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Global Equity Volatility Insights BankofAmerica Understanding when risk parity risk Merrill Lynch increases 09 August 2016 Corrected US Equity Derivatives Global Quantifying the (bond-equity correlation) risks to risk parity Last week’s sharp sell-off in JGBs renewed concerns of forced selling by risk parity funds. While the drawdowns in US Treasuries, US equities, and ultimately risk parity portfolios were small and short-lived, the latent risk remains worth monitoring, as (i} leverage is still near max levels across a variety of risk parity parametrizations, (ii) bond Global Equity Derivatives Rsch allocations are historically elevated, and (iii) markets continue to be sceptical of a 2016 MINAS Fed hike. Hence we provide a simple scenario tool to help investors assess what relative Set hey here moves in bonds and equities could catalyse significant deleveraging by rules-based risk MLPF&S parity funds running vol target overlays. For example, a -2% daily decline in the S&P chuneaniko reat earn. 6a 0 500 coupled with a -0.6% fall in 10y Treasury prices (poor diversification) could trigger a Laie 25% deleveraging (of unlevered notional} today, whereas a -4% SPX drop and +1% bond MLPF&S rally (good diversification) would generate no selling pressure, underscoring the critical nid seksenai2batnheah role played by bond-equity correlation in governing the severity of risk parity unwinds. Sheets Europe Ce eee corer Buy the seasonal oll dip via bullish X-market risk reversals aad rele > Selling rich USO (WTI tracker) 3M 25d puts to fund cheaper SXEP (European Oil & Gas ee equity) calls is historically attractive. Indeed the number (>2) of long SXEP calls per short - USO put is in the 90° %-ile since 2008. The trade leverages both our commodity aera Cane strategists’ ‘buy the dip’ view and our equity strategists’ bullish outlook on the Oil & Gas en eids@reenearn sector, which has been the worst performing over the last 1M. Moreover, the average elon payoff of being long SXEP 3M 25d calls would have been >2x greater than USO 3M 25d Equity-Linked Analys calls (owing to more frequent positive returns), when sized for the same upfront cost. PASS clenlaa Asia Eulty Linked analy Own NKY Sep/Oct calendar call at vol hit YTD low level going into the Sep BO) bein i eee erp Post the Jul-16 Bo) and the announcement of a ¥28.1tn fiscal stimulus package, NKY and a Benjamin Bowler USDJPY 1M vols have dropped to near YTD low levels, both USDJPY and NKY 2M-1M Equity-Linked Analys' MLPF&S term structures are historically steep, pricing in a slow summer. Our strategists believe eran inBewleraiemieant Sep-16 Bo)’s will likely create uncertainty, however, NKY Sep-Oct ATM fwd vol currently trades at the low end of its trading range going into Bo)’s YTD. Plus, our analysis See Team Page for Full List of Contributors >> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions. BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 25 to 26. Analyst Certification on page 23. 11657850 5 : suggests a further squeeze in yield will likely be positive for the NKY. We recommend Table 1: 3M volatility (weekly changes) 2 buying 1x NKY Oct 17500 call vs. selling 0.65x Sep 17250 call. Implied Realized : Trade update: Closing the NKY Aug/Sep put calendar trade at 0.28% premium S8&P500 19 (07 13.2 (-0.1 3 ; ; ; oe . ESTX50 92(0.6) 277 (0.4) s Korean auto-callable issuance slightly rose while NKY Uridashi issuance fell in July FTSE 26 (07 18.9 (0.1) 2 DAX 78(-1.1 24.6 (-0.1 8 NKY 21.7 (-1.1 27.2 (-12 2 HSI 75(06) 17.2(-05 2 KOSPI 26 (-0.4 12.9 (0.5) 2 EEM US 88 (08) 22.1(09 & TOP40 19.4 (03) 18.1 (0.4 - RDX 28.2 (-1.6 25.8 (-0.6 e IBOV 217(00) 217(-07 = ISE30 29.9 (-0.1 27.7 (-04 5 Source: BofA Merrill Lynch Global Research HOUSE_OVERSIGHT_025978