source: Commerzbank Corporates & Markets
During the frst recovery period,
the index freed itself from its
bearish trend and rose to 233.
AlExANDErKrMEr
TECHNICAL & INDEX ANALYST Equity fash
2
EqUITIES
STOXX Europe
Telecommunications:
Stabilisation above the
200-day line
Following the mini-sell-off, the STOXX Europe Telecommunications
found itself in a technical bottom formation at 202 index points.
Whereas the overall market began to recover as early as March
2009, the sector index followed suit only after a delay and ended
its 10-month bottom formation in July 2009 with a buy signal.
In January 2010 the process of working off the bear market
was aborted at 265 index points. At the same time the sector
developed relative weakness against the STOXX Europe 600. This
is also refected in the fact that the markets rose to new heights
in April 2010, while the sector remained stuck in a sideways
pendulum movement below 265. In May the sector slid below the
200-day line to 224 index points. After this slide, which from a
technical point of view ended in a wedge, not only did the index
lose its relative weakness, it also established a short-term upward
trend which took it back over the 200-day line. This points to a
stabilisation above the 200-day line, with a renewed attempt on
the resistance at 265 being the next item on the technical agenda
in the medium term.
O N D M A M J J A S O N D M A M J J A S O N D M A M J J A S O N
200-day
m.a.
2008 2009 2010
B = Buy signal S = Sell signal TP = Take-prot signal
200
220
240
260
280
300
320
340
360
380
400
Bull
market trend
since 03
253
390
S Bear market
trends
TP
S
Mini
sell-off
202
S
251
S
200
Mini
wedge
224
B
207
307
Upchannel
TP
243
265
B
TP
224
Stabilisation
S
Chart2:STOxxEuropeTelecommunications
In May the sector slid below the
200-day line to 224 index points.
Alexander Krmer
Equity strategy
GUNNArHAMANN
EqUITY STRATEGIST
2
27
EqUITIES
The expected proft comeback of German
MidCaps looks breathtaking at least when
judged by the latest consensus forecasts
for this year. Operating profts for the
MDAX, the German MidCap index which
includes the largest 50 stocks by market
cap and turnover below the DAX30,
collapsed during 2009. According to an
aggregation of current consensus forecasts
however, MDAX operating profts in 2010
are expected to be close to previous peaks
(see Chart 1).
While several defensives are among those companies for
which forecasts are expected to exceed their recent peaks,
many German cyclical midcap stocks proft levels still remain
substantially below peak levels (see Chart 2). However, one should
not underestimate how quickly earnings expectations could move
higher as restructuring programmes, coupled with a demand
recovery, provide a powerful cocktail for profts. By the time
this article is published, the Q2 reporting season will be in full
swing and further upgrades to 2010 proft estimates, primarily for
midcap German cyclicals, should be well within reach.
While this sounds promising, it is unfortunately the proft
outlook for next year that investors have started worrying about.
This looks understandable on the back of softening economic
indicators in China and the US, and almost synchronised
(though hardly coordinated) austerity programmes in many
European countries that all look clearly growth-negative. Indeed,
it would be hard to reject these concerns from a directional point
of view, and the key question remains as to whether currently
low equity market valuations can buffer potential earnings
downgrades suffciently.
Consequently, we have stress-tested valuation levels of the
German midcap MDAX. Based on current I/B/E/S consensus
estimates for 2010 and 2011, we calculate a fair value for the
MDAX by discounting expected earnings (at the time of writing:
548 for 2010, 719 for 2011) based on a discount rate of 8%,
Concerns in capital markets remain plentiful as leading indicators start rolling-over, fostering
debate about a potential growth slowdown or, worse, a renewed recession. No wonder that
investors are questioning the validity of earnings forecasts in this environment. However, for
German MidCaps, we have stress-tested proft estimates and conclude that the current MDAX
level is justifed even if we were to shave off close to 20% of current earnings expectations.
We still consider many of the cyclical laggards, which have recently shown the strongest
earnings upgrade momentum, to be attractive.
Source: Datastream, Commerzbank Research
Chart1:MDAxconsensusoperatingproftestimates(m)
0
1
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4,000
8,000
12,000
16,000
20,000
O EBIT margn %I, lhs
EBIT mI, rhs

Source: Bloomberg, Commerzbank Corporates & Markets
Chart2:MDAxoperatingproftsbacktopre-crisislevels
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2
Gunnar Hamann
Source: Datastream, I/B/E/S, Commerzbank Corporates & Markets
Chart5:butledtoacompressionofP/Eratios
DAX 30 vs 12monlh orward P/E
10
12
14
16
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Aug 02 Nov 02 leb 03 May 03 Aug 03 Nov 03 leb 04 May 04 Aug 04 Nov 04 leb 05
2,000
2,500
3,000
3,500
4,000
4,500
5,000
12m wd. P/E
DAX30, rhs
Chart4:Aroll-overofifoexpectationsdidnotpreventa
furtherriseinforwardearningsexpectations
80
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Aug 02 Nov 02 leb 03 May 03 Aug 03 Nov 03 leb 04 May 04 Aug 04 Nov 04 leb 05
88
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12m wd. earnngs March 2002 = 100I
o busness expeclalons, rhs

DAX 30 12monlh orward earnngs vs o busness expeclalons
Chart3:MDAxfairvalueestimateindifferentearnings
scenarios
4,000
5,000
6,000
7,000
8,000
,000
10,000
11,000
12,000
13,000
14,000
30% 20% 10% Base case 10% 20% 30%
Currenl MDAX ndex level
Derenl earnngs scenaros vs. currenl I/B/E/S consensus eslmale
2
EqUITIES
coupled with modest earnings growth assumptions (up 1%).
We also calculate the sensitivities of our fair value calculation
to varying earnings levels. Chart 3 highlights our fair value
estimates for the MDAX. Our base case, ie current consensus
forecasts, implies a fair value for the MDAX of c. 10,000%.
Interestingly, index levels at the time of writing would be
consistent with market expectations of a c. 20% reduction in
proft estimates (see Chart 3).
One of the reasons why investors have started worrying about
future profts is a roll-over of leading indicators. Undoubtedly,
the recovery in business sentiment indicators in the recent
past has been remarkably strong. One should not, however,
lose sight of the fact that business surveys have probably been
strongly impacted by the year-on-year comparison, which over
recent months has been looking very favourable. Nevertheless,
the levelling off of this benign impact could adversely weigh on
sentiment indicators.
However, this does not automatically bode ill for future earnings
estimates, which we illustrate for the case of DAX 30 proft
estimates and valuation ratios in Charts 4 & 5. Indeed, when
looking at the 200305 post-recession phase, ifo business
expectations started to come off the boil at the end of 2003. The
earnings trend, however, continued its ascent well into a period
of softer sentiment indicators (see Chart 4). Falling leading
indicators, however, brought about heightened uncertainty as to
the further progression of the cycle, consequently compressing
multiples. As depicted in the right-hand chart below, the DAX 30
P/E declined from c. 16x to a little over 12x over a year.
Undeniably, the current environment does not look that different
from the post-recession years 200405. This time around however,
starting valuation multiples are signifcantly below those seen
during previous recovery cycles. Indeed, while price\earnings
multiples were c.16x during the 20032004 recovery cycle,
current multiples for the DAX 30 are at just c. 11x. This would
argue strongly against substantial multiple contraction on the
back of a turn in leading indicators this time around!
On balance, it would be premature to reject concerns over
the further progression of the economic cycle. But, like most
post-recession years, the road to recovery remains bumpy, as
mirrored by swings in capital markets. The roll-over of leading
indicators might indeed signal softening growth ahead that
could jeopardise earnings forecasts, and for the coming years in
particular. While in previous periods, this uncertainty started a
process of multiple compression, equity markets in the current
cycle are starting from signifcantly lower valuation levels,
which should prevent equity multiples from contracting too
Chart7:valuationmultiplesarestartingfroma
signifcantlylowerbasethanin2003/05
6
8
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leb 08 May 08 Aug 08 Nov 08 1an 0 Apr 0 1ul 0 Ucl 0 Dec 0 Mar 10 1un 10
3,000
4,000
5,000
6,000
7,000
8,000
DAX 30 vs 12monlh orward P/E
12m wd. P/E
DAX30, rhs
Chart6: Evenifforwardearningsstarttoleveloff
leb 08 May 08 Aug 08 Nov 08 1an 0 Apr 0 1ul 0 Ucl 0 Dec 0 Mar 10 1un 10
12m wd. earnngs leb 2008 = 100I
o busness expeclalons, rhs

DAX 30 12monlh orward earnngs vs o busness expeclalons
60
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strongly. Our stress-test for German midcaps (MDAX) reveals
that signifcantly lower earnings levels are already embedded
in current expectations. We still consider many of the cyclical
laggards, which have recently shown the strongest earnings
upgrade momentum, to be attractive.
0
While the global economy appears to be set for a strong rebound, more and more
investors are concerned that in the medium to long term infation might erode
real returns on their investments. If positive returns on the equity market do not
beat the rate of infation, real returns are in fact negative, resulting in decreased
purchasing power. It is possible however to introduce explicit protection in
structured products in order to ensure a return that is signifcantly in excess of
the infation experienced over the investment lifetime. The proposed structures
protect investors purchasing power and investment returns by linking the payout
at maturity to the development of a well-known Euro zone infation index
(Bloomberg: CPTFEMU Index).
Hybrid Products
ANTONHONG
HEAD OF EXOTICS STRUCTURING (EMC)
THOMASETHEVE
EXOTICS STRUCTURING (EMC)
1
EqUITIES
INFlATIONlINKEDBONUSNOTE
Maturity: 5 years

Underlyings: Eurostoxx 50 Index (Bloomberg: SX5E Index) &
Eurostat Euro zone Infation Index (Bloomberg: CPTFEMU Index)
Currency: EUR
European Barrier: 55%

The Infation-linked Bonus Note offers full equity participation
and soft capital protection, together with the reassurance that the
product will generate a positive return on an infation-adjusted
basis. As long as the Eurostoxx 50 Index closes above 55% of its
initial level at maturity, investors receive the highest of the full
upside performance of the Eurostoxx 50 Index and ten times the
annualised infation rate since inception. Only if the Eurostoxx 50
Index closes below 55%, investors become long the index.
INFlATIONPrOTECTEDEqUITyPArTICIPATION
WITH90%CAPITAlGUArANTEE
Maturity: 5 years

Currency: EUR
90% capital guaranteed

This product combines the benefts of partial capital guarantee,
infation protection and participation in the equity market.
Investors receive at maturity 90% of the notional amount plus
the higher of a Eurostoxx 50 Index performance above 90% and
any infation index performance above 13.14% (2.5% pa), both
up to a cap of 45%:
Payoff = 90% + Min(45%, Max (SX5Ef 90% , CPTFEMUf
113.14% , 0%))
BESTOFEqUITy/INFlATIONNOTE

Currency: EUR
MaturityBarrier
years 70%
years 0%
years 0%
As long as the underlying equity index does not close below
the barrier at maturity, this product will pay out the higher of
the Eurostoxx 50 Index performance and the infation index
performance. Otherwise, investors are long the equity index.
5yEArINCOMENOTElINKEDTOEqUITy&INFlATION
Maturity: 5 years

Eurostat Euro zone infation index (Bloomberg: CPTFEMU Index)
Currency: EUR
Barrier: 60% (European)
Annual coupon: 150% of the European infation rate

European infation rate: year-on-year increase of the infation index
Minimum guaranteed coupon: 5% pa

The 5 year Income Note, linked to equity & infation, offers
investors an annual coupon equal to 150% of the European
infation rate (measured as the year-on-year increase of the
infation index) subject to a foor of 5%. Thus, investors will
receive infation-beating returns with a foor at more than three
times the current market rates in EUR. At maturity, in addition
to the fnal coupon, investors will receive 100% of their invested
capital unless the DJ Eurostoxx 50 Index closes below 60% of
its initial level. If the underlying index closes below the barrier
the investor will participate 100% in the performance of the
underlying index.
2
Dr.OlIVErBrOCKHAUS
HEAD OF qUANTITATIVE INNOVATION
Getting exposed to Infation
Inthisnotewediscussvariousaspectsofconsumer
priceindicessuchastheUSCPIandtheECB
harmonisedconsumerpriceindexHICP.Thesecond
partofthenotedescribesequityandinfationlinked
hybridproducts.
SOMEASPECTSOFPrICEINDICES
There seems to be no consensus as to where infation is going.
On the one hand low interest rates and weak growth in Europe
may hold infation down. On the other hand large debt burden
and central banks increasing money supply lead to fears of
increased infation. This uncertainty motivates the need to
manage infation risk.
Infation is commonly represented through consumer price
indices. A consumer price index measures the price of a fxed
basket of consumer goods over a time period and location.
Prices for a good are computed by averaging a sample of prices
obtained at a specifed time. The weight of a good in the basket
is derived from the expenditure on that good found in a sample
of households over a specifed time period.
There are many practical considerations in play when defning a
price index. To name a few, there is choice of basket, estimation
of prices and weights as well as frequency and quality of those
estimations and representation of different locations. Concerning
the basket there is debate as to whether one should include
mortgages and rents payable for housing. Also, energy cost, cost
for health care as well as pension provision and taxes may or
may not count as expenditure.
In order to measure infation over time a basket should arguably
be held constant over a time period. However, expenditure
patterns will change in time. In practice the basket is updated
regularly to account for these changes. The basket is typically
fxed at the beginning of a period for the purpose of index
computation. This method, from Etienne Laspeyres, tends to
overestimate infation since consumers reaction to price changes
over the period is ignored. If a product becomes dearer consumers
tend to buy less of it. Fixing at the end of the period as suggested
by Herman Paasche consequently underestimates infation.
Computation of consumer price indices is typically performed by
national governments. The ECB has developed a methodology
leading to the Harmonised Index of Consumer Prices HICP for
the area of countries which have adopted the Euro. The US CPI is
different from the HICP in that the US focuses on urban population.
More importantly, the HICP excludes owner-occupied housing.
Thus indices for different regions are not necessarily comparable.
EqUITIES
Dr. Oliver Brockhaus
EqUITyANDINFlATIONlINKEDHyBrIDPrODUCTS
Due to the long term nature of infation risk the proposed hybrid
products (see page 30) typically have a maturity of several
years. The products are derivatives on the most liquid and broad
indices capturing stock performance and infation for the Euro
area, namely the Eurostoxx 50E stock index and the Harmonised
Index of Consumer Prices HICP.
Infation Linked Bonus
The infation linked bonus product is a standard bonus product
with the additional feature that the investor gains positive
exposure to the infation rate. We compare the product with a
bonus product without infation.
Generally the product behaves like a capital guarantee where the
capital includes twice the infation rate:
If SX5E is above 55% then the investor receives
Strike + Max (SX5E Performance Strike, 0)

where the strike is given by
Strike = 100% + 2 * Infation Performance

Thus if the infation rate is zero then both products are identical.
If infation is positive then the payout is greater then the
corresponding standard bonus product. Another way of looking
at this product is as paying the maximum of the stock index and
infation linked strike, namely:
If SX5E is above 55% then the investor receives
Max (Infation Linked Strike, SX5E Performance)

where the strike is given by
Infation Linked Strike = 100% + 2 * Infation Performance

From this representation one can see that the price of this
product increases with decreasing correlation between infation
and stock index. The expected max has its highest value when
correlation is low since in that case one asset being low will be
offset by the other asset being high, leading to the maximum
being high.
Infation-Protected Equity Participation
The infation-protected equity participation product is a variant
of an equity participation product. The corresponding product
without infation would pay:
Min (135%, Max (90%, SX5E Performance))

Infation is introduced to give the payoff
Min (135%, Max (90%, SX5E Performance,

Infation Index 23.14%))
In particular, if the infation index grows by more than 2.5%
annually (or 13.14% over fve years) then the value increases
beyond the capital guarantee of 90%. The dependence on
infation dynamics is similar to the bonus product: positive
exposure to infation level and volatility and negative exposure
to increasing correlation.
Best of Equity and Infation
The best of equity and infation product pays at least the stock
index performance at maturity. Additionally the product includes
infation upside:
Provided the stock index return is not below some barrier there
is an additional payment of
Max (0, Infation Index SX5E Performance)

This product qualitatively produces the same exposure to
infation as the other two products.
References
E. Diewert, Harmonized Indexes of Consumer Prices: Their

Conceptual Foundations, Working Paper, March 2002,
European Central Bank, www.ecb.int
W. Lane and M. L. Schmidt, Comparing U.S. and European

infation: The CPI and the HICP, Working Paper, May 2006, US
Department of Labor, www.bls.gov
Views
from the
TradingFloor
OlIVErSUlTAN
EXOTIC EqUITY DERIVATIVES
EqUITIES
ONTHEExOTICMArKETSIDE
During the World Cup and the holiday season, business activity
has globally contracted. Institutional clients keep focusing on
cheap, capital protected structures with potential high income.
Meanwhile, other investors, especially from the Private banking
side, seek the investment opportunities that the volatility peaks
and earning seasons can offer. In these uncertain markets, we
have noticed an increasing demand for simple structures like
the classic reverse convertibles which offer attractive coupons
during periods of high volatility.
In addition, the regulators have begun to implement new rules
on the marketing of exotic fnancial products, and capital
requirements. This is to stabilise and protect the derivatives
investors and market participants, to avoid a situation similar
to the one billion dollar loss suffered on securities backed by
Lehman Brothers. The Securities and Exchange Commission
is probing several fnancial frms on how they market principal
protected notes, while in France, the French regulator AMF
recently released a guide to good marketing practice for
structured notes and certifcates.
Moreover, fears about a double dip recession, a sovereign debt
default in the Euro zone, the new Basel capital rules, and the
health of Europes banks have convinced investors to maintain a
relatively high proportion of their investments in cash. A survey
of UK investors and fund managers last month found they are
holding more cash in their portfolios than at any time since the
aftermath of the Lehman Brother collapse in September 2008.
The Reuters poll showed that cash accounted for 8.7% of their
holdings. The same poll found European investors with a 6.8%
cash holding whereas at the end of last year, those positions
were about 5%. Furthermore, mutual funds and some of our
clients favour more and more the FX as an asset class over
equities or commodities. Despite the FX market high volatility,
its high liquidity is a clear advantage.
STrUCTUrEDPrODUCTISSUED
ANDrECOMMENDED
In Exotic Equity products, we have noticed an increasing
combination of FX with equity underlyings, such as in composite
options where investors can proft from the return of both Equity
and FX asset classes. A cross option, or composite option, is
an option on some underlying in one currency with a strike
denominated in another currency. We have sold some call
composite options on emerging or ETF shares, compo SEK for
instance. In this case, the investor has a bullish view on the
emerging share and bearish on the SEK currency compared to
the US dollar.
Requests on the emerging basket are clearly more heterogeneous.
In the last six months, the focus was on China with the HSCEI Index
and Asian indices. The apprehensions over the Yuan revaluation
and the slowdown of Chinese growth has convinced investors
to look at the Latin American economy (via ETFs) or the Eastern
European indices such as the WIG20 Index (Polish Index) and the
ATX Index (Austrian Index). UK investors have found interests in
the S&P BRIC which represents the four BRIC countries equity
markets (Brazil, Russia, India, China) via long-term Lock-In call
capital protected structure which could draw insurance or pension
fund investors attention. This six year capital protected product
offers a yearly lockin mechanism on 20% steps, capped at 80% at
maturity. The distant cap will make the structure more affordable
and the lockin will capture the early performance of the index.
Due to recent uncertainties in the Equity market, clients have

tried to reduce short-term risks through small variations of our
standard product. First, the BestIn Autocallable displays an
optimised entry level during the frst month, up to three months.
Its an autocallable product, restriking at the lowest of the entry
periods closing prices.
In Germany, the Remove Worst autocallable has been very
popular for the same reasons and the capital protection allows
the investors to get rid of the worst share each year. It is a six
year autocallable capital guarantee on 10 international shares
where we check on a yearly basis if none of the shares in the
basket has closed below 75% during the observation period. The
observation period being the preceeding 12 monthly observation
dates. If this condition is satisfed, the product is terminated and
the client receives a coupon. Otherwise the worst performing
share is defnitely removed each year and the investor receives
a coupon of 3% if none of the shares of the remaining basket
has dropped below 60% during the observation periods. There
are some safer variations where the product is sold with a frst
guaranteed coupon in order to protect against any uncertainty in
the short term.
We have observed an increasing demand for phoenix autocall
structures in the last month. Within this category, the new
3Y Phoenix safe coupon enters in our range of medium-term
autocallable products on mono underlying (SX5E) with a safety
barrier at 60%. It offers a semi-annual coupon equivalent to
6% to 10% pa. Similar to a standard autocallable, the product
displays a yearly autocallability if the index is above 100% of its
initial level.
Independently, as long as the product exists, we pay a coupon
to the investors if the underlying is at least once higher than
60% (daily basis) during the six months period (obviously the
frst coupon is guaranteed). At maturity, if the product is not
terminated earlier, the capital is fully protected if the index
closes above 60%, otherwise the product is still exposed to
the index performance. Sectorial movements are now more
signifcant and correlations by sector or region are increasing
when the overall level remains relatively stable. We can observe
Oliver Sultan
2450
2500
2550
2600
2650
2700
2750
2800
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SX5E Index
24
2
34
3
44
4
V2X Index
SX5E Index
V2X Index
Sx5EIndexV2xIndex
Source: Bloomberg
A survey of UK investors and fund
managers last month found they are
holding more cash in their portfolios
than any time since the aftermath
of Lehman Brother collapse in
September 2008.
that the volatility market tends to stabilise but the Vovol (the
volatility of the implied volatility) remains elevated, fearing that
the market may hide more bad news and therefore will increase
the volatility market. Macro fgures and market data overall
are clearly not leaning towards the end of a crisis. The lack of
confdence, previously mentioned, is a dangerous leverage as
it usually comes with an extreme lack of liquidity. That could
impact the equity derivatives market in the comings weeks.
For additional information on the product features and key risks, please contact your sales advisor or refer to the contacts on page .
3 Year Phoenix Autocall on
German Equities
Key features
Potential 10% Annual Coupon
0% European Barrier
Annual Observations
EUR Currency
HOWTHISPrODUCTWOrKS
This product would suit an investor with a view that German
equities will enter a phase of little price appreciation.
On each annual observation date N (except at maturity), if all of
the shares close above 100% then the product is called and the
investor receives 110%. If all of the shares close above 60%
then the investor receives 10% coupon. Otherwise, no payment
is made at this stage.
At maturity, if the product hasnt been called previously, if all of
the shares close above 100% then the investor receives 110%.
If all of the shares close above 60% then the investor receives
100%. Otherwise, the client receives the worst performing share.
Underlyings: BloombergTicker
Adidas-Salomon
Siemens
Deutsche Telekom
ADS GY Equity
SIE GY Equity
DTE GY Equity
BENEFITS
Analysts are increasingly guarded about the prospects for the
German economy. This is apparent from the ZEW Index, which
fell in July from 28.7 to 21.2. At the same time the current
situation is predominantly described as good, for the frst time in
two years. Over the coming months the ZEW Index is likely to fall
further, thus signalling a slower pace for the economy. However,
this certainly does not mean the recovery is over. The debt
crisis in the Eurozone, growing fears of a double dip in the
USA: There are several reasons why analysts are currently less
confdent about Germanys economic prospects than they were
a few months ago. At any rate the ZEW Index fell further in July.
At 21.2 it was even lower than generally expected (Commerzbank
forecast: 20.0; consensus: 25.3). However, another reason could
be that the analysts take an increasingly positive view of the
current situation, as there are growing signs that the German
economy achieved very powerful growth in the 2nd quarter.
For the frst time since July 2008 more analysts described the
situation as good (24.7%) than as bad (10.1%), for which reason
the relevant component of the index jumped to 14.6, taking it
back into positive territory. In the past, such a turnaround in the
situation assessment has usually been followed by a signifcation
deterioration of expectations in the months thereafter, as the
analysts doubted that the good performance would continue. The
ZEW is thus likely to fall further in the coming months. This time
as well, the Germany economy is unlikely to sustain the growth
rate of up to 1.5% quarter-on-quarter which is now emerging for
the 2nd quarter. Signifcantly lower momentum can be expected
in the second half of the year, if only because the construction
sector made a strong recovery in Q2 after the hard winter.
However, and despite increasingly restrictive fscal policies in
the Eurozone, this does not mean the recovery is over. After all,
monetary policy remains highly expansionary and the buoyant
world economy and the weak euro should allow foreign demand
for German products to go on rising.
Vega indicates how much the value of a option changes by if

the implied volatility rises or falls by one percentage point.
But before we look at some actual worked examples, we will see
how it is possible to predict the effect of volatility on options
using common sense. Experts distinguish between two types
of volatility: implied and historical. Vega measures the effect of
the implied volatility on the option, in other words the effect of
volatility that is actually used to price the option.
Since volatility represents the intensity of price fuctuations,
one can naturally assume that it has a positive effect on the
value of both call and put options. The reason for this is that
the probability of the products going deep into the money also
increases when volatility is higher.
From a purely technical point of view too, vega, which is the
partial derivative of the option price with respect to the implied
volatility, is always greater than zero both for plain vanilla calls
and for puts with time remaining to maturity. However, to get a
better idea of how to interpret the vega of an option, we now take
an actual worked example.
The Allianz call with a strike price of EUR90 and an expiry
date of 16th June 2010 had a theoretical value of EUR2.48 on
18th March 2010, when the Allianz share price also stood at
EUR90. At an implied volatility of 23.5% this corresponds to
a vega of 0.16. In this case we can assume that, if the implied
volatility rises to 24.5%, the value of the option goes up by 16
euro cents to EUR2.64. Similarly, if the volatility falls to 22.5%,
we can expect the call to fall in value to EUR2.32. This worked
example makes it clear that it is not only movements in the
share or the index to which the option is linked that affect the
value of the option, but that changes in volatility can have a not
insignifcant infuence as well.
At this point we need to once again qualify our comments, as
in the case of the parameters that we have already considered:
delta and gamma. Vega too, needs to be regarded as a snapshot
of the market. In other words, all other market variables
are assumed to be constant. As every investor knows from
experience, this is not generally the case in reality. The fgure
below also shows, in relation to the concrete example, that
the vega of an option is highest when close to the strike price,
EqUITIES
has sections on the fgures we have discussed, although it is
highly technical in places.
KEy:

Callprice: Call price of the option today

Shareprice: Price of the share today

Strike: Strike price of the underlying

Volatility: Volatility of the underlying share
(assumed to be a constant in years)

Time: Time to maturity in years

Interest: Risk free interest rate.
This article is dedicated to another aspect of the famous Black & Scholes model. This
time we look in detail at another parameter which measures the effect of volatility on
the value of a option. This parameter, commonly known as vega, is occasionally also
referred to by the name of the Greek letter kappa.
So what is Vega?
0 ) (
1
=
= d N Time Shareprice
Volatility
Callprice
Vega
Call
) ( ) ( exp
1 2
) * (
d N Shareprice d N Strike Vega
Time Interest
Put
=

Time Volatility
Time
Volatility
Interest
Strike
Shareprice
d where
+ +
=
2
ln
:
2
1
and declines as the options remaining time to expiry shortens.
Do not let yourself be fooled, though, by a low vega, especially
in the case of options that are deep out of the money, as the vega
represents an absolute amount, ie a value in euros. The volatility
can often be seen to have a greater relative effect especially
on options that are deep out of the money than the price of the
underlying security itself.
In one of the forthcoming articles, readers can fnd out why
investors are concerned with the change in the option value as
a function of volatility, when the Black & Scholes model actually
assumes constant volatility. Also, different implied volatilities can
be observed for options with different strike prices and the same
time to expiry, a phenomenon known as the volatility smile.
Until then, the option calculator on our derivatives website provides
an opportunity to simulate the effect of volatility on your own option,
and learn to interpret the vega in a risk-free environment.
The Bible of option valuation is Options, Futures and Other
Derivatives by John C. Hull, which, along with many other topics,
40
Commodities
Commodity spotlight Commodity spotlight
Demand for deliveries of copper from the warehouses of the
London Metal Exchange (LME) is currently on the increase.
LME copper stocks have now fallen by more than 21% from
their 6.5 year high of mid-February to 435,000 tonnes. In
the week to 24 June, copper stocks in the warehouses of the
Shanghai Futures Exchange fell by 9% the steepest fall for
11 months and are now back to their mid-February level.
They are already 38% down from their record high at the end
of April. Stocks remain high only on the New York commodity
futures exchange COMEX, where they currently stand at just
under 102,000 tonnes (see Chart 1). However, COMEX hast lost
importance compared with the other exchanges.
At the same time the number of cancelled warrants on the
LME is rising. Cancelled warrants are an indication of how
much material is required for delivery from the warehouses.
At approximately 27,000 tonnes, cancelled warrants are
equivalent to more than 6% of total LME stockpiles. For
comparison: at the end of last year cancelled warrants fell to a
low of just 675 tonnes. Although cancelled warrants are normally
regarded as an indicator of demand, they merely show what is
about to fow out of the warehouses. Infows on the other hand
are disregarded. Nor do these statistics take account of stocks
outside the exchange-registered warehouses. The forward
cover of aggregate copper stocks on the London, Shanghai and
New York exchanges (ratio of stockpiles to global demand),
based on average consumption in 2009, currently stands at a
relatively high 0.5 months. Between 2005 and 2008 this stood
at 3-6 days, or even less in some cases.
Apart from the destocking which has now begun, other factors
such as low processing fees also point to a tighter supply.
In negotiations with Asian smelters, the worlds largest mining
company BHP Billiton recently secured signifcant reductions in
copper smelting and refning fees. These have now fallen to their
lowest level since 1973 (USD39 per mt for smelting and 3.9 US
cents per lb for refning). The low fees paid by mining companies
to smelters for processing their material point to a short supply
of copper concentrate. Zinc and lead processing fees have also
fallen a good deal recently.
A destocking tendency is also apparent in the case of aluminium.
Admittedly, at around 496,000 tonnes, stocks in the warehouses
of the Shanghai Futures Exchange remain close to their record
high, but on the LME stocks are already falling steadily. From
their all-time high in January they have so far dropped by
5.4% or 251,000 tonnes, and the fall has recently gathered
momentum. The number of cancelled warrants on the LME
points to a further decline in stocks. Cancelled warrants have
recently risen to over 276,000 tonnes, corresponding to 6.3%
of total LME aluminium stocks (see Chart 3). However, a large
proportion of exchange-registered aluminium stocks is still tied
eUGeNe weINBeRG
HEAD OF COMMODITY RESEARCH
A few weeks ago most of the metal markets entered a destocking phase which has recently
accelerated. In particular, stockpiles of copper, nickel and tin have declined considerably.
At the same time the number of cancelled warrants has risen. Yet the expected price surge
has so far failed to materialise, as the situation is currently dominated by overriding factors.
Destocking provides little uplift for metal prices
41
COMMODITIES
up in fnancial transactions and is therefore not available to the
market. According to estimates by the research consultancy CRU,
these still account for 60-70% of total LME stocks. For about the
last year, the forward cover of aluminium stocks on the London
and Shanghai exchanges has settled at around 1.5 months. In
previous years the fgure was usually between 0.2 and 0.5 months.
The forward cover of available stocks is likewise of this order.
As the aluminium price has fallen over the year so far, aluminium
production has become unproftable for many producers. China in
particular produces at relatively high cost. According to CRU the
breakeven point is around USD2,200 per tonne. The research
consultancy CBI China estimates that the Chinese aluminium
producers are currently losing an average of RMB 1,000 or around
USD150 on every tonne. Local aluminium smelters have therefore
already announced they are curtailing production. In Henan
Province, the countrys largest aluminium producing region,
capacity is to be cut by 700,000 tonnes, equivalent to 5% of
Chinas total production. This points to a further reduction in stocks.
In the case of nickel, destocking has been even more pronounced
than for copper in recent months. From their record high at the
beginning of February, stocks on the LME have fallen by 28% to
just over 120,000 tonnes which is equal to their October 2009 level.
As with the other metals, destocking has been accompanied by an
increase in cancelled warrants. Since mid-June these have risen
to their highest level in 6.5 years. Now standing at 5,300 tonnes
they are equivalent to 4.4% of total stocks. This is mainly thanks to
the revival of the stainless steel industry, which is currently in the
process of rebuilding its stockpiles which were sharply reduced in
the wake of the economic crisis. According to estimates by CRU,
global stainless steel production should increase by 15% this
year to 29 million tonnes. However, stainless steel producers have
recently reported that clients are postponing their orders, so that
impetus from this quarter could ease off. Also, the ending of the
year-long strike in Vales Canadian nickel mines could at least slow
down the destocking process due to higher production in the future.
After all, these mines account for around 10% of global nickel
production. The worlds second largest nickel producer, it has just
negotiated a new contract with the unions.
Stockpiles of tin have also been signifcantly reduced in recent
times. In the last fve months alone they have fallen by 41%
or 11,600 tonnes. At 16,400 tonnes they are now back where
they were 12 months ago. Cancelled warrants now account for
approximately 7% of total stocks.
In the case of zinc and lead the situation is rather different.
For both these metals the number of cancelled warrants has
increased, but, in contrast to copper, aluminium, nickel and tin,
stockpiles are as high as ever. LME warehouses are still holding
around 190,000 tonnes of lead the highest level since October
2002. At 616,000 tonnes, LME zinc stocks remain at a fve year high,

0
100
200
300
400
500
600
700
800
900
J
a
n

0
7
J
u
l

0
7
J
a
n

0
8
J
u
l

0
8
J
a
n

0
9
J
u
l

0
9
J
a
n

1
0
J
u
l

1
0
'000 mt
COMEX LME SHFE
Chart 1: Signifcant decline in copper stocks
Source: LME, SHFE, COMEX, Bloomberg, Commerzbank Corporates & Markets
0
100
200
300
400
500
600
2006 2007 2008 2009 2010
'000 mt
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
10,000
LME Inventories, ls
Copper (USD/mt), rs
Chart 2: Recent de-coupling of copper price and stockpiles
0
50
100
150
200
250
300
350
Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10
'000 mt
1,000
1,500
2,000
2,500
3,000
3,500
Cancelled Warrants, ls
Aluminium (USD/mt), rs
Chart 3: Rise in cancelled warrants (LMe) points to further
destocking of aluminium
42
while the warehouses of the Shanghai Futures Exchange have
around 250,000 tonnes, not far off the recent record.
While the destocking of zinc has yet to begin, steel production
has recently expanded signifcantly. Zinc is mainly used in the
galvanisation of steel. According to data of the World Steel
Association global steel production rose in May to a new all-time
high of 124 million tonnes (see Chart 4). China in particular
contributed to this rise thanks to record production. However,
this has led to a supply surplus in the worldwide steel market,
which could amount to 300 million tonnes this year according
to estimates of the World Steel Association. Moreover, steel
demand currently shows weaknesses: less steel is being ordered
particularly in China (and by the Chinese automotive industry).
For that reason the countrys second largest steel manufacturer,
Baosteel, has already announced that it is cutting both capacities
and prices in the current quarter. In addition, the company
is scaling back its medium-term expansion plans, thereby
complying with the request of the Chinese government to reduce
overcapacity. This is expected to result in weaker demand for
zinc which should, at least in the short term, prevent destocking
of this industrial metal.
However, a reduction of stockpiles or a rise in cancelled warrants
does not necessarily lead to higher metal prices. In fact, in the
past year and during the last few months of the current year the
opposite has proved to be the case: the sharp price rise in 2009
copper went up by 140% was accompanied by a signifcant rise
in stockpiles. During the same period stocks in LME warehouses
increased by 50%. The same phenomenon has been observed since
mid-February, but in the other direction: while copper stocks fell by
21%, the copper price dropped by 11% (see Chart 2). The same is
true, though to a lesser extent, for the other metals.
Metal prices currently seem to be infuenced more by other
determinants. Above all, concerns about the vigour of the global
economic recovery, particularly in China, currently dominate the
picture and tend to eclipse the recent fairly positive data. This
is refected, for example, in the Baltic Dry Index. This tracks
shipping prices of dry bulk cargoes on 22 shipping routes, and
since the end of May has fallen by 56% to its lowest level since
the beginning of May 2009 (see Chart 5). Above all a decline in
volumes of iron ore and coal shipped between Brazil and China
has contributed to this development and at the same time refects
a drop in Chinas import momentum.
The destocking observed in the last few months and the
other positive fundamental data are clearly unable to give any
signifcant uplift to metal prices. Market players currently seem
to be paying more attention to the wider economic landscape,
where clouds have recently gathered on the horizon. We think
this may be standing in the way of a signifcant rise in metal
prices for the time being.
80
85
90
95
100
105
110
115
120
125
130
Apr 08 Oct 08 Apr 09 Oct 09 Apr 10
million mt
200
400
600
800
1,000
1,200
1,400
Global Steel Production, ls
Med. Steel (USD/mt), rs

Chart 4: Record steel production points to oversupply
Source: WSA, LME, Bloomberg, Commerzbank Corporates & Markets
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10
Chart 5: Baltic Dry Index in free fall
Source: Baltic Exchange, Bloomberg, Commerzbank Corporates & Markets
Eugen Weinberg
For additional information on the product features and key risks, please contact your sales advisor or refer to the contacts on page 66.
3 Year 100% capital
protected Enhanced call up
and out on precious metals
Key features
100% capital protected
Participation on the upside performance

of the underlying that has not breached
American barrier 150%
Rebate of 5% (EUR)/4% (USD) if both

underlyings breach the barrier
PRODUCT DeSCRIPTION
This product offers investors an opportunity to gain exposure to
Gold and Silver without putting capital at risk. At maturity,
if none of the underlyings has traded above an American barrier
of 150%, investors receive 100% of the upside performance
of the equally weighted basket of Gold and Silver. However,
if any underlying has breached the barrier, the return of that
underlying is attributed a zero value but investors will still
get the performance of the remaining underlying that has not
breached the barrier. Even in the case when both underlyings
have traded above the barrier at least once, investors will still
receive a rebate of 5% (EUR)/4% (USD) at maturity.
Underlying Bloomberg code
LBMA Gold PM fxing GOLDLNPM index
LMBA Silver fxing SLVRLN index
Gold remains supported as a safe investment. In the medium to
long term, gold should remain in demand as a safe haven and
protection against infation. There might be additional support
of the gold price as a consequence of the downgrading of
Portugals credit rating by the rating agency Moodys. Market
participants risk aversion, which had previously declined in
expectation of a positive money market auction of Greece to be
held today, might therefore increase again. Gold prices below
USD1,200 continue to be used for physical purchases. Physical
demand will increase as jewellery demand from Asian countries
is also rising again. The Vietnamese government abolished the
restrictions for gold imports after jewellery producers and banks
had pressed for their abolishment.
Similarly to gold, silver exhibits safe haven characteristics.
Simultaneously, investment demand is quickly gaining
importance. After having more than doubled in 2008, it robustly
rose again last year from a good 48 million ounces to around
137 million ounces. This trend is expected to continue this year.
Compared with gold, silver can still be considered low priced.
Silver is therefore a reasonably priced and attractive alternative
to gold. Silver is also supported by its industrial demand.
The expected recovery of industrial demand and continuing high
investment demand should give the price of silver another boost.
2005 2006 2007 2008 2009 2010
300
400
500
600
700
800
900
1,000
1,100
1,200
1,300
in mm oz

0
10
20
30
40
50
60
SPDR Gold Trust iShares COMEX Gold Bullion
ETFS ZKB
Gold price (USD/oz.), r

Chart 1: Gold eTF volume is still at elevated level
44
Infation-linked bonds and derivatives are the
best way for investors to hedge infation risk.
But are they the most cost-effcient?
Both principal and interest to be paid in the then current money
of said State, in a greater or less sum, according as fve bushels of
corn, sixty-eight pounds and four-seventh parts of a pound of beef,
ten pounds of sheeps wool, and sixteen pounds of sole leather
shall then cost more or less than one hundred and thirty pounds
current money, at the then current prices of the said articles.
This was included in the terms of a bill issued by the state of
Massachusetts in 1780. Its purpose was to preserve the value of
notes extended as wages to soldiers in the American Revolution.
An earlier issue of 1742 was indexed solely on the value of silver
in the London Exchange, and was abandoned as prices showed
higher volatility and rose above general price levels.
Commodities:
an effcient infation hedge?
DR KONSTaNTINOS KaLLIGeROS
STRUCTURER, COMMODITY SOLUTIONS
This is the story of perhaps the earliest infation-indexed bond,
and if history repeats itself, it shows that commodities are at
the core of tracking infation. It also shows that to preserve
future buying power, infation indexing should be tailored to the
consumption needs of investors as well as the liability needs of
the issuing authority in this case the State of Massachusetts.
This achieves lower volatility, better tracking and lower
idiosyncratic concentration risks which occur from following a
single commodity (eg, gold or silver). This is true even in more
recent, energy-intensive times. Chart 1 shows that a single
commodity such as WTI oil may serve as a proxy infation hedge
for the energy-hungry US consumer over extended periods of
time; nevertheless, such a hedge is also subject to temporary
commodity volatility, price shocks or even temporary changes in
consumer behaviour.
INFLaTION BONDS aND DeRIvaTIveS
The most direct instruments available to retail investors for
hedging against infation are infation-indexed bonds. Currently
45
COMMODITIES
Bloomberg lists 48 counries as issuers of infation bonds, with
the largest ones being the US and the UK. In the most common
form, the notional of these bonds will be indexed to a general
index of consumer prices (eg, the CPI in the US, HICP for
European harmonised infation or GRCP2000 in Germany) and
pay fxed periodic coupons (on the adjusted notional). In other
variations, only the coupons are adjusted for infation, while the
notional remains constant. The issued volume of linkers among
G7 nations has grown from around USD200bn in 2000 to over
USD 1 trillion in 2008 according to Bloomberg and UBS.
The simplest derivative on these bonds is the infation-
linked swap. It involves two legs of cash fows between
counterparties. The fxed leg payer pays a fxed nominal
rate, while the infation rate payer makes payements linked
to a price index. An instrument with only a single payment at
maturity (a Zero-swap) gives the most straight-forward and
clean expression of market expectations for future infation:
only the fnal and initial levels of the price index matter, and
Dr. Konstantinos Kalligeros
the fact that no notional is exchanged means that short-term
rates are irrelevant. In this form, the fxed leg of an infation
zero-swap represents almost exactly the infation expectations
over the tenor. For example, if the fxed leg on a fve year swap
on European Harmonised Index for Consumer Prices (HICP-ex
tobacco) is trading at 1.30% then the market is perceived to
expect the price index to rise by 1.30% pa over the tenor of the
swap. This rate is the so-called break-even infation.
The break-even infation is also the cost of insuring a certain
notional against infation, free from money-market distortions.
Chart 2 shows the swap rate and breakeven infation rates for
various maturities. Notice the rise in infation swap rates after
three year maturities this implies the market is pricing a risk of
increased money supply and demand in that horizon.
USING COMMODITIeS TO heDGe INFLaTION
Commodities are not a perfect hedge for infation in part because
taxes, such as VAT, are not hedgeable but it can be much more
46
cost-effcient. Infation benchmarks (used in common derivatives)
are specifcally designed to represent the average increase in
purchasing power of various population groups. Moreover, they
are the legal benchmark for many institutional liabilities, which
makes them the vehicle of choice for hedging. The need for high
hedge effciency, however, comes at a relatively high cost. Chart 2
implies that the cost of securing purchasing power in the US and
Eurozone today would trim almost the entire nominal return of a
bond investor for maturities to around two years in other words,
the real interest rate is close to zero.
Commodities can be an imperfect, but more cost-effcient
infation hedge. The advantages are:
Good representation and commodity correlation with price

indices. Table 1 shows the components and broad weighting
of the German consumer price index; a large part is directly
or indirectly linked to commodity prices
Since commodity futures require no cash investment, there is

no notional cost foregone: the investor can achieve exactly the
desired exposure at theoretically zero cost
Higher commodity volatility and growth means that a

small position can hedge a large portfolio against infation.
(The caveat is that a even a small position has high volatility)
Commodities are appropriate for investors willing to sacrifce
some hedge effciency for the beneft of lower hedging costs.
The easy solution is to acquire such small commodity exposure
that the total impact on portfolio volatility is small (yet the
infation protection suffcient). Assuming infation volatility of
1.5% and commodity volatility of 25%, the commodity allocation
should carry a weight of around 6% of the total portfolio notional
(assuming this is fully exposed to infation). A potentially better
approach is to dynamically vary the allocation to commodities as
commodity volatility and infation fuctuates.
Another question is naturally, which commodities to use.
Numerous studies (see Chart 1) show that gold or oil individually
provide a poor infation hedge as stand-alone positions. Ideally, a
basket should include the mix of commodities that comprise the
production factors for the items in Table 1 (or the relevant table
for the region and population in question).
a DyNaMICaLLy aDjUSTeD COMMODITy
INFLaTION heDGe
Commerzbank has developed the technology for providing indices
designed to hedge infation. For example, the CB RiskEffcient
Infation Commodity Index is optimised for European infation,
represented by the HICP Eurozone Index, and provides exposure
to futures close to expiration for agriculture (20%), energy (40%)
and precious metals (40%). It is also dynamically adjusted to
increase exposure during times of low volatility and reduce it
when commodity prices fuctuate a lot. This has two main benefts.
Firstly, it improves the indexs correlation with infation; secondly
Table 1: Broad Infation components
(Federal Statistical Offce of Germany, 2008)
01 Food and non-alcoholic beverages 103.55
02 Alcoholic beverages, tobacco 38.99
03 Clothing and footwear 48.88
04 Housing, water, electricity, gas and other fuels 308
05 Furnishings, household equipment and routine
maintenance of the house
55.87
06 Health 40.27
07 Transport 131.9
08 Communication 31
09 Recreation and culture 115.68
10 Education 7.4
11 Restaurants and hotels 43.99
12 Miscellaneous goods and services 74.47
1000
100
120
140
160
180
200
220
240
0 20 40 60 80 100 120 140 160
CL1 Comdty
C
P
I

I
n
d
e
x
Elasticity of demand?
Excess oil volatility?
New energy regime?
= 0.6
2
Chart 1: US Consumer Price Index (CPI) against spot

wTI oil prices (CL1 Comdty).
Note: The CPI is one of the most widely recognized price measures for tracking the price of a
market basket of goods and services purchased by individuals. Monthly data 1987-2010.
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
0 1 2 3 4 5 6 7 8 9 10
time (years)
Breakeven ination rate
Swap rate
Chart 2: eU Infation and swap curves
Source: Bloomberg
47
COMMODITIES
it provides an implicit protection on the downside. In a previous
article (July 2010) we showed that historically, commodity prices
decline in an environment of high volatility in these cases,
exposure to the index is lower.
Chart 3 and Table 2 show how an exposure of 25% of a Notional
Amount to the CB RiskEffcient Infation Index has tracked the
infation for 100% of the same notional. (represented by HICP
Eurozone Index). The excess volatility compensates the reduced
cost of hedging. The dynamic adjustment feature increases the
probability that deviations from the price index are mainly on
the upside.
hOT PRODUCT: CaPITaL GUaRaNTeeD COMMODITy
INFLaTION heDGe
Mainfeatures
Capital guaranteed, low-cost hedging product for European

HICP Infation using commodity futures
100% of the portfolio is hedged using only 25% of portfolio

value invested in the Commodity Infation Hedge
RiskEffcient methodology takes advantage of commodity

markets behaviour to generate exposure mainly to the upside
Exposure to agricultural (20%), energy (40%) and precious

metals (40%) futures
Available as capital guaranteed note at costs lower than

infation zero-swaps
90
95
100
105
110
115
120
125
Oct 01 Oct 02 Oct 03 Oct 04 Oct 05 Oct 06 Oct 07 Oct 08 Oct 09
HICP Eurozone Index
CB RiskEfcient Index EUR

Chart 3: historical track of hICP eurozone infation with
the CB Riskeffcient Infation Index
Table 2: Growth and volatility of hICP eurozone infation
and CB Riskeffcient Infation Index
Code annual Return volatility
25% portfolio allocation to
CB RiskEffcient Infation Index 1.9% 2.7%
HICP Eurozone Index 2.0% 1.2%
Underlying
Commerzbank RiskEffcient Infation Index: near-to-expire futures from sectors:
Agriculture (20%),Energy (40%), Precious Metals (40%)
Maturity 5 years
Commerzbank pays
On the Maturity Date, the Note redeems at Commerzbank will pay an amount in USD determined by the Calculation Agent in accordance
with the following formula: Notional X (100%+max[0,Index
T
1)
Index
t
asset Participation
Indicative Terms and Conditions
W
A,t
= min

200%
TargetVol
HistVol
t-1
Where

TargetVol
=The Target Volatility = 15.0%
HistVol
t-1

= Annualized standard deviation of the past 20 Asset Returns =
= StDev(AR
t-1
,AR
t-2
,...,AR
t-20
)x 252

StDev
(
X
)
=
Avg(X
2
) Avg(X))
2

where X is a vector of returns and
Avg(X)
means the average of X.

Index
t
= Index
t-1
x 1+W
A,t-1
x AR
t

where AR
t
=
CBREIC
t

1 and

CBREIC
t 1
Index
0
= 1
48
Absolute Tortoise
or Absolute Hare?
hUw PRICe
SENIOR INVESTMENT MANAGEMENT STRUCTURER
Huw Price
I am conscious that I have already introduced a Goose
and a Gander to my articles so apologise upfront for
creating an analogous menagerie by using aesops Fable
of The hare and the Tortoise in this months edition.
Most people will be familiar with the story of a sedentary
Tortoise who challenges the uber-confdent Hare to a race in the
face of constant taunting by the latter over his superior speed
and prowess. In the contest the Hare decides to take a nap as he
is so far in the lead and while he sleeps the Tortoise catches up,
passes the sleeping hare and wins the race. This fable appears
very simple, however, there has been some debate about the
primary lesson to be learned from it. Some cultures see it as a
simple, slowly but surely lesson, others pride comes before
a fall. Another interpretation centres on the folly of accepting
a challenge when the outcome will only be embarrassing if the
race is lost and of no value if it is won.
For me the fable, as I suspect was intended, is too simplistic
to draw conclusion. There is an extrapolation of the story that
places the race just before the onset of a calamitous forest fre.
Those who witnessed the race wish to send a messenger to the
animals of the forest who are about to be consumed by fre.
Funds Platform
Fundamentals
49
FUNDS PLATFORM
On the result of the race they conclude that the Tortoise is the
fastest and send him the results are naturally disastrous!
Equally, if you add context to the race the outcome is deeply
unsatisfactory. If the race were to run another ten times what
would the outcome be?
Now for my familiar and tortured analogy! If we view the
Tortoise as a fund of G7 Government bonds; the Hare as a fund
of Technology stocks and emerging market small caps and the
distance of the race as 0 to 100% return on capital (its easy if
you try hard enough) we can arrive at some trite and suitably
sobering observations about investment and associated risk.
The Hare is confdence personifed, all energy, entrepreneurial
and performance driven. There is, however, a volatility
and tendency to be over confdent which can lead to under
achievement and even stagnation.
The Tortoise is slow but steady, does what it says on the shell,
reliable if not exciting, it will get you there but slowly.
If you are presented with these attributes and have a target of
100% return on capital you have a binary decision to make. Do I
go with the Hare fund of small cap and tech risking a slow down?
Or do I opt for reliability and certainty with the Tortoise fund?
Of course this is where the torturing of the analogy goes too far
and the analogy dies on the rack. In the real world the decision
is not binary. There are too many contextual variables. The Hare
fund may get you to the 100% return sooner or it may not. The
Tortoise fund is likely to be far too slow. In reality somebody will
Post Scriptum How did John Gander Do?
I know you have been waiting on the edge of your seats so without further ado here are the results of johns world Cup
investments.
England to score more than 10 goals in the whole tournament (2/1) Lost
At least one semi-fnal goes into extra time (2/1) Lost
At least one African Nation in the Quarterfnals (2/1) won Ghana
Over 12 corners in the England versus Algeria game (2/1) won 13 Corners
More than two hat-tricks in the tournament (2/1) Lost David villa missing against honduras costing dear
Overall result Two singles and a double
= 30 + 30 + 90 = 150
Total Loss (160 = 310 - 150)
suggest combining the two, which does not address the situation
satisfactorily, why hold the Tortoise if the Hare does go the full
distance? Others will suggest bringing more contestants in to the race!
I would suggest going further and introducing dynamic
management based on risk indicators. I as a consumer do not
want a Tortoise fund or Hare fund, I want a real Absolute Return
Fund. I want a manager with a full array of asset classes (I will
spare trying to anthropomorphise any further animals so they
characterise the human attitudes to risk). In my fable I want
the race to be monitored, I want to be with the Hare, until or
shortly before he stops, and then swap him with the Tortoise.
When the Hare wakes, I want him to replace the Tortoise again.
Better still I want an alternative to the Tortoise and to only rely
on the Tortoise in extremes. In choosing this manager I want to
see a track record of monitoring the Hare, using indicators to
show when confdence is going to get the better of him. I want
included those other animals that are relatively faster than the
Tortoise but more reliable than the Hare. I want to get to the
end of the race as quickly as possible while avoiding any risk of
retrenchment. This is the challenge I want the asset management
industry to deliver.
On balance, I have to forget how fast the Hare can run because
he may not arrive and I have to accept that sometimes my best
bet is the Tortoise. I want the race to be concluded faster than
the Tortoise can achieve and I want to give that mandate to
someone who can deliver it!
In future articles we will look closely at Absolute Return
strategies, the challenges, the failures and the successes.
50
New ETF in the fund universe:
NYSE Arca Gold BUGS
TM
Index
DaNIeL BRISeMaNN
COMMODITY RESEARCH
51
FUNDS PLATFORM
Fund universe: The ComStage eTF on the NySe arca
Gold BUGS
TM
Index (SIN eTF 091) gives investors
the opportunity to participate in the performance of
companies involved in gold mining, and hence in the
rising price of gold.
There are various advantages to investing in the index as
opposed to a direct investment in gold, including: the leverage
effect of the companies due to high mining costs, independence
from purely speculative gold futures investors, the central banks,
combined with the ease of investing in a share index compared
with gold derivatives.
Composition of NySe arca Gold BUGS
TM
Index versus
Philadelphia Stock exchange Gold and Silver
NySe arca Gold BUGS
TM
Index
Goldcorp Inc. 15.27%
Barrick Gold Corp. 14.77%
Newmont Mining Corp. 9.92%
Eldorado Gold Corp. 5.68%
Randgold Resources Ltd. 5.13%
Cia de Minas Buenaventura SA 4.99%
Iamgold Corp. 4.97%
Lihir Gold Ltd. 4.91%
AngloGold Ashanti Ltd. 4.68%
Gold Fields Ltd. 4.64%
Yaman Gold Inc. 4.46%
Agnico-Eagle Mines Ltd. 4.33%
Harmony Gold Mining Co. Ltd. 4.30%
Kinross Gold Corp. 4.06%
Hecla Mining Co. 3.96%
Coeur dAlene Mines Corp. 3.93%
Philadelphia Stock exchange Gold &
Silver Index
Barrick Gold Corp. 19.30%
Goldcorp Inc. 14.66%
Freeport McMoRan Copper &
Gold Inc. 12.82%
Newmont Mining Corp. 12.30%
AngloGold Ashanti Ltd. 7.15%
Kinross Gold Corp. 5.56%
Gold Fields Ltd. 4.40%
Cia de Minas Buenaventura SA 4.38%
Agnico-Eagle Mines Ltd. 4.28%
Randgold Resources Ltd. 3.68%
Yaman Gold Inc. 3.65%
Silver Wheaton Corp. 2.94%
Harmony Gold Mining Co. Ltd. 1.92%
Pan American Silver Corp. 1.22%
Royal Gold Inc. 1.10%
Silver Standard Resources Inc. 0.64%
As at May 2010; Source: Bloomberg, Commerzbank Corporates & Markets
The index was launched on 15 March 1996 and includes the 16
largest gold mining companies trading in the US. The companies
in the index must not hedge their gold production beyond 18
months. The index was originally designed to offer equity investors
the opportunity to participate in short-term changes in the price of
gold, as no gold ETFs or similar derivatives were yet available at
the time of the index launch. The index has proved popular with
investors over the last few years and has now become the best-
known gold mining share index in the world. This is due in part to
its very good price performance since 2000: the NYSE Arca Gold
BUGS
TM
Index has risen by 420% since the beginning of 2000,
whereas the S&P 500 share index has shed nearly 25% of its value
over the same period. The performance of the NYSE Arca Gold
BUGS
TM
Index is closely linked to the price of gold, as refected
by the high correlation (see Chart 1). The gold mining shares
contained in the index can be seen as a substitute warrant with a
strike price equivalent to production costs. Investors can therefore
proft disproportionately from the rising gold price. The NYSE
Arca Gold BUGS
TM
Index also gained disproportionately compared
with the Philadelphia Stock Exchange Gold and Silver Index. This
share index, which is also very well known, includes the top gold
and silver mining companies that are traded in the US, and which
also partially hedge their gold production. The composition and
weighting of the two indices are shown in the table.
Gold and gold mining shares specifcally, and precious metals
generally can provide rewarding opportunities, including as part of
a portfolio, due to their low correlation with other asset classes. The
GSCI Precious Metals Index, for example, has a maximum correlation
of 0.5 to the worlds most famous equity indices. The correlation to most
government bonds, bond indices and currencies is much lower, and
in many cases negative, which suggests a high diversifcation effect.
52
why wILL The PRICe OF GOLD CONTINUe TO RISe?
Despite the appreciation of the US dollar on a wide front, the
price of gold hit a new record high of nearly USD 1,264 per troy
ounce in June. Gold also reached new record levels in other
currencies such as Euros, British Pounds and Swiss Francs (see
Chart 2). Its price performance in euros is particularly striking:
in the frst quarter, gold still cost an average of EUR800 per
troy ounce, but by the end of May its price had gone as high
as EUR1,060. Gold is benefting from its role as a safe-haven
investment. On this occasion it is the fear of a widening of the
debt crisis in the eurozone which is driving investors to the
yellow metal. Investors need for added security is refected,
among other things, in signifcant fows of funds into ETFs.
The worlds largest gold ETF, SPDR Gold Trust, reported an
increase of more than 100 tons in its gold holdings in May, with
an increase of as much as 30 tons in a single day.
The fund has now amassed nearly 1,290 tons of gold (see
Chart 3). Other ETF providers such as ETF Securities have also
reported large infows recently. Much of this capital is likely to stay
put, we believe. Demand for gold coins has also rocketed again in the
last few weeks.
The bailouts agreed by the EU and the IMF look set to boost
demand for gold still further, the reason being that the billions
in loan guarantees are likely to increase the infation risk in the
medium to long term. Speculative fnancial investors, too, are
continuing to bet on rising gold prices. Net long positions have
now increased to over 200,000 contracts, only just below the
record high of last October.
The price is receiving an additional undercurrent of support from
supply-side factors: according to the World Gold Council, the
European central banks that are party to the Central Bank Gold
Agreement (CBGA) sold less than 2 tons of gold in the frst six
months of the current contractual year. A further 24 tons were
sold on the market by the IMF. Therefore last years sales volume
of 150 tons will probably only be matched if the IMF is able to
sell on-market most of the remaining nearly 170 tons that are
still for sale by the end of September. This would appear to be
unlikely to materialise. Sales are certainly likely to fall well short
of the ceiling of 400 tons set by the CBGA again this year.
We are expecting the price of gold to continue rising. However,
there is likely to be a fall in the price at some point, when
investment demand loses momentum. The high price level is likely
to take its toll on demand for jewellery, as is shown by the latest
data on Indian gold imports, and result in a further rise in the
supply of scrap gold. Next year we are likely to see a sustained
rise in the price of gold to over USD 1,300 per troy ounce.
0.4
0.5
0.6
0.7
0.8
0.
1.0
16 17 18 1 2000 2001 2002 2003 2004 2005 2006 2007 2008 200 2010
Chart 1: Correlation NySe arca Gold BUGS Index and gold
(52 week correlation of weekly performance)
800
00
1,000
1,100
1,200
1,300
1,400
1,500
Apr 0 1un 0 Aug 0 Ucl 0 Dec 0 leb 10 Apr 10 1un 10
500
550
600
650
700
750
800
850
00
50
1,000
1,050
per lroy ounce
n USD, lel
n CHl, lel
n EUR, rghl
n CBP, rghl
Chart 2: Gold price development
1,100
1,150
1,200
1,250
1,300
1,350
1.4 8.4 15.4 22.4 2.4 6.5 13.5 20.5 27.5 3.6 10.6 17.6 24.6 1.7 8.7 15.7
Chart 3: Gold holdings of SPDR Gold Trust in metric tons
Name Underlying index SIN Flat fee Fund currency
ComStage ETF NYSE Arca Gold
BUGS
TM
ETF 091 0.65% pa US dollars
53
FUNDS PLATFORM
Type Fund Name Bloomberg Inception
auM
(Mn)
Infows
over last
quarter Perf 2009 Perf yTD
annual
Return
since
Inception
eQUITy
Balanced / Diversifed Carmignac Patrimoine CARMPAT FP Oct 1989 25,428 5,088 17.6% 7.5% 9.7%
BlackRock Global Allocation Fund MERGAAI LX Jan 1997 13,356 -664 22.2% -4.8% 7.3%
Allianz RCM Oriental Income ALORIAA LX Dec 2005 448 -22 41.6% -8.3% 3.2%
Global Equities Carmignac Investissement CARINVT FP Jan 1989 8,001 751 42.6% 6.9% 11.6%
j.P. Morgan Global Focus Fund FLGLRVA LX Dec 2006 1,028 295 62.6% -8.7% -4.1%
SocGen International SOCGISD LX Aug 1996 814 24 20.4% -1.1% 10.7%
DWS Akkumula AKKMULA GR Jul 1961 3,251 -479 27.9% -4.1% 6.0%
UniGlobal UNIGLOB GR Jan 1960 5,610 130 30.8% 3.2% 0.0%
US Equity Allianz RCM US Equity DITUSIT ID Oct 2006 2,328 28 46.9% -7.8% -2.1%
Schroder US Small & Mid-Cap Equity SCHUMAA LX Dec 2004 2,020 280 35.8% -4.9% 4.1%
BlackRock US Flexible Equity Fund MLFLEUA LX Oct 2002 2,088 -212 23.4% -6.9% 4.1%
Robeco US Premium Equities RGCUPUD LX Oct 2005 2,782 852 32.7% -7.0% 0.2%
Europe Allianz RCM Wachstum Europa DITWEUR GR Jan 1997 755 -35 50.4% 9.5% 5.6%
BlackRock European Equity MEREUDE LX May 2006 2,610 160 39.7% -2.1% -0.3%
UniFonds (focus Germany) UNIFNDS GR Apr 1956 2,100 -100 22.5% -0.3% 2.6%
Japan Invesco Japanese Equity Core Fund INVJPCA ID Mar 1994 741 -29 36.4% -4.0% 0.1%
Emerging Markets HSBC BRIC Freestyle HSBRIM2 LX Apr 2005 1,751 -269 109.1% -7.1% 15.6%
Franklin Templeton BRIC Fund TEMBRAC LX Oct 2005 2,674 -336 89.1% -12.2% 10.0%
Templeton Emerging Markets TEMEMXA LX Apr 2000 1,007 -153 70.7% -9.9% 5.9%
Schroder ISF Emerging Markets SCHIMAI LX Mar 1994 2,009 119 74.3% -9.5% 4.7%
Comgest Magellan MAGLNSV FP Mar 1988 4,066 216 57.7% 9.3% 7.1%
Baring Global Emerging Markets Fund BRGGEMI ID Feb 1992 1,655 35 78.1% -5.6% 6.4%
Templeton Frontier Markets Fund TEMFMAU LX Oct 2008 299 255 51.0% 1.6% 25.5%
Fund Watchlist
Over the last quarter, the fnancial markets have been volatile.
This has been refected by the disparate performance and asset
fows within the fund industry.
The strongest performing funds were the BlackRock World Gold
and Schroder Asian bond. Fixed income funds were fat, while
on the whole, equity linked funds suffered, mainly emerging
markets, US equities and some Thematic funds like mining,
energy and private equity.
The infows have been really signifcant in Global Bond, Balanced
and Emerging Market Debt. Global and US equities also had
some positive infows, following a return from investors towards
more risky assets.
Here is a list of funds that we recommend for the 3rd quarter.
For investors who are keen to have protection against the
possibility of rising infation in the near future, we can propose
solutions linked to Infation linked bond funds, as well as
Gold Funds.
XavIeR BURKhaRDT
FUND DERIVATIVES STRUCTURER
54
auM
(Mn)
Infows
over last
annual
Return
since
Inception
EM Small Cap Templeton Emerging Markets Small-cap TEMCACU LX Oct 2007 259 -11 86.7% 1.8% -11.7%
j.P. Morgan emerging Markets Small
Cap
JPMEMSA LX Nov 2007 212 148.0% -0.7% -3.2%
Asia Templeton Asian Growth Fund TEMFRBX LX Sep 2002 9,715 -305 102.1% 0.6% 18.6%
Baring Hong Kong China Fund BRGHKGI ID Jan 1994 4,433 -757 63.5% -9.9% 11.3%
HSBC India HSBCINE LX May 2003 6,505 -375 130.4% 0.0% 29.9%
Franklin Templeton Korea Fund TEMKORI LX May 1995 88 -12 67.1% -15.4% -4.3%
J.P. Morgan Singapore Fund FLEFSGA LX May 2001 175 -15 78.5% -0.2% 15.5%
J.P. Morgan Taiwan Fund FLEFTWA LX May 2001 339 -141 57.6% -14.4% -1.6%
Fortis Equity Indonesia FOREINI LX Mar 2007 122 32 149.8% 15.6% 20.4%
Franklin Templeton Thailand TEMTHAI LX Jun 2007 142 2 76.6% 5.4% 0.9%
Latam BlackRock Latin America Fund MERLTAI LX Aug 1997 6,221 -549 120.7% -9.5% 11.1%
HSBC Brazil HSBBRAZ LX Sep 2004 2,068 -402 156.5% -10.2% 22.1%
Russia J.P. Morgan Russia Fund JPMRUSS LX Nov 2005 2,036 -694 191.4% -4.8% 3.9%
east Capital Russian Fund ECRFAUS LX Jan 2007 110 141.0% -2.1% -7.9%
Mena Ocean Fund Equities MENA Opportunities OCEANMA LX Jun 2007 238 -42 23.6% -0.1% -9.6%
Themes Pictet Clean Energy PFLCLNP LX May 2007 616 -124 47.2% -17.9% -10.5%
Sarasin New Energy Fund SARENER LX Apr 2000 146 -14 17.6% -10.5% -5.4%
SAM Sustainable Water Fund JBSAMSW LX Sep 2001 1,143 -177 33.8% 5.0% 4.1%
Allianz RCM Global EcoTrends DITGETA LX May 2006 307 -63 18.8% -6.0% -6.5%
Invesco Asia Infrastructure INVAIAA LX Mar 2006 2,548 -422 47.8% -7.7% 4.7%
Credit Suisse Infrastructure Fund CSEFINB LX Jun 2007 588 -102 52.1% -2.0% -12.5%
Pictet Timber PFLTMPC LX Sep 2008 94 4 58.1% -7.7% -0.4%
Henderson Horizon Global Technology HENGLTI LX Oct 1996 1,167 167 60.3% -8.2% 7.8%
Partners Group Invest Listed Private Equity PGILPQD LX Sep 2004 155 5 38.5% -6.7% -4.9%
Equity Income DWS Top Dividende DWSTOPD GR Apr 2003 4,443 -87 24.9% 5.9% 5.8%
DWS Invest Top Dividend Europe DWSEDLC LX Aug 2004 372 -68 25.0% -5.1% 0.8%
j.P. Morgan europe Strategic Dividend
Fund
JPMEUAA LX Feb 2005 395 154 40.4% -1.9% 1.9%
Ethical & Sustainable Carnegie worldwide ethical CARETHI LX Dec 2000 381 20.5% 7.7% -1.0%
Pictet european Sustainable equities PTFSEER LX Sep 2002 81 31.0% -0.5% 3.4%
Property Securities Morgan Stanley Asian Property Fund MORAPAI LX Sept 1997 678 -162 42.9% -8.8% 2.3%
Schroder ISF Global Property Securities SCHGPSA LX Oct 2005 384 -6 40.0% -6.5% -1.3%
Fortis Real Estate Securities Europe FORRECC LX Oct 2002 493 -7 52.8% -6.8% 4.0%
iShares DJ U.S. Real Estate Index Fund IYR US Jun 2000 2,728 -73 23.3% 2.8% 3.0%
55
FUNDS PLATFORM
auM
(Mn)
Infows
over last
annual
Return
since
Inception
FIXeD INCOMe
Global Bond Pimco Total Return Bond Fund PIMTRII ID Jan 1999 13,830 1,500 12.1% 4.8% 6.2%
Franklin Global Bond Fund FTGBFAC LX Apr 2006 25,230 3,680 18.8% 3.2% 10.8%
Pimco Diversifed Income PGDIFIA ID Jun 2005 917 -23 26.9% 6.1% 7.3%
DWS Invest Diversifed Fixed Income
Strategy
DWDFXNC LX Jul 2008 109 -51 9.6% -1.7% 3.7%
Corporate Bond BlueBay Investment Grade Bond Fund BBGRABF LX Dec 2004 11,622 452 20.0% 2.6% 5.4%
Schroder ISF Euro Corporate Bond Fund SCHEHIA LX Jun 2000 5,622 -108 16.3% 0.8% 4.5%
Pimco Investment Grade Credit Fund PIMGIIA ID Sep 2003 6,416 -14 19.7% 5.1% 5.5%
BlueBay High Yield Bond Fund BBYHYBF LX Sep 2002 2,697 217 50.4% 4.0% 11.9%
Emerging Markets
Debt
Pimco Emerging Markets Bond PIMEMBI ID Jul 2001 2,603 -907 28.1% 5.3% 12.8%
Templeton Emerging Markets Bond TEMEMFI LX Jul 1991 3,814 624 39.7% 0.6% 3.4%
Schroder Emerging Markets Debt SCHEDAA LX Jan 2000 7,147 597 17.4% 0.4% 8.7%
Bluebay Emerging Market Local Currency
Bond
BLEMLCB LX Dec 2005 1,500 390 29.8% 3.8% 8.8%
Pictet Emerging Local Currency Debt PFEMGDR LX Jun 2006 6,861 2,271 19.7% 2.9% 12.1%
Schroder Asian Bond SCHABDA LX Oct 1998 1,413 13 3.5% 6.6% 6.5%
Infation Linked Bond Schroder ISF Global Infation linked Bond SCHGRRB LX Nov 2003 443 73 6.1% 2.1% 2.7%
PIMCO Global Real Return Fund PIMGRAI ID Sep 2003 1,466 106 15.0% 4.5% 5.5%
Convertible Bond J.P. Morgan Global Convertibles FFGCVBA LX May 2001 2,838 -932 28.5% -4.2% -0.2%
auM
(Mn)
Infows
over last
annual
Return
since
Inception
COMMODITy
Commodity-physical Diapason RICI Fund DIAPASC KY Jan 2005 950 24.0% -10.5% -0.5%
Commodity-equities J.P. Morgan Global Natural Resources FLEGNRE LX Dec 2004 1,913 193 111.4% 9.6% 12.5%
Carmignac Commodities CARCOMM LX Mar 2003 1,128 158 70.3% 2.1% 15.9%
Allianz RCM Rohstoffonds DTROHST GR Jul 1983 1,068 48 102.9% -2.0% 5.3%
BlackRock World Gold Fund MIGGMFI LX Dec 1994 6,892 12 48.5% 7.7% 11.5%
BlackRock World Mining Fund MIGWMFA LX Mar 1997 13,015 -915 103.9% -13.6% 13.5%
BlackRock World Energy Fund MERENER LX Apr 2001 3,736 -404 36.3% -15.0% 7.3%
DWS Invest Global Agribusiness DWSAGLC LX Sep 2006 762 -58 72.7% -12.3% 1.8%
Note: New funds listed are in bold
56
Indices
The Enhanced Value Strategy
aLICIa KeRBRaT
INDICES & STRATEGIES STRUCTURER
The enhanced value Strategy aims to outperform
a reference index in both bullish and bearish
environments. It achieves this by following a systematic
set of rules and combining two simple strategies:
selecting stocks with high dividend yield and then
applying the volatility Control Mechanism. This
combination enhances the risk-adjusted return over the
long-term. The enhanced value Strategy can be applied
to a wide range of indices.
Research suggests that stocks with high dividend yields tend to
outperform low yield stocks as they are likely to be undervalued,
their dividend being high, relative to their stock price.
However, these value stocks suffer from sell offs in the market
and empirical evidence suggests these stocks will also have
an associated higher volatility. The negative effect of higher
volatility can be reduced by applying the Volatility Control
Mechanism, allowing the strategy to beneft from the expected
outperformance with lower overall risk.
The Enhanced Value Strategy is a two stage procedure.
First, an equity sub-index is created using systematic rules to
select the liquid stocks with the highest dividend yield.
Then the Volatility Control Mechanism determines a risk
controlled exposure to the equity sub-index. This mechanism is
described in my previous article Volatility Control Index Family
available in Thinking Ahead June 2010.
57
INDICES
Alicia Kerbrat
0.00
0.50
1.00
1.50
2.00
2.50
2001 2002 2003 2004 2005 2006 2007 2008 200
Reerence Index
Equly subndex
Enhanced Value Index

Chart 1: Performance Comparison from
02 january 2001 31 December 2009
Reerence Index
Equly subndex
Enhanced Value Index

0.00
0.20
0.40
0.60
0.80
1.00
2001 2002 2003 2004 2005 2006 2007 2008 200
Chart 2: 1-Month Realised volatility from
01 February 2001 31 December 2009
Example:
The Enhanced Value Strategy has been applied successfully to
an ethical index. This reference index is composed of around
600 US listed stocks.
1.TheEquitySub-Index:IdentifyValueStocks
The equity sub-index is an annually rebalanced total return
index. Initially, the stocks of the ethical index are screened
using liquidity criteria based on capitalisation and average
daily turnover. Forty stocks with the highest dividend yield are
then selected and assigned equal weight.
2.TheVolatilityControlMechanism
The allocation to the equity sub-index is reviewed daily based
on the ratio between a volatility control parameter (here set
at 15%) and the one month realised volatility of the equity
sub-index. This mechanism systematically tracks the volatility of
the index and dynamically reallocates funds between the equity
sub-index and cash. For instance, if the one month realised
volatility of the equity sub-index is lower than the control
parameter, the capital is fully invested in the sub-equity index.
However, if volatility exceeds the control parameter, exposure
to the equity sub-index is reduced in favour of the money
market account (earning overnight USD Libor).
Reference
Index
equity
Sub-Index
enhanced
value Index
Annualised Realised Volatility 22.30% 21.05% 13.70%
Annualised Rate of Return 0.84% 9.79% 8.32%
Annualised Risk Free Return 2.78% 2.78% 2.78%
Sharpe Ratio
1
-0.0871 0.3332 0.4043
Daily Alpha
2
0.03%
Annualised Alpha 7.59%

Time period from 02/01/2001 to 31/12/2009
The annualised returns and alpha are respectively the compounded daily returns and
alpha over 252 trading days.
1
The Sharpe ratio is a measure of the excess return (or Risk Premium) per unit of risk
in an investment asset or a trading strategy
2
The alpha is the average daily outperformance of the Enhanced Value Index compared to
the Reference Index
58
Strategy Description Performance BBG ticker
Strategy Benchmark**
Equity
Europe Equity Volatility The Europe Equity Volatility Index represents a systematic
investment strategy which aims to exploit the Implied Volatility
Bias on the SX5E Index.
Weekly:
3 months:
3M Volatility*:
0.00%
-12.01%
28.10%
-1.33%
-6.86%
33.74%
CBKIEVI1
Index
US Equity Volatility The US Equity Volatility Index represents a systematic investment
strategy which aims to exploit the Implied Volatility Bias on the
SPX Index.
Weekly:
3 months:
3M Volatility*:
0.00%
-16.22%
31.25%
-1.21%
6.04%
23.96%
CBKIEVI2
Index
Europe CORE A rules-based investment strategy that aims to generate absolute
returns through a proprietary sector allocation model that
analyses certain macroeconomic variables in the Eurozone
and invests in sectors within the Eurozone that are expected
to outperform others.
Weekly:
3 months:
3M Volatility*:
-1.32%
-16.68%
36.79%
-1.33%
-6.86%
33.74%
CBKICORE
Index
Europe Balanced
Premia
A rules-based investment strategy that aims to provide investors
with a stable low volatility return in both rising and falling
markets by monitoring market trends.
Weekly:
3 months:
3M Volatility*:
0.24%
-5.42%
14.74%
-1.33%
-6.86%
33.74%
CBKIEBP
Index
Europe Beta Plus A systematic investment strategy that aims to provide investors
with enhanced participation in rising markets whilst taking no
additional downside market risk.
Weekly:
3 months:
3M Volatility*:
-1.36%
-3.72%
36.61%
-1.33%
-6.86%
33.74%
CBKIEBEP
Index
Europe Defensive
Premia
A systematic investment strategy that aims to provide investors
with a stable low volatility return that has no exposure to equity
market downside.
Weekly:
3 months:
3M Volatility*:
0.05%
0.20%
3.28%
-1.33%
-6.86%
33.74%
CBKIEDP
Index
Europe Long Short A rules-based investment strategy that aims to provide investors
with positive performance in both rising and falling markets by
monitoring market trends.
Weekly:
3 months:
3M Volatility*:
0.31%
-7.20%
17.77%
-1.33%
-6.86%
33.74%
CBKIELS
Index
Europe Premia A systematic investment strategy that represents the value of a
portfolio of one or more virtual reverse convertible bonds on the
SX5E Index.
Weekly:
3 months:
3M Volatility*:
0.21%
-6.57%
25.97%
-1.33%
-6.86%
33.74%
CBKIEP
Index
UK Balanced Premia A rules-based investment strategy that aims to provide investors
with a stable low volatility return in both rising and falling
markets by monitoring market trends.
Weekly:
3 months:
3M Volatility*:
-0.11%
-7.23%
15.35%
0.50%
-8.39%
21.93%
CBKIUBP
Index
UK Beta Plus A systematic investment strategy that aims to provide investors
with enhanced participation in rising markets whilst taking no
additional downside market risk.
Weekly:
3 months:
3M Volatility*:
0.70%
-7.41%
22.30%
0.50%
-8.39%
21.93%
CBKIUBEP
Index
UK Defensive Premia A systematic investment strategy that aims to provide investors
with a stable low volatility return that has no exposure to equity
market downside.
Weekly:
3 months:
3M Volatility*:
-0.02%
0.99%
1.39%
0.50%
-8.39%
21.93%
CBKIUDP
Index
Strategies Update
59
INDICES
UK Long Short A rules-based investment strategy that aims to provide investors
with positive performance in both rising and falling markets by
monitoring market trends.
Weekly:
3 months:
3M Volatility*:
-0.17%
-10.38%
18.73%
0.50%
-8.39%
21.93%
CBKIULS
Index
UK Premia A systematic investment strategy that represents the value of a
portfolio of one or more virtual reverse convertible bonds on the
FTSE 100 Index.
Weekly:
3 months:
3M Volatility*:
0.06%
-7.39%
19.07%
0.50%
-8.39%
21.93%
CBKIUP
Index
Commodity
CBCI Excess Return
(EUR)
A systematic investment strategy that allows investors to track the
return of various physically-settled commodity futures contracts.
The CBCI methodology inverses the effects of the roll losses
in sideways contango markets. The Index represents a broad
commodity exposure across energy, base metals, agricultural and
precious metal markets.
Weekly:
3 months:
3M Volatility*:
-0.77%
0.18%
16.89%
0.18%
-5.31%
22.56%
CBCIEUR
Index
CBCI Excess Return
(USD)
A systematic investment strategy that allows investors to track the
return of various physically-settled commodity futures contracts.
The CBCI methodology inverses the effects of the roll losses
in sideways contango markets. The Index represents a broad
commodity exposure across energy, base metals, agricultural and
precious metal markets.
Weekly:
3 months:
3M Volatility*:
-0.76%
0.49%
16.37%
0.18%
-5.31%
22.56%
CBCIUSD
Index
CBCI Long Short Excess
Return (EUR)
A rules-based investment strategy that invests in a basket of the
four sectoral CBCI indices (precious metals, base metals, energy
and agriculture). Each allocation is rebalanced as frequently
as once per week based on purely quantitative momentum and
volatility indicators.
Weekly:
3 months:
3M Volatility*:
1.53%
-1.19%
19.66%
-0.77%
0.18%
16.89%
CBCILSEP
Index
CBCI Long Short Excess
Return (USD)
Weekly:
3 months:
3M Volatility*:
1.45%
-0.22%
19.79%
-0.76%
0.49%
16.37%
CBCILSUP
Index
CBCI Long Short Total
Return (EUR)
Weekly:
3 months:
3M Volatility*:
1.46%
-1.08%
19.58%
-0.77%
0.18%
16.89%
CBCILSET
Index
* Annualised
** Benchmarks: Eurostoxx 50 Index for Europe Equity Volatility, Europe CORE, Europe Balanced Premia, Europe Beta Plus, Europe Defensive Premia, Europe Long Short and Europe Premia;
FTSE100 Index for UK Balanced Premia, UK Beta Plus, UK Defensive Premia, UK Long Short and UK Premia; S&P 500 Index for US Equity Volatility; S&P GSCI Commodity Index for CBCI
Excess Return (EUR) and CBCI Excess Return (USD); CBCI Excess Return (EUR) for CBCI Long Short (EUR) and CBCI Total Return (EUR); CBCI Excess Return (USD) for CBCI Long Short (USD)
60
Asia Focus
China: Infation
risks to the upside
aShLey DavIeS
EMERGING ASIA SENIOR ECONOMIST
There have been confusing signs for China on
the infation front in recent months. Given the
different forces acting on infation we argue
for relatively moderate infation over 2010
and 2011. However, the risks to us lie
much more strongly on the upside than
the downside. A wage infation-spiral,
should it happen, could lead to a fast
tracking of policy reform, including
the yuan.
61
ASIA FOCUS
MONey SUPPLy GROwTh SUGGeSTS
ONGOING INFLaTION RISKS
Milton Friedman famously said that infation is always and
everywhere a monetary phenomenon. Certainly in the case of
China over the past decade an increase in money supply growth
has tended to precede a pickup in infation. This is demonstrated
in Chart 1. M1 grew rapidly in 2009 as banks were instructed
by the authorities to lend freely in an effort to stimulate the
economy. They succeeded and in 2010 the policy focus has been
on restricting credit growth and accordingly M1 growth has
moderated again. Our reading is that even with the moderation
in M1 growth, the surge in lending last year is suffciently strong
to keep infation risks tilted to the upside.
CyCLICaL PReSSUReS CaP INFLaTION FOR NOw
Chinas economic growth surge has been a consequence of
government stimulus efforts, with real GDP growth peaking at
11.9% year-on-year as of Q1 this year. The economy slowed
to 10.3% year-on-year in Q2 and leading indicators point to a
further cooling. Our base case assumption is that the economy
grows at an annualised rate of 8% over H2, which should leave
overall growth for 2010 at 10.5%. A cyclical cooling in the
economy should help to prevent the rapid M1 growth of last year
from translating into an outbreak in infation this year.
RISING waGeS IN ChINa IS aN IMPORTaNT TReND
For years, wages in China have not kept up growth in the
nominal GDP. Research by the US National Bureau of Statistics
calculates that hourly compensation costs for manufacturing
employees in China grew at an average 8% between 2002 and
2006. This is well below the average nominal GDP growth rate
over the same time period of 15.8%.
An important development this year has been an increase in
labour unrest among Chinas low-wage manufacturing workers.
In numerous case strikes have resulted in signifcant increases in
wages over and above nominal GDP growth. It seems that Chinese
workers are fnally fnding bargaining power. This may refect a
reduction in the wage gap between coastal and inland areas. If
that is the case, then the era of virtually unlimited labour prepared
to work on subsistence wages may fnally be over for China.
Long-term demographics trends, as a consequence of Chinas
one-child policy introduced in 1978, could sustain the trend of
higher wage growth. According to one estimate, the number of
15-24 year olds in China will fall by one-third, from 225 million
today to 150 million in 2022.
The initial global infationary impact is probably limited for now.
The labour share of value in many of Chinas exports is fairly low
and as a consequence even a doubling of manufacturing wages
in China would have a limited impact on the fnal product price
in western markets.
0
5
10
15
20
25
30
35
40
45
2002 2004 2006 2008 2010
4
2
0
2
4
6
8
10
M1 Year on Year % versus CPI nalon Year on Year %
M1 Y/Y lSI
CPI Y/Y RSI

Chart 1: Growth in money supply has been excessive
Source: CEIC, Commerzbank Corporates & Markets
Quarlerly real CDP Year on Year Crey bars or H2 2010 orecaslsI
0
2
4
6
8
10
12
14
Dec 07 1un 08 Dec 08 1un 0 Dec 0 1un 10 Dec 10
% YoYI
lorecasls
Chart 2: a slowing economy eases near-term infation risks
Average hourly compensalon cosls o manuaclurng employees, 2006
0 20 40 60 80 100 120 140
Unled Slales
Chna
Mexco
1apan
Phlppnes
Easl Asa excludng 1apan
Euro area
Chart 3: Plenty of scope for higher wages in China
62
However, the infationary impact for China could be more
important. Rising wages for rural migrant workers will lead to
higher wages for agricultural workers. Accordingly, Chinas cost
of living will be under broad-based pressure to rise.
ChINa LaCKS POLICy FLeXIBILITy TO
TaCKLe INFLaTION
Chinas lack of an independent monetary policy means that it
is vulnerable to a damaging wage-infation spiral. The PBoC is
restricted in its ability to raise interest rates due to its managed
exchange rate policy. Higher interest rates in China would lead
to a pickup in capital infows attempting to arbitrage widening
Chinese interest rate differentials over foreign interest rates.
The PBoC then has to intervene to sell yuan to prevent the
currency from appreciating too rapidly. This in turn increases
domestic money supply, short-circuiting the tightening in
monetary policy.
As a consequence China is unable to frmly anchor infation
expectations. It is not inconceivable that workers could demand
higher wages in anticipation of a higher cost of living. Australia
for example in the early 1980s suffered from a damaging wage-
infation spiral. The solution was the foating of the Australian
dollar a couple of years later in 1983.
CONCLUDING ReMaRKS
It should hopefully be clear from the above that the outlook
for infation in China is complex and the task facing the PBoC
in managing infation is also very complex. For now we target
China CPI infation at 3.2% in 2010 and 3.1% in 2011.
However, we will monitor the wage developments with interest.
A wage-infation spiral would likely lead to a fast-tracking
of yuan reform.
Change n lX Reserves versus USDCNY spol
O Change n lX Reserves lSI
USDCNY RSI
60
40
20
0
20
40
60
80
100
2006 2007 2008 200 2010
USDbnI USDCNYI
6.0
6.5
7.0
7.5
8.0
8.5
.0
Chart 4: The PBoC is restricted in its ability to raise interest
rates due to the CNy regime
63
Growth vs. Infation
SaN TaM
EXOTIC EQUITY DERIVATIVES STRUCTURER, ASIA
The Chinese economy is currently in a short period of High Growth; Low Infation mode.
Some are expecting it to move towards a Low Growth; High Infation phase. However, fgures
show that the economy remains very healthy and infation is steadily going up, under the close
scrutiny of the Central Government. With its strong export and solid consumption growth, the
general public is optimistic about the Chinese economy and it is expected to maintain a high
growth rate.
According to the China Quarterly Update, released in June 2010
by the World Bank, Chinas economy has continued to grow
robustly. Infation has picked up but core infation remains
low. However, soaring property prices triggered tough
property-specifc measures and the pressure of increasing wages
may lead to an upward trend in infation and slow down the
economy. Even though some signs of softening have appeared,
the economic outlook remains favourable. The GDP growth rates
estimated by the World Bank were 9.5% in 2010 and 8.5%
in 2011.
It is diffcult to analyse the Chinese economy as some fgures
show the economy is healthy and booming while, on the
other hand, some economic data show it is slowing down.
For example, the PMI in June 2010 dropped from 53.9 in May to
52.1 which suggests the manufacturing economy is shrinking.
However, the export fgure in June 2010 just reached a record
high of USD137.4bn and the China Shipping Container Lines
recently indicated an increase in fees because of the shortage
of cargoes. All this shows the economy is booming rapidly. One
of the explanations to this dilemma is that the raw materials
shipment is shrinking while the export shipment remains strong.
One of the major factors that affects the Chinese economy
is the infation trend. Infation on consumables has gone up
because of the higher prices of food but core infation is likely
to remain contained. The expansionary monetary stance since
the Financial Crisis has increased the infation expectations.
High-food prices and rental charges are exerting some upward
price pressure. However, through the absence of upward
pressure on commodity and food prices on the global scale,
the high food prices in China are not likely to be sustained.
Also, the increase in wages at the lower end of the income
0
2
4
6
8
10
12
14
M
a
r

0
0
M
a
r

0
1
M
a
r

0
2
M
a
r

0
3
M
a
r

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4
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a
r

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a
r

0
6
M
a
r

0
7
M
a
r

0
8
M
a
r

0
M
a
r

1
0
%
Chart 1: China GDP Constant Price year on year
Source: Bloomberg
0
20
40
60
80
100
120
140
160
bllon USD
M
a
r

0
0
M
a
r

0
1
M
a
r

0
2
M
a
r

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a
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a
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a
r

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8
M
a
r

0
M
a
r

1
0
Chart 2: China export Trade
Source: Bloomberg
64
distribution may also affect infation. However, given the
fexibility and track record of Chinas overall manufacturing
sector in absorbing wage increases and keeping unit labour cost
growth down, the rise in wages is unlikely to set in motion a
wage-infation spiral.
Household Consumption growth has remained solid in line
with a favourable labour market. A strong labour market since
2009 has partly fueled the recovery of consumer confdence
and caused the continued consumer spending growth.
Employment recovered on the back of strong domestic economy.
Consumption is boosted by strong sales of cars (accounting
for around one-tenth of total retail sales) and housing, with
the latter driving the sales of furniture, home appliances, and
building materials. Shifting the view from domestic to export,
export volumes have recovered rapidly in the past 12 months,
refecting improved global demand and further market share
gains. The year-on year export growth jumped from -26% in
May 2009 to 44% in June 2010. Market share gains confrmed
that Chinas exporters continued to boost price competitiveness,
upgrade products, and enter new markets. In fact, proft margins
in sectors that export a large share of output such as textiles and
electronics now exceed pre-crisis levels.
In China, growth is likely to ease somewhat but remains at
a high rate. Market expects the growth in 2010 to be less
investment-driven and to beneft from more favourable external
trade. Governmentled investment is decelerating after 2009
but has been offset by the strong real estate investment.
The continued growth in consumption as well as net external
trades, together with contained infation, strongly support the
expectation of continued growth in Chinas economy.
30
35
40
45
50
55
60
65
1
a
n

0
5
A
p
r

0
5
1
u
l

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U
c
l

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1
a
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p
r

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A
p
r

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8
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c
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8
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a
n

0
A
p
r

0
1
u
l

0
U
c
l

0
1
a
n

1
0
A
p
r

1
0
Chart 3: China Manufacturing PMI
Source: Bloomberg
40
30
20
10
0
10
20
30
40
50
60
%
M
a
r

0
0
S
e
p

0
0
M
a
r

0
1
S
e
p

0
1
M
a
r

0
2
S
e
p

0
2
M
a
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S
e
p

0
3
M
a
r

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S
e
p

0
4
M
a
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S
e
p

0
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M
a
r

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S
e
p

0
6
M
a
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S
e
p

0
7
M
a
r

0
8
S
e
p

0
8
M
a
r

0
S
e
p

0
M
a
r

1
0
Chart 4: China export Trade year on year
Source: Bloomberg
For additional information on the product features and key risks, please contact your sales advisor or refer to the contacts on page 66.
5 Year Volatility Target
on HSCEI
Key features
95% Principal Guaranteed
Target Volatility = 10%
Conditional Annual Coupon = 5%
Unlimited upside paid at Maturity
Coupon Barrier 105%
Participation 100%
USD Currency
PRODUCT DeSCRIPTION
This 5 year USD denominated note is linked to Hang Seng China
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above 105% of its initial level and the Index level will decrease
by the same amount of the coupon. At maturity, the fnal payoff
will be the Floor amount plus the upside of the Index (In-the-
money Call).
China is booming and playing an important role in the global

economy
HSCEI Index is a well diversifed index covering 40 Chinese

corporates across 10 different sectors
HSCEI has signifcantly outperformed the developed markets

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66
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Infation: What lies ahead?

What you should know

According to the Nobel Prize laureate Milton Friedman

THINKING AHEAD, AUGUST 2010 | ISSUE 17

Nel debl/Equly %, rhsI

Nel debl/EBITDA %, rhsI

12M Clobal equly und ows % o AuMI

12M HY bond und ows % o AuM, rhsI

Elasticia In October 2010, NGM will launch a new trading

Finland and Norway With the launch of Elasticia, NDX will

ETPs NDX is also in the process of launching a segment for

EBIT mI, rhs

12m wd. P/E

12m wd. earnngs March 2002 = 100I

o busness expeclalons, rhs

12m wd. P/E

12m wd. earnngs leb 2008 = 100I

o busness expeclalons, rhs

European Barrier: 55%

90% capital guaranteed

Barrier: 60% (European)

Annual coupon: 150% of the European infation rate

Minimum guaranteed coupon: 5% pa

Strike + Max (SX5E Performance Strike, 0)

Strike = 100% + 2 * Infation Performance

Max (Infation Linked Strike, SX5E Performance)

Infation Linked Strike = 100% + 2 * Infation Performance

Min (135%, Max (90%, SX5E Performance))

Min (135%, Max (90%, SX5E Performance,

Max (0, Infation Index SX5E Performance)

E. Diewert, Harmonized Indexes of Consumer Prices: Their

W. Lane and M. L. Schmidt, Comparing U.S. and European

Due to recent uncertainties in the Equity market, clients have

Potential 10% Annual Coupon

Vega indicates how much the value of a option changes by if

Med. Steel (USD/mt), rs

100% capital protected

Participation on the upside performance

Rebate of 5% (EUR)/4% (USD) if both

Gold price (USD/oz.), r

Good representation and commodity correlation with price

Since commodity futures require no cash investment, there is

Higher commodity volatility and growth means that a

Chart 1: US Consumer Price Index (CPI) against spot

Breakeven ination rate

Capital guaranteed, low-cost hedging product for European

100% of the portfolio is hedged using only 25% of portfolio

RiskEffcient methodology takes advantage of commodity

Exposure to agricultural (20%), energy (40%) and precious

Available as capital guaranteed note at costs lower than

HICP Eurozone Index

CB RiskEfcient Index EUR

At least one semi-fnal goes into extra time (2/1) Lost

At least one African Nation in the Quarterfnals (2/1) won Ghana

Enhanced Value Index

Enhanced Value Index

CPI Y/Y RSI

95% Principal Guaranteed

Target Volatility = 10%

Conditional Annual Coupon = 5%

Unlimited upside paid at Maturity

Coupon Barrier 105%