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The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

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Page 1: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:
Page 2: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

The Future of Global Capital Markets:

Will the U.S. Continue to Rule?

Sponsored By:

Page 3: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Financial Innovation : Last 1000 Years

1000 1100 1200 1300 1400 1500 1600 1700 1800 1900

1156:Foreign exchange contract1160: Bill of Credit

3000 - 2000 BC: Development of Banking in Mesopotamia

806: Paper money

1401: Bank of Barcelona founded

1494 : Double entry book keeping1498: Capital and foreign exchange markets

1609: The central bank founded

1633: Promissory notes1640: Short sale for cash flow financing.

1681: First public note-issuing bank founded

1723: Notes secured by Mortgage

1751: Consols1770: Clearing House1772: Branch Banking1775: Savings and Loans

1829: Deposit Insurance

1881: Post office notes

1200:Contracts promising future delivery (derivatives)

1868: Chicago board of trade;Mutual Fund Started

1920: Payment card

Page 4: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Financial Innovation: Last 50+ Years

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

1995: Electronic Cash Card

1997: Bowie Bonds : Bond Backed By Copyrights

1990: First international computerized matching service for foreign exchange rates

1973: Black-Scholes formula

1951: First credit card issued

1970: Magnetized Credit Card

1977: First financial future contract traded

1974: Modern high-yield market started

1960s: Warrant and Convertibles Bonds

1967: First ATM machine

1970: First mortgage backed securities issued

2003: DRAM future contract launched

1994: First credit enhanced securitization of aircraft lease 1994: Catastrophe bond

1999: Italy Securitized delinquency social security receipts

1989: First securitization of non-performing loans

1997: Weather derivatives

Page 5: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

World’s Equity Market Share

Market Capitalization1950

Other6%

Europe26%

U.S.59%Japan

9%

Market Capitalization2003

Other10%

Europe26%

U.S.52%

Japan9%

Page 6: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

World’s Equity Market Share

Market Capitalization1988

Other14%

Europe26%

U.S.29%

Japan40%

Market Capitalization2003

Other10%

Europe26%

U.S.52%

Japan9%

Page 7: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

World Equity Market PerformanceTop 10 2004 USD Adjusted Returns

NorwayMexico

PolandPeru

JordanAustria

Czech RepublicHungary

ColombiaEgypt

140

120

100

80

60

40

Percent Change, Year Ago

Page 8: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

$100 in the Dow in 1995 = $280 Today

2004200320022001200019991998199719961995

300

250

200

150

100

50

Jan. 1995 = 100

DJIAFTSEMSCI WORLD

Page 9: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Decline of the Dollar

200420032002200120001999

1.20

1.10

1.00

0.90

0.80

0.70

135

130

125

120

115

110

105

100

Euros Yen

Euros per DollarYen per Dollar

Page 10: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

2004200220001998199619941992199019881986

0

-1

-2

-3

-4

-5

-6

50

40

30

20

10

0

U.S. Trillions % of GDP

Cumulative Trade Deficit Since 1985

Cumulative Trade Balance as % of GDP (R)

$4.8 trillions as of 2004Q3

Cumulative Trade Deficit Since 1985 (L)

Page 11: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

20042003200220012000

-2.0

-2.5

-3.0

-3.5

-4.0

-4.5

-5.0

130

120

110

100

90

80

70

U.S. Trillions Jan 2000 = 100

Trade Deficit and US Dollar

Yen/Dollar (R)

Euro/Dollar (R)

Cumulative Trade Deficit Since 1985 (L)

$4.8 trillions as of 2004Q3

Page 12: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Lower Dollar, Higher Oil Price

20042003200220012000

200

180

160

140

120

100

80

60

145

136

127

118

109

100

91

82

Jan 2000 = 100 Jan 2000 = 100

Crude Oil

Trade-weighted dollar

Page 13: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Growing U.S. Budget Deficit

04999489847974

4

2

0

-2

-4

-6

-8

% of GDP

Page 14: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

20042003200220012000

8.0

7.5

7.0

6.5

6.0

5.5

66

64

62

60

58

56

U.S. Trillions % of GDP

In 2005, U.S. Public Debt Increases $2.1 Billions Daily

U.S. Government Outstanding Debt (L)

Outstanding Debt as % of GDP (R)

$7.78 Trillions as of Mar. 31, 2005

Page 15: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Interest Expense on Public Debt$322 Billions in 2004

200420022000199819961994199219901988

400

350

300

250

200

10

8

6

4

2

U.S. Billions %

Declining interest rate on public debt (R)

Declining interest expense as % of GDP (R)

Interest expenses on total government debt

Page 16: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Total Debt Outstanding Since the 60s

20041994198419741964

70

60

50

40

30

% of GDP

Page 17: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Total Debt Outstanding Since the 30s

20041994198419741964195419441934

140

120

100

80

60

40

20

0

% of GDP

Page 18: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Raising Gov. Debt and Sovereign Rating

66

A-30ChinaBBB-34RussiaAAA40United KingdomBB-59BrazilBB+60IndiaAAA62United StatesDDD66ArgentinaAAAGermanyAA170Japan

Sovereign Debt Rating

Public Debt % of GDP

Page 19: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

20042003

180

160

140

120

100

80

60

60

50

40

30

20

Jan 2003 = 100 $US Per Barrel

Stock and Crude Oil Price

Emerging Markets

Nikkei

DJIA

FTSE

WTI Crude Oil Price (R)

Page 20: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

0604020098969492908886848280

3.5

3.0

2.5

2.0

1.5

1.0

0.5

US$ per Gallon

Rising U.S. Retail Gasoline Prices

Real (2005 dollars)

Nominal

Proj

ectio

ns

Page 21: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

U.S. Energy ConsumptionShare of GDP

04989286807468625650

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

Percent

Gasoline and Oil

Fuel Oil and Coal

Page 22: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Quickly Flattening Treasury Yield Curve

March 31, 2004

September 30, 2004

March 31, 2005

20Y10Y7Y5Y3Y2Y1Y6M3M1M

6

5

4

3

2

1

0

Percent

Page 23: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Rising Costs of Raw Materials

200420032002

350

300

250

200

150

100

50

Percent

Crude Oil

Scrap Steel

Copper

Page 24: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

00959085807570

1400

1200

1000

800

600

400

200

0

US$ Billions, Annualized

U.S. Corporate Profits

$1.27 trillion dollars in 2004 Q4, of which 15% is profit from abroad

Domestic non-financial

Domestic financial

Profits from abroad

Page 25: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

China Trade Surplus with U.S., Deficit with Rest of The World

2004200220001998199619941992

100

50

0

-50

-100

US$ Billions

$US 95 billions annual trade surplus with the U.S.

$US 44 billions annual trade deficit with rest of the world

Page 26: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Relative Growth Rate Comparisons

Japan

United States

Germany

009590858075706560

25

20

15

10

5

0

-5

Percent Change in GDP, Year Ago

Page 27: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Relative Growth RatesReal GDP Growth

8.59.58.29.79.8China6.77.35.45.75.6India6.07.16.8-5.2n/aRussia3.75.21.91.83.0Brazil0.82.61.41.73.7Japan2.12.52.02.02.1EU3.64.42.43.13.1United States

2005E200400-0390-9980-89

Page 28: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Relative Inflation Rates

3.03.90.47.87.5China4.04.84.09.69.1India

11.810.918.0411.9n/aRussia6.56.69.3854.8332.3Brazil-0.20.0-0.71.22.5Japan2.02.22.37.59.5EU3.03.02.53.05.6United States

2005E200400-0390-9980-89

Page 29: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

World’s Interest Rate OptionsNotional Amount

1990 $595.4 Billions

Asia10.3%

Europe33.0%

North America56.7%

2004 $24.6 Trillions

North America62.1%

Others0.1%

Asia0.1%

Europe37.7%

Page 30: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

World’s Currency FuturesNotional Amount

1990 $17 Billions

Other Markets

1.2%Asia0.6%

North America98.2%

2004 $104.5 Billions

North America88.6%

Others0.1%

Asia3.5%

Europe0.3%

Page 31: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

2003 Share of World Trade

Total: $7.4 trillion

EU40%

United States10%

Japan6%

China6%

Canada4%

Rest of World31%

Hong Kong3%

Page 32: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Top Oil Producing Nations: 2003

LibyaBrazil

AlgeriaNigeria

KuwaitUK

UAECanada

Ven.Norway

ChinaMex

IranUSA

RussiaS. Arabia

10

8

6

4

2

0

Barrels per day, Millions

Page 33: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

World Oil Consumption 2003

Total: $78.1 million Barrels per Day

Rest of World48%

United States25%

Germany3%

China8%

Japan7%

Russia3%

South Korea3%

India3%

Page 34: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Bond Market: Amount Outstanding

S. AmericaMiddle East & Africa

AsiaEurope

N. America

25

20

15

10

5

0

US$ Trillions

199020002004

Page 35: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

New Private Placements2004

EuropeU.S.AsiaLatin America

300

250

200

150

100

50

0

US$ billions

Page 36: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

World Financial Structure

2003200220012000199919981997199619951994

160

140

120

100

80

60

40

Percent of World GDP

Bank AssetsEquity Market CapitalizationDomestic Debt

Page 37: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

RussiaIndia

BrazilUSA

JapanChina

GermanyUK

400

300

200

100

0

Percent of GDP

Bank AssetsEquity Market CapitalizationDomestic Debt

Structure of Financial MarketsSelected Countries, 2003

Page 38: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Countries that Export Capital: 2004

Taiwan 3%

Korea 3%

Netherlands 2%

Hong Kong 2%

Other Countries

21%

Singapore 3%

Sweden 3%

China5%

Switzerland 4% Norway5%

Russia7%

Germany14%

Saudi Arabia6%

Japan19%

Canada 3%

Page 39: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Countries that Import Capital: 2004

United States71%

Greece 1%

Turkey 1%Italy 2%

France 1%

United Kingdom

5%

Portugal 1%

Australia 4%

Spain 4%

Hungary 1%Other

Countries9%

Page 40: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Global Futures MarketNotional Amounts

040302010099989796959493929190

20

15

10

5

0

800

600

400

200

0

US$ trillions US$ billions

Interest Rate (L)

Equity Index (R)

Currency (R)

Page 41: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Global Options MarketNotional Amounts

040302010099989796959493929190

25

20

15

10

5

0

140

120

100

80

60

40

20

0

US$ trillions US$ billions

Interest Rate (L)

Equity Index (L)

Currency (R)

Page 42: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Global Credit Derivatives Market

20042003200220012000199919981997

5

4

3

2

1

0

US$ Trillions

Page 43: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

04020098969492908886848280

2000

1500

1000

500

0

40

30

20

10

0

US$ Billions Percent Change, Year Ago

Gross Domestic Product - LGDP Growth - R

China: Gross Domestic Product1980-2004

Page 44: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

20502045204020352030202520202015201020052000

50

40

30

20

10

0

Nominal GDP, US$ Trillions

China

United StatesIndia

Japan

Germany

China GDP Will Pass Japan, Germany and United States

Page 45: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

1966-76 Cultural

Revolution

1990Shanghai and

Shenzhen Stock Exchanges established

2001Member of

WTO

China: More Than Two Decades of Growth

200019951990198519801975197019651960

20

10

0

-10

-20

-30

Percent Change in RGDP, Year Ago

Page 46: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

China: Stock Market vs. GDP Growth

2004200320022001200019991998199719961995

2500

2000

1500

1000

500

0

12

11

10

9

8

7

6

Index Percent, Year Ago

Shanghai Stock Exchange Composite IndexReal GDP Growth

Page 47: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

U.S. - Japan Financial HoldingsDecember 2004

Equity 7.4%

Equity 32.4%

Bond 9.7%

Bond 2.5 %

Banks 55.9%

Banks 12.4%

Insurance and Pension

30.0%

Insurance and Pension

28.0%

Others 15.5 %

Others 6.2%

0% 20% 40% 60% 80% 100%

Japan

US

$13.9T

$36.8 T

Page 48: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Undiversified Financial System

High Income Countries

Bank31%

Equity34%

Bond35%

Bank56% Bond

22%

Equity22%

Equity31%

Bond12%

Bank57%

Low Income Countries

Middle Income Countries

Page 49: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Corporate Bond Credit SpreadYield to Maturity

ML Corp AAA 1-5 Yr (R)

ML Corp BBB 1-5 Yr (R) Spread (L)

2004200320022001200019991998199719961995

300

250

200

150

100

50

0

10

8

6

4

2

0

Basis Points Percent

Page 50: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

040302010099989796959493929190

500

400

300

200

100

0

-100

10

8

6

4

2

0

-2

Basis Points Percent

U.S. Treasury Bond Maturity SpreadMiddle Rate

Treasury 3 Month (R)

Treasury 1 Year (R) Spread (L)

Page 51: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Sources of Hedge Funds’ $66 Billion of Institutional Money, 2003

Public Plans18%

Endowments and

Foundations53%

Private Plans22% Other

7%

Page 52: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Hedge Fund Investing Institutional Investors’ Top Concerns, 2003

Fees13%

Transparency 15%

Headline risk38%

Impact of capital flows on returns

34%

Page 53: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

• Absolute Performance- Hedge Funds attempt to produce consistent absolute returns regardless of the market direction.

• Focus on Risk Management- Hedge Fund Managers focus on preserving capital by carefully managing investment risks. – Hedge Fund Managers are often heavily invested in their

own funds.• Greater Diversification- Funds of Hedge Funds add a

further dimension of risk management, investor discipline and access to a diversified portfolio.

• Lower Volatility- The combined focus on absolute performance, risk management and diversification lead to a low volatility of performance.

Why Invest in Hedge Funds

Page 54: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Comparative Risk Adjusted ReturnsJanuary 1990-February 2005

MSCI World Index

S&P 500

Hedge Funds

HY BondsLehman Agg. Bond Index

Gov't Bonds1-5Yr

90 Day T-Bill

0%

4%

8%

12%

16%

0% 2% 4% 6% 8% 10% 12% 14% 16%Risk (Standard Deviation)

Annualized Return

Hedge funds are represented by the HFRI Fund Weighted Composite Index. Asset class statistics were derived using monthly returns of major market indices from January 1994 through August 2004.

Page 55: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Historical Hedge Fund Performance 1990- Feb 2005

20042002200019981996199419921990

8

6

4

2

0

Jan 1990 = 1

Lehman Brothers Agg. Bond Index

Hedge Fund Composite S&P 500

Historically, Hedge Funds have Outperformed both Equity and Bond Indices.

Hedge Funds are represented by the HFRI Fund Weighted Composite Index. All Index monthly returns and performance statistics werederived from and calculated by the Pertrac Software.

Page 56: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Long/Short Equity

Emerging Mkts

S&P 500

MSCI World Index

Distressed Securities

Event Driven

Hedge Fund Composite

Relative Value

Convertible Arb

Merger Arb

Equity Market Neutral

Fixed Income Arb

Lehman Agg. Bond

0%

4%

8%

12%

16%

20%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%Risk (Standard Deviation)

Composite Risk Adjusted Performance Risk vs. Reward Analysis of Hedge Fund Strategies (1990-2005)

Annualized Return

All Index monthly returns and performance statistics were derived from and calculated by the Pertrac Software.

Page 57: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Historical Hedge Fund Asset Growth

20042000199819951990

1200

1000

800

600

400

200

0

US$ Billions

1000

600

350

190

50

Asset Growth figures from 1990-2002 are from Bernstein Research Call – May 2003. Total Current Assets are from HedgeCo.net.

Page 58: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Looming Risks to Fixed Income

• Rising Interest Rates:– Telegraphed by the Fed

• Increasing Default Rates:– Default rates abnormally low last 4 years

• Undue Pressure to Chase Yield:– Credit spreads are the lowest in 6 years

Page 59: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Impact of Portfolio Losses on Overall Return The Importance of Protecting the Downside

1,459,142 63.88*1,459,142 6.502005

890,348 10.881,370,087 6.502004

802,983 28.701,286,466 6.502003

623,919 -22.101,207,950 6.502002

800,923 -11.881,134,225 6.502001

908,900 -9.111,065,000 6.502000

US$ 1M Invested on Jan. 1, 2000

Annual Return

(%)

US$ 1M Invested on Jan. 1, 2000

Annual Return

(%)Year

S&P 500 InvestmentHypothetical Fixed Return

*The S&P 500 must return 63.88% in 2005 to match the return of the Hypothetical Fixed Return Fund.

Page 60: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Demonstrated Impact of Alternative Investments

10M-50M50M-100M100M-500M500M-1B>1B

100

90

80

70

60

50

16

14

12

10

8

Percent Percent

8.99.3

10.010.8

12.5

89.687.8

81.8

74.5

55.0

NACUBO 10 Year Annual Performance (R)

Daily Liquidity of Portfolio (L)

Source: Commonfund Presentation, Commonfund Allocation Planning ModelTM and Commonfund Benchmarks Study ® - Educational Endowment Report. 2003 NACUBO Endowment Study, the two smaller fund groupings as reported by NACUBO, $26M - $50M and <$25M, are represented in the $10M - $50M grouping equally weighted.

Page 61: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

22

6

1516 18

9

19

1114

7

20

1014

9

17

11 1115

2824

37

4245

48

9

0

10

20

30

40

50

60

Hedge Funds Venture Capital Private Equity Energy &Natural

Resources

Private/PublicEquity Real

Estate

FY 2000

FY 2001

FY 2002

FY 2003

FY 2004

Alternative Strategies Asset Mix Trends for Endowments

Percent

Source: Commonfund Presentation. Commonfund Benchmarks Study®

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23

41 4250 50 47

13

1520

21 24 29

17

1514

13 10 8

9

23

129

5 419 15 12 9 7 4

5

23

2 5

3

0%

20%

40%

60%

80%

100%

> $1B $500M - $1B $100M -$500M

$50M -$100M

$10M - $50M $0M - $10M

Dom. Equities Fixed Income Intl. Equities

Short Term Securities/Cash Alternatives Hedge Funds

Allocations by Asset Classes

Source: 2005 Commonfund Benchmarks Study – Educational Endowment ReportCopyright 2003 The Commonfund for Nonprofit Organizations

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17.8

7.8 12

.2

10.1

37.6

16.8

11.7

7.2 12

.2

4.7

22.9

14.7

11.5

7.1 11

.0

4.2

0

10

20

30

40

50

DomesticEquities

DomesticBonds

AbsoluteReturn

ForeignEquities

PrivateEquities

Real Assets 10 YearPerformance

Yale ReturnsActive BenchmarkPassive Benchmark

Yale Performance Relative to Benchmarks (10 Years)

Active Benchmarks:Domestic Equity: Frank Russell Median Manager, U.S. EquityFixed income: Frank Russell Median Manager, Fixed IncomeAbsolute Return: CSFB CompositeForeign Equity: Frank Russell Median Manager Composite, Foreign EquityPrivate Equity: Cambridge Associates CompositeReal Assets: NCREIF and Cambridge Associates Composite

Passive Benchmarks:Domestic Equity: Wilshire 5000Fixed income: Lehman Brothers U.S. Treasury IndexAbsolute Return: 1-year Constant Maturity Treasure +6%Foreign Equity: 50% MSCI EAFE Index, 50% MSCI EM IndexPrivate Equity: University Inflation +10%Real Assets: University Inflation +6%

$<1B

–12

.5

$100

M -

500M

–8.

9

Yal

e R

etu

rns

–16

.8

4.6% CAGR Difference Between Domestic Bonds and Absolute Performance.

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Asset Allocations

3.53.2Cash18.86.3Real Estates14.55.5Private Equity14.815.6Foreign Equity26.115.1Absolute Return7.417.5Fixed Income

14.836.8Domestic Equity

Yale University

(%)

Educational Institutions

(%)

Page 65: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Rising Short-term Interest Rates

JANJULJANJULJAN200520042003

3.0

2.5

2.0

1.5

1.0

0.5

Percent

Fed Fund Target

3-month Treasury

Page 66: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Corporate Bond Default Rates

04020098969492908886848280

15

12

9

6

3

0

%

Page 67: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

Corporate Defaulted Bonds Par Values

04020098969492908886848280

100

80

60

40

20

0

US$, billions

Page 68: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

High Yield Spread Over Treasuries

0402009896949290

2500

2000

1500

1000

500

0

Basis points

High Yield Distressed Debt

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200420022000199819961994

300

250

200

150

100

50

Index, 1994=100

All DistressedEmerging Mkts Event Driven

Hedge Fund Returns by Strategy

Page 70: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

200420022000199819961994

300

250

200

150

100

50

Index, 1994=100

Risk Arb Global MacroLong/Short Equity Mkt Neutral

Hedge Fund Returns by Strategy

Page 71: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

U.S. vs. Europe Equity Markets Comparison

• Significant growth of market capitalisations on both sides of the Atlantic with U.S. still outstripping Europe (US$13tn vs. US$10tn)

• Total market capitalisations currently U.S. 57% vs. 43% in Europe, roughly the same in 1995

• Significant trading volume growth in Europe over last 10 years, both markets now evenly balanced

• Europe now closing gap in terms of forward trading multiples with US vs. late 90s/early 2000 when U.S. was two to three points higher than Europe

• Number of US IPOs (288 in 2004) still significantly ahead of Europe (89 in 2004) but U.S. deals smaller on average

• US$44bn raised in U.S. in 2004 with average size of US$237m, US$35bn raised in Europe with average size of US$353m

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U.S. vs. EuropeBroad Themes

• Spitzer has made his mark on both sides of the Atlantic• Sarbanes-Oxley compliance having a significant impact on

non-US companies– over half of large European companies spending more than 100,000

hours on corporate governance, double number of their US counterparts

– increasing propensity to consider delisting and then deregistering• Increasing interest in trading directly on a Company’s home market

– demise of ADR trading, reduced number of 144A placings• Investor audience changing rapidly

– global vs domestic portfolio managers• Hedge fund explosion, now over US$1 trillion (7,000–8,000

worldwide)– uses of derivatives, contracts for differences– generated as much as US$25bn in revenues for investment banks– largely unregistered, actively managed, performance oriented– account for 30–50%of LSE volumes

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U.S. vs. EuropeLooking Forward

• UBS forecasting continued dollar weakness, supportive of underweight US call, overweight Europe, Japan, Asia

• Broad rate increases driven by US and this will continue—UBS forecasting year end Fed Funds rate of 4% and US 10 year treasuries at 5.3%

• Positive on non-US equities– valuations more supportable– profitability and restructuring– productivity gains and lower unit labor costs

• Extremely healthy global corporate picture spurring growth, job creation and greater price competition

Page 74: The Future of...Financial Innovation : Last 1000 Years 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1156:Foreign exchange contract 1160: Bill of Credit 3000 - 2000 BC:

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