Investment Management Using Options in a TAA Refl ections Process No 1, 1996

FQ Perspective TODD MILLER CFA Associate Director ROBERT D. ARNOTT President, Chief Executive Offi cer

TAA REVIEW Exhibit 1 U.S. TAA Value-Added 70/30 Benchmark To date we have written numerous monographs and Rolling 12 Month Value-Added papers exploring the attributes of a quantitative tactical asset allocation process. Throughout these publications, 40 Dom TAA we have identified a disciplined approach to asset 30 allocation, which rests on four basic assumptions:

20 • Long-term returns for various asset classes are directly observable in the markets. 10 12 Month Value-Added 0 • These returns reflect the consensus view of all market participants on the relative attractiveness of -10 asset classes. 6901 7101 7301 7501 7701 7901 8101 8301 8501 8701 8901 9101 9301 9501 Simulated results 6801-9604 • These returns tend to exhibit a normal or “equilibrium” level, relative to one another. this occur? Should we expect TAA to add value evenly and consistently as we expect the best equity managers • As future returns stray from this normal to do, for example? equilibrium, when measured against investment alternatives, eventually capital flows into the out- To understand why such episodic results are derived of-favor market, and thereby market forces pull the from TAA, it may be useful to think more precisely markets back into line. about what TAA attempts to do. Principally, tactical asset allocation aims to tilt the asset mix towards those These four assumptions provide the foundation for asset classes which are likely to provide unusually our quantitative modeling of world financial markets favorable near-term returns and away from those which in our tactical asset allocation process, and allow us to are likely to significantly underperform in the near- respond opportunistically to the changing patterns of term. We know that stocks, on average, have tended to reward in the markets. It does so by shifting the asset outperform bonds by a few hundred basis points per mix toward the market priced to offer superior near- annum (e.g., 330 basis points per annum in the US term rewards. Tactical asset allocation strategies sell over the last 33 years). This fact, however, has already after a market rally and buy after a decline. Therefore, been taken into account in the formation of the long- it is inherently contrarian and affords one the term policy mix, so the aim of TAA is not to tilt the confidence to invest more aggressively in an out of policy mix towards stocks to merely take advantage of favor asset class. In short, tactical asset allocation: the long-term superior performance of stocks over bonds. In fact, a TAA strategy tends to leave the • Objectively measures prospective returns. average asset mix unchanged relative to the long-term policy mix over the course of a typical market cycle. • Has a disciplined framework to provide confidence to invest in out-of-favor, hence contrarian assets. So, if it is not the average differential return between asset classes which rewards TAA, then what does? It is FQ PERSPECTIVE FQ • Takes advantage of the liquidity and opportunity the impressive variance in these relative returns which provided by investors favoring the comfortable motivates the tactical asset mix shifts. Stock and bond 1 asset class. prices move together more than they diverge, but when they diverge, the relative performance has often been We have long made a point of bringing to light the dramatic. In 1980, for instance, US equities episodic nature of value added associated with tactical outperformed US bonds by 36%, while we witnessed asset allocation. Exhibit 1 will show that TAA’s value bonds outperforming stocks in 1974 by 32%! Such added tends to arrive in episodic bursts. Why should return differentials dwarf the 3-4% long-term average FIRSTQUADRANT.COM

Past and simulated performance is no guarantee of future results. Potential for profi t is accompanied by possibility of loss. 2 FQ PERSPECTIVE FIRSTQUADRANT.COM profits whenthreeconditionsaremet t t u drive fairlyvaluedassetsawayfromfairvalue,orover t v TAA models from fairvalue(e.g.,sharpchangesinshort-termrates) forces whichworkedtopushfairlyvaluedassetsawa l n t between stockandbondreturnshavehistoricallybee i divergence where TAA playsitsmostsignificant rol differential, anditisexactlytheseepisodesof h n theoverallfundprogram he morepromisingassetclasses hi aking intoaccountthemarketforceswhichwilleithe ow relativetobondyields),ormeasurablemarket oticeably fromhistoricalnorms(e.g.,stockyieldsver ndervalued assetsbacktowardsfairvalue.Ultimatel alue deviatesfromitsnorm,whilesimultaneousl e • To statetheobvious, TAA canonlyprovide larg I

12 Month Value-Added s mportantly, theseepisodesofsignificant divergenc r -10 10 20 30 40 tran 9170 3170 7170 1180 5180 9190 319501 9301 9101 8901 8701 8501 8301 8101 7901 7701 7501 7301 7101 6901 0 allocation whenassetclassesoffer similarreturns. c There mustbesubstantialdivergence amongasset esu la ss lt s r lat Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process o e es f t , u therefore int e rn ith s. o e

ar r O ne cannotaddvaluefrom asse e Simulated results 6801-9604 results Simulated lati , eco seektodeterminewhenrelativ o A Diff.Vol Dom TAA ve mm .

v e al n TAA ections, No1,1996 u ded . ati o mix Correlation: 0.76 Correlation: n : V s alue-Added vs. Asset Return Differential

w w hi hi c h c h fa d iff 0 5 10 vo e r Exhi Average Differential Volatility ed r y y y n y e e e e s r / t .

Annual Value-Added (rolling) b -10 10 15 20 25 30 35 40 -5 it 0 5 o periods ofundifferentiated assetreturns(asindicated experience ofourowntacticalprograms.Durin l t m be i m and bondsaresimilar? Virtually bydefinition, no period hasnotexisted TAA hascapturedthegreatestaddedvalue. Sucha periods characterizedbylarge differential returnswher o differential ismeasured 12345678 osses. Exhibit2showsthatthishasbeen actical shiftswillyieldneithersignificantgainsno n amark n therightaxiswheremonthlyaverageabsolut n average,yieldedasmalleralpha.Ithasbeenth 2 arket forcespromisetodisturbthisequilibrium,the eaningful valuewillbeaddedthroughtacticalshift So, whatshouldweexpectwhenthereturnstostock Thus, whenassetsarefairlyvaluedandnosignificant • • t wee The TAA disciplinemust,ofcourse,becorrect! The TAA disciplinemustsuggest(inadvance of “ m t his divergence) thatmarkets aresufficientl bet”, favoring onemarket over another ispriced relative tooneanothermeritalarg n a e sse t w t h c Simulated Results1/68-3/96 la e r sses. e Annual Dispersion(rolling) littl s e in theUSmarket

) , tacticalassetallocationhas, o r n o

d iff e r e ntial r t sincethelate , infact e . t u rn e , xi 0 5 10 15 20 th s t y n g e e e e e s s s r 3 FQ PERSPECTIVE FIRSTQUADRANT.COM t o performance. Isthereanythingthatcanbedonei v episodic natureof TAA istypified byshortbursts of ari 1980’s. But,outsideoftheUS,suchopportunitieshav S E while notdetractingfrom TAA’s abilitytoaddvalu t t n positions, bothlongandshort,wecreateamarket desired objectives.Bylayeringputandcalloptio TAA profits during themarketturbulencethattypicallyleadsto t during theturbulent market environments. This mean c would betodesignaprogramwhich k o portfolio whosecharacteristicsshouldachievethes we areabletostructurevariousoptionpositionsina hese flatperiods? We thinkso ypically difficult market environments for TAA hat theenhancementprogrammustnotlosemuch rendless periodsofthemarketcycle,whichar onsistently addvalueduringthecalmmarketperiods, rder toimprovetheprospectsofaddingvaluedurin ey objectivestokeepinmind f enhancingabaseinvestmentprogram,therearetwo eutral portfoliowhichisdesignedtoprofitduringth alue added,followedbylongerperiodsofflat TRATE N So whatcananinvestment managerdo? Th B For a TAA basedinvestment strategy, theobjectiv Theenhancementprogrammustnotrestrictth 2. Theenhancementprogrammustprovidevalue- 1. W se HA y usingthenaturalpropertiesofoptioncontracts, hen designingamethodologywhichhastheintent n an base strategy’s abilitytoprofit produce amorestablecompositevalue-added added whenthebasestrategydoesnot,soasto NC d G Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process ha I Y NG . ve

A bee B n r ASE ew

ar I NV ded. E : . S ections, No1,1996 TME . N T . . g n n e e e e e e e e s T O o c v i s s based onchangesintheunderlyingmarketcondition t “ are commonlyreferredtobytheGreekterms:“Delta”, A o s o u r t o o s m 0 to100,withacalloptiondeltarepresentinglon r o price relationship,deltacanalsobeviewedasa s price sensitivitiesisrequiredinordertounderstandth ntroduction toeachtermanditsaffect ontheoption erms willexplainhowanoptionsvaluechang han thatofanoptionwhichisin-the-moneyand elationship forcallandputoptions.Deltarangesfro pecific option)andinterestrates.Listedbelowisa ensitivity oftheoptionwillincrease.Becausethi tructure ofanoptionportfolioconstructedwithth hort marketexposure.Ingeneral,anatthemone eflects thelessenedinfluencechangesinth uch as:price,volatility, timetoexpiration (ofth Gamma”, “Theta”,“Kappa”,and“Rho”.Eachofthes hange inthepriceofanoptiongivenachangepric al bjective ofprofitingduringspecificmarketconditions f theunderlyingasset. As deltaincreases,thepric ut-of-the-money option nderlying marketpricewillhaveontheofa ption whichisout-of-the-moneywillalsobelowe ption hasamarket exposure of50%. The deltaofa ptions marketexposure.Exhibit3illustratesthi descriptionofthesecharacteristicsandsensitivitie arket exposureandputoptionsdeltarepresentin U A PTI ue. Market Exposure D -100% 100% T -50% basicunderstandingofoptioncharacteristicsand 50% 0% e O 7 8 9 0 1 2 630 620 610 600 590 570 580 lta ON RIAL - The deltaofanoptionreflectstheexpected

C H ARA C D Strike Price=600 TERI e S&P 500Option lta Exhi . vs S b TI . Pri it CS 3 ce - A S HO RT (S&P Level) Put Delta Call Data m n n n y g g n e e e e e e e e s s s s s r . 4 FQ PERSPECTIVE FIRSTQUADRANT.COM c o i l t explains whyanoptionsdeltaismoresensitivewhe m becomes moresensitivetounderlyingpric c u anticipated changeindelta,foragiventh i l t c a 50deltaoption. The premiumona90deltaoption i delta option,thereislessoptionpremiumtodecayvs decay ofa10deltaor90option. With a1 t t o i as theta. The rateoftimepremiumdecayforanoptio t n l expires, itiswortheitherits“intrinsicvalue”(market i he optionis“at-the-money”.Optionswhichhavever s duetothehighdegreeof“timepremium”whichis ess “timepremium”todecayvs.the50deltaoption ime decayofa50deltaoptionishigherthanthetim he optionsdelta,theresultisalso“bellshaped”. Th s notconstant,withthedecayrateacceleratingasth he optionduesolelytothepassageoftime,isknow evel lessstrikingprice)ornothing, ncluded inthepricingofanoption:onceoptio he-money statusoftheoption.Consequently, therei ncremental underlyingpricechanges,whereasa ow orveryhighdeltasarenotassensitiveto hanges intheunderlyingpricemovement hange”, asgammaincreases,thedeltaofoptio omposed primarilyofintrinsicvalueduetothein- ption withadeltaof50willbemoresusceptibleto ption approachesexpiration. When comparingthetato nderlying marketprice.Definedasthe“rateof o longerchange ovements. The “bell”shapeofgamma(Exhibit4 G Th

Gamma amma 0.00 0.50 1.00 1.50 2.00 2.50 e t 7 8 9 0 1 2 630 620 610 600 590 580 570 a -Optionsareknownas“wastingassets”,this Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process -Gammaisthetermusedtoexplainth . G The decayofvalue over thelifeof amma vs.Price Strike Price=600 Exhi S&P 500Option b it 4 ections, No1,1996 a n d

t h . at

value (S&P Level) Gamma

ca . n n n n n n 0 y n e e e e e e s ) s . due totheincreasingeffect ofthetaonoptionsasthe expiration thanoptionswithashorttermtoexpiration, m t v s approach expiration v i pricing ofderivativesecuritiesincreases,thusth i r put andcalloptionsdifferently duetotheeffect interest i t he priceofanoptionwillincrease. Volatility willhav ncrease inthevalueofcalloptionsanddecreasei nterest ratesincrease,thecostofcarryelementinth nterest rates.Changesininterestrateswillinfluenc he priceoftheoptionwithrespecttochangesi ates have inthepricingofderivative securities. A ensitivity ofanoptionspricegivenachangeinth olatility oftheunderlyingasset. As volatility increases, alue ofputoptions ore affect onanoptionwithalongertermto R Option Price 10 12 14 16 18

h Option Price 0 2 4 6 8 0 1 2 3 4 5 6 05 03 01 0 10 20 30 40 50 60 o %1%1%1%1%1%15% 14% 13% 12% 11% 10% 9% - The rhoofan optionistherateofchangei The - -Thekappaofanoptionreflectsth K Theta ofanOption appa ofanOption (Time toExpiration) . . Exhi Exhi Volatility b b it it 5 6 Theta vs.Time n n n e e y e e e e s 5 FQ PERSPECTIVE FIRSTQUADRANT.COM W “ t program isreducedwhenmarketsareturbulent,it t o n from ourcombinedoptionpositionsas“market co t exposures areusedtoidentifyandmanagetherisksof positions toreachadesiredobjective. Further, thes exposures, themanageristhenabletoconstructoptio portfolio. Byactivelymonitoringtheseportfolio g i t o a portfolioofoptions,inordertocalculatethe“net portfolio isnearzero.Sincetheprofitabilityofthi he degreethatthenetmarketexposureoftotal he portfolio,givenchangesintheunderlyingmarket nvestment managerisabletocalculatethenetdelta, he weightedsumforeachoptionintheportfolio,th hen importanttohaveanestablisheddefinitionof market neutral”inordertomeetourobjectives ption positionintheportfoliowilloffset theotherto amma, theta,kappa,andrhoexposuresfortheentir ption characteristic”fortheentireportfolio.Bytakin eutral”. This isbecausethemarket exposures ofeach • • W n HAT

d Option Price 0 1 2 3 4 5 6 e define theportfoliocharacteristicwhichresult A directionallybasedoptionportfolioismor Consistent profitsduringcalmmarketperiod n s portfolio c iti %4 %6 7% 6% 5% 4% 3% usceptible toadversemarketmovesthana annot beachievedinadirectionallybasedoptio eutral optionstructure o

n I s. Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process S M . A RKET R ho ofanOption Interest Rates

N E . U TRAL ections, No1,1996 ? Call Option Put Option : n g n e e e e s s s world” scenario-thestrikepricesofputandcall 0%, ormarketneutral. This would representa“perfect exposures ofeachoptionpositiontogetherweca leve o c t o example, thedeltaexposureofshortcallandput c position intheportfolioislistedalongwithth o h he longoptionpositions.Byaddingthedelta ompute thenetmarketexposureofportfolioas orresponding deltaandmarketexposure.Inthi ption basedprogram.Inthetablebeloweachoptio elp illustratetheconceptofmarketneutralwithinthi ptions offset eachother, asdothedeltaexposure of ptions soldareequidistantfromtheactualmarket The followingExhibits(8and9)aredesignedto The OptionPortfolio(moretypicalsituation) Net Market Exposure = 0% = Exposure Market Net hr 8 u pin()2 +25% -25% +20% 25 Long 575PutOption(+) 25 Short 580PutOption(-) 20 Short 620CallOption(-) Long 625CallOption(+) Net Market Exposure = -5% = Exposure Market Net hr 8 u pin()1 +18% -33% +26% 18 Long 575PutOption(+) 33 Short 580PutOption(-) 26 Short 620CallOption(-) Long 625CallOption(+) S&P 500 Level = 600 = Level 500 S&P l S&P 500 Level = 610 = Level 500 S&P "Market Neutral." This portfoliohas0%marketexposure,oris acceptably closeto"MarketNeutral." This portfoliohas-5%marketexposure, o f 600 The OptionPortfolio(perfectworld) . W The OptionPortfoli hat isMarket Exhi Exhibit b Delta Delta it 8 5-15% 15 0-20% 20 9 N eutral? Exposure Exposure Market o Market n n e s s 6 FQ PERSPECTIVE FIRSTQUADRANT.COM will changegivenchangesintheunderlyingmarket accelerate. This increaseinexposure levels isadirect exposure isduetothedifferent gamma relationshipsof leve es o r c program equalsrisk,andincreasingexposurelevel o r t s flat astheunderlyingmarketoscillatesbetweenth l s will entertheportfolio u exposures willappearintheportfolio. As th u t u n The netmarketexposureoftheportfoliochangeswith also changes,decreasingasthemarketlevelincreases m m t m his casefrom600to610.Notehowthedelta evels. Notehowmarketexposuresremainrelativel he optionsintheportfolio.Consequently, asth esult inperiodsofunderperformance. At somestage, hese strikeprices,marketexposurebeginsto esult ofthechanginggammarelationshipsth trike pricessold. As theunderlyingmarketapproache how themarketexposureofoptionportfolio ounter todirectionalmovesoftheunderlyingca nderlying marketdecreases,positiveexposur nderlying market increases. This changeinnetmarket egative marketexposureenteringtheportfolioasth f course,onemustreadjustoptionpositionstore- nderlying marketlevelsincrease,negative ptions intheportfolio.Marketexposurethi arket level increases. The deltaoftheputoption arket exposure)ofthecalloptionsincreasesasth arket exposureastheunderlyingmarketmoves,i ta This nexttableisdesignedtoshowthechangesi So whatismarketneutral?Exhibit10designedto -100% +100% b l s li ar

Market Exposure s Short 580PutOption(-) Long 575PutOption(+) h th e

Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process e Monthly Returnswithin+/-5 x Market ExposureofOptionStrategy e Option mark ceeded. Strike Long PUT 575 Option Strike Short PUT 580 e We define "Market Neutral" "Market define We t n 9 0 610 600 590 eu within this area. this within . tral b Short Call620Option(-) Long Call625Option(+) an ections, No1,1996 d Option Strike CALL Short 620

w h Option Strike CALL Long e 625 n th ese % Market Level thr es ( h and o l n n d y n e e e e e e e s s s s . O delta neutralstructure(marketexposureoftheput periods. As awhole,thetwo optionswillprovide a c c equal distantfromtheunderlyingmarketlevels,weca put andcalloptionswhicharesetwithstrikeprice t o m l t l t c decreases. The resultisanincreasingmarket exposur i o o u positions becomesevidentinthisstructureasth Defined as“gammarisk”,theriskfromshortoptio u o program thatwouldappreciablyunderminetheabilit with shortdatedoptions profit fromtherapidtimedecay(“theta”)associated ncreases, whilethemarketexposureofotheroptio urbulent ordivergent periodsinthemarket he periodsinthemarketwhicharecharacterizedb eads toanapproachwhichwouldtendprofitdurin he typicallyflatperformanceperiodsfor TAA. Thi ow volatility, orbyoscillating,non-trendingpric omplement a TAA program,wefocusedonimprovin reate aportfoliowhichbegins tooffer thedesired haracteristic ofaddingvalueduringcalmmarket ption strike levels. As thisoccurs, themarket exposur nderlying marketpriceapproachesoneoftheshort nlimited potentialforlossfromshortoptionpositions ffsets themarketexposure ofthecall),andwould f thebase TAA programtoaddvalue duringth f theoptionapproachingin-the-moneystatu ovements. Notsurprisingly, wewould notseeka B I The riskwiththisportfolioiscenteredonth PTI

$ Profit n designinganoptionbasedstrategywhichwould -4 -3 -2 -1 0 1 2 3 4 5 y sellingshortdated(30-45daystoexpiration 6 7 8 9 0 1 2 3 640 630 620 610 600 590 580 570 560 Profit Profile:SellPutandCallOption ONS A 7 625 575 ND T u pinSrk 580 600 620 = = Put OptionStrike = Call OptionStrike Market Level S&P500Options A C Exhi TI . C AL b it 11

A SS ET

A L L . OC ATI (S&P Level) s ON n g n n y y g e e e e e e s s s ) . 7 FQ PERSPECTIVE FIRSTQUADRANT.COM profile (Exhibit12)thatresultsfromthepurchaseof g beyond thesestrikeprices,thispositioncanrealiz decay ofoptionpremiums. As themarketlevels extend t i s t 9 portfolio byaddingthepurchaseoflong-dated(45- affect the TAA performance t v s premiums received. This particularapproachwould c s i and calloptions. These profits arearesultofthedeca within therangedefinedbystrikepriceofput portfolio willprofitwhentheunderlyingmarkettrade m l m which iscountertothemovementinunderlyin exceed thecostofoptions and calloptions. As themarket extendsbeyond th ncurred astheunderlyingmarketlevelsstaywithi he callandputoptionisoppositeofthebaseoptio n optionpremiumsreceivedfromthesaleofput osses whicharelimitedonlybythemovementofth he strikepricesoftheoptionsbought,duetoth he secondobjective,thedesiretonotappreciabl tructure. Lossesfromthislongoptionpositionwillb atisfy thefirstobjective,namelyabilitytoadd trike prices,lossescanbeincurredasthecosti losing outtheshortoptionpositionscanexceedth 0 daystoexpiration) putandcalloptions. The profit alue duringthecalmmarketperiods,butwouldfailat ains asthenetpremiumsofoptionpositions ark arket. Leftunprotected,thispositioncangenerat To offset thisrisk,wecanmodifythebaseoptio A $ Profit -4 -3 -2 -1 s theaboveprofitprofilesuggests,thisoptio 0 1 2 3 4 5 e 6 7 8 9 0 1 2 3 640 630 620 610 600 590 580 570 560 Profit Profile:Buy“OutoftheMoney t . Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process 7 625 575 Put andCallOption Put OptionStrike=575 Call OptionStrike=625 =600 Market Level S&P500Options Exhi b . it 1 . 2 ections, No1,1996 s ” (S&P Level) y n n g n y n n e e e e e e e s exposure (delta)oftheshortputandcalloptio t faster ratethanthelongoptionpositions,inadditio s o portfolio whichisbettersuitedtoreachingourstated positions withthelongoption-wecreatea portfolio asnetgammaexposurestartstoincrease This isduetothegrowingmarketexposureofth approaches orexceedstheshortoptionstrikeprice i l t o o u t put andcalloptionpositions. The portfoliomaintain positions areoffset bythemarket exposures ofthelon c o (Exhibit 13)willreflectanabilitytoprofitfromth due tothe“netshorttheta”positionofportfolio- profit withinthisdefinedrangeofpricemovementis with theshortoptionpositions potential by“capping”thedownsideriskassociated ncurred intheportfolioasunderlyingmarketpric onger datedoptions(seeExhibit14).Lossescanb he shortdatedoptionswilldecayfasterthanth his marketneutraloutlookoverawiderangeof here isanimprovedabilitytomanageanyloss hort optionpositionasthesepremiumswilldecayata haracteristics oftheoptionportfolio.Themarket ption positionswillalsoneutralizetheeffects ofeach nderlying pricemovements,becausethelayeringof ptions gammaexposure.Theportfoliosabilityto bjectives. Theprofileofthecombinedportfolio ption positionsextendsthemarketneutral B The layeringoflongoptionpositionswithshort $ Profit -4 -3 -2 -1 0 1 2 3 4 5 y combiningthetwopositions-shortoptio 6 7 8 9 0 1 2 3 640 630 620 610 600 590 580 570 560 Sell CallOption=620Strike Buy CallOption=625Strike This graph represents the typical profile of the option strategy over a wide range of market prices. market of range wide a over strategy option the of profile typical the represents graph This Pr 575 o fit Pr fit Market Level=600 o S&P 500Options Exhi fil e : T b it 13 o tal P . Buy PutOption=575Strike Sell PutOption=580Strike o rtf 625 o li o (S&P Level) . n n n g e e e e e s . 8 FQ PERSPECTIVE FIRSTQUADRANT.COM O c A i are usedintheprogram. A market selectionprocessis process. This doesnotmeanhowever, thatallmarkets i I o m and HongKonghaveproventobethemorevolatil m t 5 each globalequitymarketfellwithinabandof+or- n t c which willoffer themostconsistent profit opportunity hat themajorityofthesereturnsfallwithinafairl ncorporated inordertoidentifythoseoptionmarkets o bethemostsubdued,withroughly80%ofth ncome andequitymarkets covered byour TA t canbedesignedtouseoptionsonallglobalfixed hara overing allcountries inourGTAA programshows f th % onthemonth.TheU.S.equitymarkethasprove arrow band.Exhibit15showsthepercentageoftim ll optionmarketsareanalyzedforthefollowin arkets, withreturnsexceedinga5%bandover50% onths fallingbetweenthesereturnlevels.Norwa A • • • This sortofprogramneednotbelimitedtotheUS PTI Decay RateDifferenceShortvs.LongOption n analysisofmonthlyglobalequityreturns Implied volatilityconsistentlyabovehistoric Liquid optionmarkets Moderate levels ofvolatility v e c olatility tim positions. decay betweenthelongdatedandshortoption The strategyisdesignedtoprofitfromthedifferenceintime The graphrepresentsanoption'stimevaluetoexpiration. t ON e ri 00Days 40 Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process s M e. ti cs: Time toExpiration(ofshortoptionposition) . A Option Value RKET 02 10 20 30 Nearby Option S Value . ections, No1,1996 Longer Option . Value s A n y g y e e e . . 16). Trading markets whichexhibit moderatelevels of r probability ofbeingcontainedwithinanarrowpric B r n i m r v program. Financialmarketswhichexhibitverylow s v c o Equity Markets withModerateLevels of Volatilit n amark ange, weareabletogreatlyimprovetheconsistenc anges isoneaspectinthemarketselectionprocess esulting lowoptionpremiumlevels;conversel trategy becauseoftheriskcontrolmechanismsth haracterized withmoderatevolatilitylevels(Exhibit olatility donotoffer muchopportunity becauseofth eed toreadjustpositions.Transactioncostsalonewill olatility isimportantinmanagingthismarketneutral New Zealand f theprogram. Typically, thesemarkets willb y selectingthosemarketswhichcarryahighe arkets withexcessive volatility aredifficult tomanag Switzerland Hong Kong I German Fran U J U Netherland Singapore Germany Denmark dentifying marketswhichtradeinmanageabl pn2.7 .0 11 7.20% 22.87% apan Australia Average impliedvolatilitylevels of ATM options S. Africa Sweden Belgium Canada Norway .K . Finland France Austria Ireland U.S.A. S. Japan Spain U.K. Italy . ce %2%4%6%8%100% 80% 60% 40% 20% 0% y Monthly Returns within ± 5 Monthly Returnswithin± e t n 17.35 21.82 16.04 11.67 M eu e tral nD an % % % % 1 e / Exhi Exhi 91 to12 n tnadV Standard v ir 1.97 3.24 4.33 3.52 ev o b b iati nm it 1 it 1 % % % % o / e 5 6 9 nR nt 4 due 10 15 10 7.93 . . . . 79 6 4 6 t V 8 7 9 % o % % % % olatility % th -17.92 ange -30.98 -41.62 -30.37 -45.74 e

co n % s % % % % - tant y y y e e e e e e r . 9 FQ PERSPECTIVE FIRSTQUADRANT.COM an optionareobservableexceptthepricevolatilityof m t s o s be m l s “ l v s l o “ m between premiumlevelsandtheabilitytomaintaina - m o along withsufficient market sizetoabsorbinstitutional exhibit bid/askspreadswhichareconsistentlynarrow, eat awayanyprofitassociatedwiththenormallyhigh iquidity isbestjudgedbythebid/askspreadandth iquidity inavarietyofmarketconditions.Exhibit1 he security. UsingtheBlack-Scholesoptionpricin iquidity ofamarketisanalyzedovervariety 25.0%onanannualbasis ecurity’s pricevolatility. All factors inthepricingof ecurity price,timetoexpiration,exercisepriceofth hows howliquidityhasenteredthemarketsasoptio ized tradeswithoutcreatingmarket impact. Th depth” andliquidity. Itisimportanttoidentifyspecific n olume hasincreased. The consistency ofamarket ption marketswhichexhibitaconsistentlevelof ption, risk-freeinterestrateandtheunderlyin ption premiumlevels.Marketswhichexhibita odel, ifthepriceofanoptionisknown,thenpric arket neutraloptionportfolio oderate level ofvolatility, generallybetween10.0% arket conditionsinordertogaugeconsistenc A W t o wee rmal” mark n optionspriceisafunctionoftheunderlyin e alsoanalyzeglobaloptionmarkets forthei n emn A . 1. 0. 9.3% 107.0 117.0 1.7 DAX CA Germany France U J U c Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process apa alm an K TS 0 . 351. 38.2 17.0 23.5 1.1 FT-SE 100 .K. . S. n e t d s t iz u e. r bu Th l e e nt mark m , offeradesirablebalanc os & 0 4285060028.9 81.7% 640.0 170.0 825.0 309.0 14.2 $35.5 Nikk S&P 100 S&P 500 . ections, No1,1996 t A des e -02.2 C-40 t e co 2 2 i 225 ira n b A d l iti verage DailyNumberofContracts e mark o Number ofcontracts (000’s n s. L isted Options Volume e t s

($ w Exhibit 1 Billion ill n g 7 g g y e e e e e s r . 628 L 2.00% orhigherbeingdesirable.Overtime,thi i c experienced (historic) a v premium workstotheadvantageofprogramas s o m o m o t h “ t u Historic volatility istheactualvolatility ofthesecurity, o m i v mplied andhistoricvolatility, weareabletoimprov he impliedandhistoricvolatilitywillfluctuatebased he two, impliedminushistoricvolatility, representsth nputs. Theimpliedvolatilityoftheoptionisth pread canfluctuatebetweenmarkets,withaspreadof haracterized byaconsistentlevelofpremiumbetwee premium” anoptionsellerwillreceiveoverth olatility thatissold(implied)consistentlyhigher, istoric riskofowning thesecurity. The spreadbetwee sually quotedinannualterms.Thedifferencebetwee f thesecuritywillbeoverlengthofoption olatility canbe“implied”basedontheothermodel ur opportunitytoprofit. Typically, theworld equit ) ver historicvolatility. As Exhibit18reflects,thi n changingsupplyanddemandconditionsinth cross allofthesemarket 7 ark arkets willtradewithahealthypremiumofimplied arkets “best-guess”atwhattheactualpricevolatilit I B N y identifyingoptionmarketswhichar KI e t . NG

) O 9419 % 1993 1994 002. 46.3 20.5 30.0 PTI . 534 ONS .

I N T O TA s .5 thanactualvolatilit A - 17.4 C hange % % % % n n y n y y e e e e e e s s . 10 FQ PERSPECTIVE FIRSTQUADRANT.COM n that thiskindofprogramaddsvaluewhenTAA doe program wouldvanish. s v s from “sellingvolatility”andtheta.”Ifthislong- I s s v process tendstobeepisodicinnature t i s i These aretheperiodsthat TAA was designedto v Typically, thesearetheperiodswhenmarkets aremost v m l r periods ofmarketactivity-andexplainwhyth o addvalue ina TAA programduringthese“calm” mplied volatility isgreaterthanhistorical.Itdifficult dentify andaddvaluetotheunderlyingportfolio ong termsuccess.Duringtheperiodswhenactual elationship isthedeterminingfactorinprogram n otherwords,theprincipalsourceofprofitscome een historically(bothinsimulationandonliveassets) tanding tendencyinoptionsmarketstooverestimat hould nolongerexhibitthekindsofprofitswehav ubdued marketreturnsaretypicallytheperiodswhe uddenly becamefairlypriced,theprofitsforthi olatility converge, then thiskindofoptionsstrateg olatility stops(whichwethinkunlikely),andoption olatile, withexcessivedirectionalmovesoccurring olatility sold,theprogramwillunderperform ot; thatcrucialadvantageremainsunaltered arket volatilityexceedstheimpliedlevelsof I Market periodswhicharecharacterizedbyrelativel The abilitytosystematicallyprofitfromthisspread German Fran U J U f priceimpliedvolatilityandsubsequentactual apa K 16.04 11.67 .K. .S. n ce I Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process y mplied vs.Subsequent Volatilit mle usqetSprea Subsequent Implied 17.35 21.82 22.87 % % % % % 1 / 91 to12 But, thegreatestattractioni 15.01 17.23 18.79 12.16 9.13 / ections, No1,1996 9 4 % % % % % . y 2.54 2.35 4.59 4.08 3.88 . . % % % % % d n y y e e e s s s s s s . . . D A T alpha ofthebaseprogramwhilereducingstandard provide anapproximationofhowthetwoprograms along withestimatesfortransactioncostsandslippage, m c t g h ou C o s o dev c figures willshowhowtheoptionprogramca program andcombinedresults. Analysis ofthes t N s m o equity, 10%Frenchequity, and10%Japaneseequity 30% U.S.equity, 10%U.K.equity, 10%Germa m m program undervariousmarketconditions we B adding theoptionprogramtoabaseGTAA strategy allocation betweentheU.S.fixedincomeandequit heoretic prices. With thismodel,weareableto he benchmarkreturns,GTAA program,optio imulation ofoptionpricesbasedonmarketcondition imulation areshowninExhibit19 onstruct asimulationtoillustratetheimpacthistoric omplement a TAA programbyincreasingtheoverall ver thepast10years. The secondmethodisaMont a enerates adailyrecommendedoptionportfolioand ur reportedGTAA performancefigures inorderto ption strategies historically. The first isadail arlo simulationbasedonthemarketcharacteristicsof y usingtheoptionprogramthatwehavedescribed, o arkets, U.K.,German,FrenchandJapaneseequit arket conditionswouldhavehadontheprogram arkets. An allocationof30%U.S.fixed income ay have performedtogether. The results ofthis AC U First A The resultsofthissimulationareincorporatedwith The simulationwasgeneratedusingaconstant A N ve r t

iati e IL A sing theBlack-Scholesoptionpricingmodel,w reviewoftheresultswillhighlightbenefits d c

th ata TI co an Y N o e Q C n n S ALY b ann s c a AL uadrant usestwomethodstosimulatethes o tr IM se. al f th uc cu S

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l o w o f th n hi c . o n y n y y h n e e e e e s f , . . 11 FQ PERSPECTIVE FIRSTQUADRANT.COM a benchmarkobjectiveof50%stock/bond,w added of1240bpsforthemonth. As expected durin i c c TAA program an between thetwoprogramsandtranslatesintoahighe r flatter, alongwithaslightlyhigherintercept. This isa programs. Notehowtheslopeofregressionlinei s o t r a tacticaloptionprogram.Inthisinstanceth TAA tendstoaddmorevalue. Exhibit21isaplotof u m t as thebenchmarkreturnsbecomemoreturbulent 1987 TAA program. With arecommendedshiftofasset nto bondsandcash,oursimulationsprojectavalu he nextpage.Exhibit20representstheplottingof he benchmarkreturnsbecomemoreturbulent egression lineisdownwardsloping,indicatingthatas esult ofthenon-correlationinalphageneratio an simulatetheeffect ombined program.UsingaU.S.basedportfolio,with h pward slopeoftheregressionlinewhichsuggeststhat ption programwilltendtolosevalue.Exhibit2 onthly TAA alphaover thepast7years. Noteth I A 9.69 B Standard Deviation A 199 199 1993 199 1991 199 198 d ows t isalsoworth notingtheeffect thattheOctober, m e nn closerlookatthetwoprogramsisillustratedo n 5 4 2 0 9 U c u o

hmark: al . r s S e Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process im

. stockmarketcrashwouldhavehadona co u n lat . s i s ed t e nt r s e tr t u O e am rn ctober wouldhavehadona s ecmr A-ieOto rga TAA/Option OptionProgram TAA-Live Benchmark f o W 5 5 R f r G 17.22 12.52 19.24 - - ections, No1,1996 o 0 0 1.22 4.73 6 5 2.42 eturn lobal orld Bond r % % .97 .70 e t Solomo EAFE o u % % % % % % % % rn f th % A s TAA andOptionBased Approac

ove e

n co r th m e b V

, in b th alue Added a ed G se 12.99 -6.55 n 2 g n e e e e e s s r 1.73 0.53 1.71 3.30 2.08 1.78 , 4.55 oa Tactical lobal % % % % % % % % % t v t program inOctober, 1987tothe TAA programismor t W during themostturbulentperiodsinmarketcycle program doesnotundermine TAA’s abilitytoaddvalu t deviation event, theOctober, 1987period,highlight r c would haveunderperformedby230bps.Th a turbulent marketperiod,the Tactical OptionProgra would haveresultedbyoverlayingthetacticaloptio ypical marketcycle han offset bytheprogramsconsistentabilitytoadd he importancethatthiskindofrisk-controlledoptio o thebaseprogram,18%dropinalphawhich esulted inasolidgainof1010bps. An 8standard ombination ofthetwoprogramswouldhavestill alue duringthemajorityofmarketenvironmentsina hen comparedwiththeincreasedabilitytoaddvalu V alue Added h 1.27 0.22 0.12 0.54 0.72 0.94 1.37 2.36 0.66 . % % % % % % % % % V C alue Adde ombine 13.25 -4.33 3.02 0.65 2.27 4.04 3.04 3.18 4.39 % % % % % % % % % d d m n n e e e e s . 12 FQ PERSPECTIVE FIRSTQUADRANT.COM

TAA and Options Combined Value-Added TAA Value-Added 10% 12% 14% 16%

10% 12% Option Value-Added -4% -2% -6% -4% -2% -8% -6% -4% -2% 0% 2% 0% 2% 4% 6% 8% 0% 2% 4% 6% 8% %2 %6 %1%1%14% 12% 10% 8% 6% 4% 2% 0% %2 %6 %1%1%14% 12% 10% 8% 6% 4% 2% 0% %2 %6 %1%1%14% 12% 10% 8% 6% 4% 2% 0% US Based Investor Based US US Based Investor Based US US Based Investor Based US TAA, withOptions,vs.Benchmark Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process Options vs.Benchmark TAA Absolute BenchmarkReturn(Monthly) Absolute BenchmarkReturn(Monthly) Absolute BenchmarkReturn(Monthly) Exhi Exhi vs (1989-1995) (1989-1995) (1989-1995) . B b b e it 2 it 21 n c hmark 2 ections, No1,1996 M c equity. A portfoliosimulationwas calculatedb German equity, 10%Frenchequity, and10%Japanes fixed income,30%U.S.equity, 10%U.K.equity, 10% t i c m To testtheprogram,asimulationcovering 5,00 a i i i m r o program returnsbeingattributedtothemarket i v m distribution fallingbetween-35bpsand+66pe m m r Th t affect theprogram,withroughly1/3ofprogram experience be profitable. This isnotunlike the live-asset 23 Option Programoveralargesetofmarketconditions nt ested togenerateatotalprogramreturnforthatperiod he programandbasedonanallocationof:30%U.S s underlyingmarketreturn,withroughly2/3ofth dentify theprobabilisticcharacteristicsofaspecific ncorporating theattributesofourdatabase,wear esults onthetotaloptionportfolio. The simulated nvestment strategy. Byconstructingamodel eturns beingattributedtochangesinunderlyin ombining theindividualmarketresultsofeachperiod haracteristics ofmonthlyreturn,impliedvolatilityand b f theunderlyingmarket.Fluctuationsinvolatilityalso ariable toinfluencethereturnstreamofprogra arkets impliedvolatilities onthly periodswasgeneratedbasedonourdatabas onth. Itiscalculatedthat68 ean returnfortheportfolioisestimatedat18bpspe onth or216bpsperannum.,with80%ofth I Monte Carlosimulationsareusedinordertohelp A Exhibit 24displaysthemonthlysimulatedprofit/los l . e e ON n e r r closerlookathesimulationshows thatthelargest d t es i esu v o T t rat i

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o e s f th t a ed c h mark inExhi e Ta c e ti t i c b m al it y 0 n g e e e e e s s r r . . . 13 FQ PERSPECTIVE FIRSTQUADRANT.COM utss45 .165 .860 .59.0 5.75 6.08 5.08 6.52 6.01 0.01 4.56 b Mean Std.Error Range Max Range Min 0.41 C Kurtosis S V Std. Deviation M M M ased on5 kewness arianc oeff. of ode ed e an R ia n e e Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process t u Probability V 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% r , . ra.23 .409 .624 87 145.4 -8.77 2.44 4.26 0.94 5.14 2.36 ariab. . 000 trials n 10%-.8 05%-.3 01%01%03%05%08%10%1.25% 1.03% 0.80% 0.58% 0.35% 0.13% -0.10% -0.33% -0.55% -0.78% -1.00% otoi Equit Portfolio - 1.18 .905 02 .9-.6-.7-1.91 -1.67 -0.96 0.69 -0.21 3.24 0.50 0.29 0.00 0.17 0.18 0.17 oa ..FxdJpnUK emn France Germany U.K. Japan Fixed U.S. Total ections, No1,1996 % % % % % % % % 10.15 -3.43 0.01 0.22 0.17 0.23 0.02 1.16 Monte % % % % % % % % y P Frequency Chart o 5,000 Trials rtf Exhi I o C -1.34 n 0.96 0.00 0.16 0.08 0.20 li 0.00 0.18 U arlo Result co o b . S R it 2 m . % % % % % % % % e e 4 t u rn -4.98 qiyEut qiyEquit Equity Equity Equity s 8.85 0.02 0.23 0.35 0.35 0.02 1.49 % % % % % % % % -2.57 2.35 0.00 0.26 0.31 0.24 0.01 0.58 % % % % % % % % -4.67 -0.11 2.54 0.01 0.15 0.01 0.99 0.05 0 20 40 60 80 100 120 140 % % % % % % % %

Frequency -4.77 -0.06 3.28 0.01 0.08 0.01 0.01 0.85 7 5 % % % % % % % % y 14 FQ PERSPECTIVE FIRSTQUADRANT.COM Copyright ©by First Quadrant, LP, 2014,all rightsreserved. MARKETING SERVICES FIRST QUADRANT, L.P. |800E.COLORADO BLVD. SUITE900,PASADENA, CALIFORNIA 91101 other conditions. Allmaterialhasbeenobtained from sources believed to be reliable, butitsaccuracy isnot guaranteed. This materialisfor your private information. Theviews expressed are theviews ofFirst Quadrant, L.P.only through thisperi S enhance returnswhilereducingtheriskofagive allocation programenablesaportfoliomanagerto betting onquietmarkets),withabasetacticalasset benchmark settings o s exposures andriskismanagedasawhole. The market position tomarketsalreadyfamiliartheportfolio.Net which areusedinthe TAA process,welimitou i o t portfolio. Becausetheinvestment objectives ofthes s programs includetheeaseandflexibilityof mplementation. Byusingonlythoseoptionsmarket wo programsdiffer, theytendtocomplementeach election processisflexibletoallowallocationsbased eeks profits by“selling”volatility andtheta(thereby, ther verywell n fundinvestment objectives, riskparameterso U [email protected] | The combinationofanoptionbasedprocess,which A • • • MMARY dditional benefitsthatresultbycombiningthetwo TAA i g t fr periods ofthemarket cycle, whenassetsdiverg The twoprogramsarehighlycomplementaryand The A tacticaloptionsprogramwilladdvaluedurin TAA mosttypicallyaddsvalue duringthevolatil he trendlessperiodsofthemarketcycle nevitable quiet,henceunprofitable,spansfo ive usamechanismtoaddvalueduringth o m th Investment ManagementRefl FQ Perspective: UsingOptionsinaTAA Process . e ir hi : s t o . ri c n o OFFICE rm s. 6266834223 | ections, No1,1996 WEB . FIRSTQUADRANT.COM g n e e e e s r r r od andare subjecttochangebased onmarket and