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Risk Management in the Era of Dissonance The research views expressed herein are those of the author and do not necessarily represent the views of the CME Group or its affiliates. All examples in this presentation are hypothetical interpretations of situations and are used for explanation purposes only. This report and the information herein should not be considered investment advice or the results of actual market experience.

Blu Putnam Chief Economist, CME Group April 2012


Risk Disclosures Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. The Globe Logo, CME, Chicago Mercantile Exchange, and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago. NYMEX, New York Mercantile Exchange, and ClearPort are trademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. CME Group is a trademark of CME Group Inc. All other trademarks are the property of their respective owners. The information within this presentation has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this presentation are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, CBOT, and NYMEX rules. Current rules should be consulted in all cases concerning contract specifications.

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Risk Management in the Era of Dissonance Sources of Dissonance (Long-Term Challenges) Global Economic Divergence (Current Outlook) Risk Management Implications

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Sources of Dissonance: Long-Term Challenges Population Dynamics Politics of Maturing Countries Politics of Youthful Nations

Property Rights Are the rules of the game fixed or changing? Can one plan ahead with confidence? Or must one learn the skills of dealing with increasing ambiguity?

Policy Constraint Challenges in the Maturing Countries Fiscal Austerity to cope with too much debt Complexity of exiting quantitative easing programs

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Sources of Dissonance: Population Dynamics – Aging

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Sources of Dissonance: Population Dynamics – The Elders

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Political Implications: Maturing Countries Health and Wealth Keep safe what you have earned already Economic preferences for price and currency stability Focus on health care systems and costs Political challenges associated with managing costs for skyrocketing demands for health care as a population ages

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Sources of Dissonance: Population Dynamics – Youth

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Political Implications: Youthful Nations Job Creation With half the population under 30 and a rapidly growing work force, the focus is on job creation. Youthful nations fear a strong currency can derail job growth and create a spiral of political instability.

Greater Inflation Tolerance A rapidly growing labor force and middle class creates additional frictional inflation pressures not felt in maturing economies. Compared to maturing nations, youthful nations may choose to accept a moderately higher rate of inflation (say 4% to 8%) as part of the price of managing rapid real economic growth in a dynamic economy.

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Current Status United States Potential labor force growth slowing and already limiting long-run economic growth potential China Politics of aging are beginning to compete with the politics of job creation. The larger aging challenges are still a decade away, but they will slow economic growth dramatically when they arrive. Europe & Japan Labor force growth has been non-existent for a long time, and long-run potential real GDP growth average 1.5% to 2.0% at best. Emerging Markets Strong long-term potential, robust growth of middle class.

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Sources of Dissonance: Economic Growth Divide (Last Decade)

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Sources of Dissonance: Economic Growth Divide (Next Decade) C u m u la tiv e  R e a l G D P  G ro w th  P ro je c tio n   fo r 2 0 1 1 ‐2 0 Ja p a n E u r o ‐Z o n e UK US B ra z il In d ia C h in a 0%

© 2011 CME Group. All rights reserved

50% 100% 150% S o u r c e :  C M E  R e s e a r c h  E s tim a te s .

200%

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Sources of Dissonance: Property Rights Property Rights – Broadly defined as the legal and political context which influences how well individuals and corporations can plan for the future. United States Dodd-Frank Rules Still Uncertain Health Care Legislation in Front of the Supreme Court Taxation Changes Delayed into 2013 (and beyond?) China Changing Rules/Pace for RMB Normalization and Bond Market Europe & UK Financial Transaction Tax and Future of City of London Emerging Markets Pendulum of property rights swinging in their favor, in general

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Example: US Financial Company Profits Remain Impacted by Dodd-Frank Uncertainty US Financial Corporate Profits si 600 sa B   500 P D  G , 400 e ta  R la 300 u n n A  , 200 sr al l 100 o  D S U  f 0  o s n‐100 o il li 2000 B

© 2011 CME Group. All rights reserved

2002

2004

2006

2008

2010

Source: Financial Company Profits (CPBIDIF2) provided through the  Bloomberg Professional.

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Sources of Dissonance: Constrained Fiscal Policy

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Sources of Dissonance: Fiscal Policy Status United States Major fiscal decisions delayed until 2013 helps 2012 economic growth outlook, makes for an uncertain long-run. In all scenarios, though, economic growth is likely to be constrained for a decade. UK Very tough fiscal reform has taken its toll on the economy. Europe Sovereign debt situation is no longer a crisis, but the medicine involves a protracted fiscal drag on the EU economies. Japan If the credit ratings had any consistency in how they rank countries, Japan would look like a nightmare debt bubble. China & Emerging Markets Fiscal policies generally in good shape.

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Sources of Dissonance: Monetary Policy Status United States Federal Reserve to debate exit strategy from Quantitative Easing in second half of 2012 and into 2013. FOMC may commence raising the Federal funds rate in 2013 instead of 2014. Recent decision by the FOMC to publish Fed funds rate projections of its participants may lead to some market volatility around publication dates (4 times per year). China May choose to adopt highly expansionary monetary policy as growth decelerates. Foreign reserve growth may halt as a consequence. RMB normalization progress may accelerate.

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Sources of Dissonance: Monetary Policy Status UK Monetary policy to stay accommodative to offset tough fiscal reform, but this policy mix has not worked so far. Europe ECB likely to keep rates on hold. ECB has provided nearly unlimited long-term liquidity to the under-capitalized banking system. ECB will NOT be a lender of last resort to countries in fiscal trouble. Japan Zero-rates for ever? Emerging Markets Rates being cut to cushion economic growth deceleration.

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Economic Divergence: 2012 Update United States 3.0% to 4.0% real GDP growth in 2012, slowing a little in 2013 Europe & UK Flirting with recession on average, some growth in northern European countries which benefit more from the weaker Euro. China Decelerating growth in 2012. Transition to consumer-driven economy will not be smooth or easy. Japan Reasonable (trend) year for economic growth, as the rebuilding from the devastating earthquake and tsunami in 2011 continues. Emerging Markets Slower growth in 2012, but middle class expansion continues to suggest excellent long-run potential.

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US Economic Growth Outlook U S Real G DP G row th Rate 5% e g n 4% a h 3% C   e g 2% at n 1% e cr e 0% P   ‐1% e g ar ‐2% e v‐3% A  l a‐4% u n n A

3 .4 7 %

3 .6 5 % 3 .0 7 %

2 .5 4 %

3 .0 3 %

2 .6 6 % 1 .9 1 %

1 .8 1 %

2 .7 4 % 1 .7 2 %

1 .0 8 %

‐0 .3 4 %

Fo recasts

‐3 .4 9 %

1 0 0 2

2 0 0 2

3 0 0 2

4 0 0 2

5 0 0 2

6 0 0 2

7 0 0 2

8 0 0 2

9 0 0 2

0 1 0 2

1 1 0 2

2 1 0 2

3 1 0 2

So u rce :  Blo o m b erg Pro fessional (GD P CH W G), Fo recasts b y CM E Gro u p  Rese arch . 

© 2011 CME Group. All rights reserved

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US Consumer Credit US Consumer Credit 3.0 2.5

sr all o2.0 D  S U  f 1.5 o  s n o ill 1.0 ir T

End of Deleveraging by US  Consumer during 2011

0.5 0.0

1 9 9 1

2 9 9 1

3 9 9 1

4 9 9 1

5 9 9 1

6 9 9 1

7 9 9 1

8 9 9 1

9 9 9 1

0 0 0 2

1 0 0 2

2 0 0 2

3 0 0 2

4 0 0 2

5 0 0 2

6 0 0 2

7 0 0 2

8 0 0 2

9 0 0 2

0 1 0 2

1 1 0 2

Source:  Bloomberg Professional   (CCOSTOT  Index)

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US Corporate Profits Have Recovered from the 2008-2009 Financial Panic US NonFinancial  and Financial Company  Profits (GDP Basis with Inventory Adjustment) s1200 e ta R  l 1000 a u n 800 n A  t a  600 sr al l 400 o D  S  U f 200 o  s n 0 o il li B ‐200

Non‐Financial Corporations

Financial Corporations 1981

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1986 1991 1996 2001 2006 2011 Source: Financial (CPBIDIF2) and NonFinancial (CPBIDIN2) Profits  provided through the Bloomberg Profressional.

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US New Weekly Unemployment Claims New Weekly Unemployment Claims Have  Continued to Decline ‐‐ the Unemployment  Rate Will Eventually Follow e c n ar u s n I  t n e m y o l p m e n U   w e N

700 k600 e e500 W  r e400 p  s 0300 0 0 200  1 ,s m ia100 l 0 C

2006

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2007 2008 2009 2010 2011 2012 Source:  Unemployment Claims Data (INJCJC) from the  Bloomberg Profressional.

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Increased Consumer Credit will Feed Into Retail Sales US Retail Sales Growth 15%

e g 10% n a h C  t 5% n e cr e P  r 0% a e Y  r ‐5% e v o  r a‐10% e Y

Steadier Retail  Sales Growth  Ahead

‐15%

Dec‐04

Dec‐05

Dec‐06

Dec‐07

Dec‐08

Dec‐09

Dec‐10

Dec‐11

Source:  Bloomberg Professional  ( RSTATOTLIndex)

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Fiscal Policy Post Office has adopted plan to shed 100,000 jobs through attrition, less service – may postpone cash flow crunch temporarily. Bush tax cuts will expire on 31 December 2012, and it will be left to the next Congress to retro-actively (to January 1, 2013) decide on new tax rates. Debt ceiling will be hit again early in 2013. The Joint Budget Super Committee failed, so large spending cuts automatically kick-in in FY 2013, unless the new Congress decides to make some changes.

All the big fiscal policy decisions will hit the new Congress just after they are sworn into office.

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US Inflation Outlook Inflation Creeps Higher in 2013‐2014, Core Converges  on Total Inflation, as Monetary Policy Gains Traction 5% e ta R   d e zil 4% a u n n3%  A ra e Y ‐r2% e v o ‐r a1% e Y  , t n e cr0% e P

Total CPI Inflation

Core Inflation 6 0 0 2

7 0 0 2

8 0 0 2

9 0 0 2

0 1 0 2

1 1 0 2

2 1 0 2

3 1 0 2

4 1 0 2

Source:  Blooomberg Professional  for Historical  Data,  CME Research for Forecasts  through 2014.

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There is a Wide Dispersion of Views on the FOMC Views of FOMC Participants on When to Raise the  Federal Funds Rate 6 st 5 n a p ic it 4 ra P   C M3 O F  f o  r 2 e b m u N1 0

2012

2013

2014

2015

2016

Source: FOMC Participants' Supplemental Economic Projections, Federal Reserve Board,25 January 2012

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Back 32 Months of Eurodollar Futures Trading Volume

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Top Trading Days in 2011 for Weekly Rate Options Trade Date

Total Volume

Open Interest

Event

Thursday, October 27, 2011

50,736

77,598 50% Greek Haircut Agreement

Thursday, August 04, 2011

49,693

65,018 August Unemployment

Thursday, March 10, 2011

48,673

56,321 Japanese Earthquake

Friday, March 04, 2011

41,453

22,002 March Unemployment

Thursday, March 03, 2011

40,889

56,886 March Unemployment

Friday, October 28, 2011

40,226

31,201 October Unemployment

Thursday, March 31, 2011

36,857

59,387 Jobless Claims

Friday, November 04, 2011

34,427

16,787 November Unemployment

Friday, December 02, 2011

34,103

18,981 December Unemployment

Thursday, January 05, 2012

33,828

46,695 January Unemployment

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FOMC 2011 Real GDP Projections were too Optimistic FOMC Participants 2011 Real GDP Projections 6%

Upper Range Central Tendency

4%

Lower Range

2%

0%

Source: FOMC Participants' Supplemental Economic Projections, Federal  Reserve Board

© 2011 CME Group. All rights reserved

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FOMC 2012 Real GDP Projections have been depressed by their 2011 Mistakes FOMC Participants 2012 Real GDP Projections 6% Upper Range

4%

Central Tendency

Lower Range

2%

0%

Source: FOMC Participants' Supplemental Economic Projections, Federal  Reserve Board

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European Bank Stocks European Bank Stocks: Hit Hard in the  Summer of 2011 Have Now Stabilized 0140 0 1  =120   1 1 0100  2 yr a 80 u n aJ   60 1   o t  d 40 e x e 20 d n I  s e ci 0 r  P kc o tS

© 2011 CME Group. All rights reserved

Euro Stoxx 50 Index

Societe Generale Stock

Source:  Bloomberg Professional (GLE FP & SX5E) 

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European Bond Spreads

 s d a e r p S  d l e i Y  r Y ‐ 0 1   n ail at I  d n a  h si n a p S

European Soveriegn Bond Market Tensions Finally  Start to Ease in Q4/2011 with Arrival of IMF,  Coordinated Global Central Bank Support, and  clearer ECB Policy Stance

6%

st n i 5% o P   4% e ga t3% n e cr2% e P   n  iy1% n a0% m r e G  r e v o

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Spain

Italy

Source:  10‐Year Generic Government Debt Yields provided by Bloomberg  Professional.

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Market Implications: Counterparty Risk

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China Economic Growth China: Average Annual GDP Growth by Decade 12% 10.4% e ta R   h t 8% w o r  G e ga r e v A l a 4% u n n A

10.5%

9.3%

6.2%

6.5% Estimate

3.6%

0% 1961‐1970 1971‐1980 1981‐1990 1991‐2000 2001‐2010 2011‐2020 Source:  Real GDP History based on World Bank Annual  Data provided through  the Bloomberg Professional.   Forecasts by CME Research.

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China will hit a Brick Wall in terms of Economic Growth in the 2020s China’s current rapid rate of real GDP growth is fueled by the rural to urban migration which will run its course during this decade.

China is aging (in terms of average age) faster than any major country ever has, thanks to decades of the one-child policy.

In the decade of the 2020s, China’s rapidly aging population and stagnant labor force will totally change growth dynamics in the country.

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China Foreign Reserve Growth to Slow

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Japan Economic Growth

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Brazil: Short-Term Interest Rates & Inflation Brazil Overnight Rate and Inflation Both Headed Downward 20%

SELIC Rate

18% e ta16% R   14% e ga t 12% n e cr 10% e  P la 8% u 6% n n 4% A 2%

Inflation Rate

0% 2006

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2007 2008 2009 2010 2011 Source: SELIC (BZSELICA) and Inflation (BZPIIPCA) provided  through the Bloomberg Professional.

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India: Short-Term Interest Rates & Inflation India: Inflation Declining, Rates May Follow 25% Inflation 20% e ta R   e ga t 15% n e cr e P  l 10% a u n n A 5% Money Market Rate 0% 2006

2007

2008

2009

2010

2011

Source: Money market rate (NSERO) and Inflation (INCPIIND) provided  through the Bloomberg Professional. 

© 2011 CME Group. All rights reserved

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Commodity Market Challenges for 2012 Oil Declining US Imports. Increased US and Canada supply Weakening China and Emerging Market Demand Weaker fundamentals point to lower prices, but Iran fears can trump supply/demand fundamentals Gold Debate in US over exit from Quantitative Easing Declining market fears associated with Europe Central Bank Buying Corn & Wheat Rise of middle class in Emerging Market Countries Continued volatile weather patterns

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US Crude Oil Imports may be leveling off? US Monthly Oil Imports 45 e ta40 R  y35 l h t30 n o M  , 25 s n o il 20 li B  r15 lal o10  D S U5 0 2000

2002

2004

2006

2008

2010

Source: US Monthly Crude Oil Imports (USIMCRUD) provided through  the Bloomberg Professional.

© 2011 CME Group. All rights reserved

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Policy: Foreign Reserves – Gold & Diversification Challenge the US dollar

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Changes in Ground Water have tremendous potential to disturb agricultural production.

Source: Map produced by NASA using data from the NASA/German Aerospace Center Gravity Recovery and Climate Experiment (Grace) mission.

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Rain Patterns: Extra rain in 2010 actually resulted in a net transfer of water from the sea to the land – temporarily.

Source: Map produced by NASA using data from the NASA/German Aerospace Center Gravity Recovery and Climate Experiment (Grace) mission.

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Era of Dissonance: Risk Management Implications Politics matter more than ever for financial risk management Risk managers need to embrace forward-looking approaches given the limits of historical data and Quantitative systems need to be dynamic and error-learning Counterparty risk can matter as much as market price risk Exposures, such as options, that focus on dynamic volatility will play an increasingly important role in risk management. FX markets will often be the focal point as the arbiter of different economic prospects and policies between countries Asset classes are more inter-connected than ever, but not necessarily in a stable manner Security exposures within an asset class may rise and reduce diversification at the wrong times

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Risk Management in the Era of Dissonance The research views expressed herein are those of the author and do not necessarily represent the views of the CME Group or its affiliates. All examples in this presentation are hypothetical interpretations of situations and are used for explanation purposes only. This report and the information herein should not be considered investment advice or the results of actual market experience.

Blu Putnam Chief Economist, CME Group April 2012


Era-of-Dissonance-Summary-Visuals_keynote