[Federal Register Volume 64, Number 92 (Thursday, May 13, 1999)]
[Notices]
[Pages 25932-25936]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-12066]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-41368; File No. SR-CBOE-98-50]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change by the Chicago Board Options Exchange, Incorporated Relating to
the Trading of Differential Index Options
May 5, 1999.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on November 21, 1998, the Chicago Board Options Exchange, Incorporated
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange
Commission (``Commission'') the proposed rule change as described in
Items I, II, and III below, which Items have been prepared by the CBOE.
The Exchange filed Amendment No. 1 \3\ to the proposed rule change on
April 27, 1999. The Commission is publishing this notice to solicit
comments on the proposed rule change as amended from interested
persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19B-4.
\3\ See Letter to Michael A. Walinskas, Division of Market
Regulation, Commission, from Timothy Thompson, CBOE, dated April 26,
1999 (``Amendment No. 1''). Amendment No. 1 makes certain technical
changes to the proposed rule change.
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I. Self-Regulatory Organization's Statement of the Terms of
Substance of the Proposed Rule Change
The Exchange proposes to trade Differential Index Options, a new
type of standardized index option whose value at expiration is based on
the relative performance of either a designated index versus a
benchmark index, a designated stock versus a benchmark index, or a
designated stock versus a benchmark stock. The text of the proposed
rule change is available at the Office of the Secretary, the CBOE and
at the Commission.
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the CBOE included statements
concerning the purpose of, and basis for, the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. The CBOE has prepared summaries, set forth in sections
A, B, and C below, of the most significant aspects of such statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
1. Purpose
The Exchange is proposing to trade a new type of standardized index
option, the Differential Index Option, which will offer new investment
and hedging opportunities. Differential Index Options will have a value
at expiration based on an index, called the ``differential index,'' of
the relative performance of a designated index versus a benchmark index
over a specific time period (``Index Differential Option''); of a
designated stock versus a benchmark index over a specific time period
(``Equity Differential Option''); or of a designated stock versus a
benchmark stock over a specific time period (``Paired Stock
Differential Option''). If the percent gain in the level of the
designated index or stock during the period is greater than the percent
gain in the underlying benchmark index or stock, then a Differential
Call Option originally struck at the money will have a positive value
at expiration and a Differential Put Option originally struck at the
money will expire worthless. If the percentage gain in the level of the
designated index or stock during the period is less than the percent
gain in the underlying benchmark, then a Differential Put Option
originally struck at the money will have a positive value at expiration
and a Differential Call Option originally struck at the money will
expire worthless. Thus, a Differential Index Option affords an investor
the opportunity, through a single investment, to participate in the
relative outperformance of a designated index or stock versus a
benchmark index or stock (a Differential Call Option) or the relative
underperformance of a designated index or stock versus a benchmark
index or stock (a Differential Put Option) over the life of the option,
regardless of the
[[Page 25933]]
absolute performance of the designated index or stock.
For example, an investor may feel that software companies will
outperform the broader market over the next several months, but is
unsure whether the overall market will move higher or lower. If the
investor were to buy an at-the-money standardized CBOE Computer
Software Index (``CWX'') call option and the Index declined, the option
would expire worthless even if the Index declined by a much smaller
percentage than the overall market. On the other hand, if the investor
were to purchase an at-the-money Index Differential Call Option on the
relative performance of the CBOE Computer Software Index versus the
Standard & Poor's 100 Stock Index (``S&P 100''), a benchmark measure of
large capitalization stock market performance, and CWX declined by a
smaller percentage than the S&P 100, the Index Differential Call Option
would have a positive value at expiration. Conversely, an investor who
believes that CWX will underperform the S&P 100 may purchase at-the-
money Index Differential Put Options perhaps to hedge a portfolio of
software company stocks against such market underperformance. If CWX
underperforms the S&P 100, the Index Differential Put Options will have
a positive value at expiration, regardless of whether the CWX index
level itself has increased or decreased on an absolute basis. In
effect, the Differential Option structure removes the overall market
risk component from the CBOE Computer Software Index performance.
Differential Calculation. The underlying security for a
Differential Index Option is an index (called the ``differential
index'') of the performance of the designated stock or index relative
to the benchmark stock or index. The differential index is calculated
as follows: on the base date of each year, prior to the listing of a
Differential Index Option series, base reference prices are established
for the designated index or stock and the benchmark index or stock
(typically, the closing levels on a designated business day).
Thereafter, percent changes from the base values of both the designated
index or stock and the benchmark index or stock are continuously
calculated and the percent change in the benchmark is subtracted from
the percent change in the designated index or stock, providing a
positive number if the designated index or stock has either out-gained
or suffered a lesser percentage decline than the benchmark, and a
negative number if the benchmark has out-gained the designated index or
stock or suffered a lesser percent loss.
The percentage differential in the relative gain or loss is then
multiplied by 100 and added to a fixed base index value (typically 100)
to yield the differential index which will underlie the Differential
Index Options:
Dt=((It/Io)-(Bt/
Bo)) x 100 + F
Where:
D = differential index;
I = designated index or security;
B = benchmark index or security;
t = current or settlement value of index or security;
o = base reference value of index or security;
F=a fixed base index value, typically 100.
Thus, if the designated index or security has outperformed the
benchmark by 7%, and the fixed value, F, is set at 100, the
differential index value will be 107; if it has underperformed by 7%,
the differential index value would be 93. The base reference values
will remain in effect for a predetermined, fixed period (expected to be
between six months and two years). Similar to other index values
published by the Exchange, the value of each differential index will be
calculated continuously and disseminated every 15 seconds \4\ under
separate symbol by the Option Price Reporting Authority.
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\4\ Telephone call between Sonia Patton, Attorney, Division of
Market Regulation, Commission, and William Speth, Research and
Planning, CBOE, on April 23, 1999.
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Adjustments. For Differential Index Options whose benchmark and
designated securities are both indexes, adjustments will be made to the
Differential Index Options whenever significant action has been taken
by the publisher of the index. Such actions may include the splitting
of the value of the designated or benchmark index or a change in the
method of calculation. For example, if the publisher of an index were
to split the index two-for-one, the Exchange would halve the base
reference value of the index in the differential calculation. If an
index ceases to be published, the Exchange (1) may replace it with a
substitute index (i.e., one that correlates highly with the index being
replaced) or a successor index (i.e., an index intended by the
publisher as a replacement to the original index); or (2) may undertake
to publish the index using the same procedures last used to calculate
the index prior to its discontinuance.
The stock component of an Equity Differential and a Paired Stock
Differential will be adjusted as follows: (1) for a stock dividend,
stock distribution, or stock split, whereby a number of shares (whether
a whole number or other than a whole number) of the security are issued
with respect to each outstanding share, the base price will be adjusted
by the split factor in the Differential Index calculation; (2) for a
reverse stock split or combination of shares whereby a number of shares
(whether a whole number or other than a whole number) of the security
are replaced by or combined into a single share, the base price will be
adjusted by the split factor in the Differential Index calculation; (3)
generally, there will be no adjustments to reflect ordinary cash
dividends or distributions, or ordinary stock dividends or
distributions made by the issuer of the benchmark or designated stock
(The terms ``ordinary cash dividends or distributions'' shall have the
meanings as set forth in Article VI, Section 11 of the By-Laws of The
Options Clearing Corporation.); (4) when a security is converted into a
right to receive a fixed amount of cash, such as in a merger, the
Exchange will replace that security with the cash value and may
accelerate the expiration and settlement of the European-style
Differential Index option of which the security was a part or allow the
option to continue to trade until its original expiration using the
cash value as the current security price in the Differential Index
calculation; and (5) in the case of a corporate reorganization, re-
incorporation or similar occurrence by the issuer of a security which
results in an automatic share-for-share exchange of shares of the
issuer for shares in the resulting company, the Exchange will
substitute the new security for the original security in the
Differential Index calculation in the appropriate ratio.
In addition, contract adjustment will be made to differential
Indexes to limit the likelihood of negative index values. In the event
that the level of a Differential Index settles below 20, the contract
will be adjusted by: (1) Adding 100 to the Differential Index level,
and (2) adding 100 to the exercise price of the options.
Designated Indexes, Designated Stocks, Benchmark Indexes and
Benchmark Stocks. Only stocks which meet the current Exchange Rules for
listing standardize equity options will be eligible designated stocks
in Equity Differential Options. Only stocks which meet the current
Exchange Rules for listing standardized equity options will be eligible
designated stocks or benchmark stocks in Paired Stock Differential
Options. In this way, only
[[Page 25934]]
the most liquid, actively traded stocks will be considered.
Similarly, only indexes that meet the current Exchange Rules for
listing index options or that have been approved for options or warrant
trading by the Commission will be eligible for designation either as
designated indexes or benchmark indexes in Equity and Index
Differential Options. In this way, only those indexes already deemed by
the Commission to be suitable for options trading will be considered.
Expiration and Settlement. The proposed Differential Index Options
will be European style (i.e., exercises permitted at expiration only),
and cash settled. Index Differential Options in which both the
designated or benchmark indexes are broad-based will trade between the
hours of 8:30 a.m. and 3:15 p.m. Central time. All other Differential
Index Options will trade between 8:30 a.m. and 3:02 p.m. Central time.
Differential Index Options will expire on the Sunday following the
third Friday of the expiration month (``Expiration Friday''). The last
trading day in an expiring options series will normally be the second
to last business day preceding the Saturday following the third Friday
of the expiration month (normally a Thursday). Trading in expiring
options will cease at the close of trading on the last trading day.
While the Exchange seeks approval to list series of Differential
Index Options as set forth in Rule 28.4(a)(i), (ii), (iii) and (iv), it
is anticipated that the Exchange will initially list only five series
with expirations corresponding to the four calendar months in the March
cycle in the current calendar year, and a fifth series expiring in
March of the following calendar year.
The exercise settlement value for Index Differential Options will
be calculated based on the respective exercise settlement values for
standardized options on each of the designated and benchmark indexes
expiring on the same day. The exercise settlement value for Equity
Differential Options will be calculated based on (i) the primary
exchange regular-way opening sale price of the designated stock, or, in
the case of a stock traded through the NASDAQ system, the first
reported regular way sale that occurs when the markets are unlocked and
uncrossed, provided that such sale price is within the current best bid
or offer, and (ii) the exercise settlement value for standardized
options on the benchmark index expiring on the same day. The exercise
settlement value for Paired Stock Differential Options will be
calculated based on the primary exchange regular way opening sale
prices of the designated and benchmark stocks, or, in the case of a
stock trade through the NASDAQ system, the first reported regular way
sale that occurs when the markets are unlocked and uncrossed, provided
that such sale price is within the current best bid or offer. To ensure
that the settlement price used satisfies these factors, the Exchange
reserves the right to exclude a price from the settlement calculation
for a Differential Index Option if it believes, in its best judgment,
that such price is not indicative of the true price at that time.
Applicable Exchange Rules. CBOE Rules 28.1 through 28.12 will apply
to the trading of Differential Index Option contracts. These Rules
cover issues such as exercise prices and positions limits. Surveillance
procedures currently used to monitor trading in each of the Exchange's
options will also be used to monitor trading in Differential Index
Options. In addition, Differential Index Options will be subject to the
Exchange's sales practice and suitability rules applicable to
standardized options.
Differential Index Options are ``securities'' under Section
3(a)(10) of the Act, and therefore are exempt pursuant to Section 28(a)
of the Act from any state law that prohibits or regulates the making or
promoting of wagering or gaming contracts, or the operation of ``bucket
shops'' or other similar or related activities. Differential Index
Options will be traded pursuant to the Exchange's rules and rule
amendments discussed herein, which are subject to prior approval by the
Commission.
Position Limits. The Exchange proposes that the position limits for
Index Differential Options be set at the lower of the separate position
limits for standardized index options trading on the designated index
and the benchmark index. In the event that one or both of the indexes
is not currently the subject of standardized index options trading,
then the Exchange will establish position limits as the lesser of those
that would be in effect for standardized options on the indexes if such
options were trading. In the event neither the designated index nor the
benchmark index is subject to position limits the Index Differential
Options shall not be subject to position limits. The Index Differential
Options shall be subject to any reporting requirements applicable to
the underlying indexes.
For Equity Differential Options, the Exchange proposes that the
position limits be set at the position limit of standardized equity
options trading on the designated stock. In the event that standardized
options currently do not trade on the designated stock, then the
Exchange will establish a position limit at the level that would be in
effect if standardized options did trade on such stock. For Paired
Stock Differential Options, the Exchange proposes that the position
limits be set at the lower of the separate position limits of
standardized equity options trading on the designated and benchmark
stocks. In the event that one or both of the stocks is not currently
the subject of standardized options trading, then the Exchange will
establish position limits as the lesser of those that would be in
effect for standardized options on the stocks if such options were
trading.
The Exchange also proposes, for position and exercise limit
purposes, to require that positions in Differential options with the
same designated or benchmark stock or narrow-based index be aggregated.
For example, if a Paired Stock Differential option has been created
using General Motors Corporation stock as the benchmark and Ford Motor
Company as the designated stock, positions in that differential option
will be aggregated with position in other Paired Stock Differentials
and Equity Differentials using narrow-based indexes created using
either General Motors or Ford as the benchmark or designated stocks to
determine whether the account is in compliance with the position and
exercise limit rules. However, with respect to the use of broad-based
indexes as either the benchmark or designated index in an Equity or
Index Differential, no aggregation of positions will be required. For
example, if Equity Differentials are created using the S&P 100 as the
benchmark index and AT&T Corp., Dow Chemical Company, and International
Business Machines as designated stocks, members will not be required to
aggregate positions in those Differential Options to determine whether
an account is in compliance with position and exercise limit rules.
In consultation with the Commission, the Exchange will establish
the appropriate option position limit for a Differential Index option,
where the Exchange chooses as either a designated or benchmark index, a
broad-based index that has been approved by the Commission for index
warrant trading only. The position limit for a Differential Option
using a narrow-based index warrant will be established using the
Exchange's narrow-based index option rules.
The Exchange further proposes that Differential Index Options not
be aggregated with other standardized options on the underlying
designated
[[Page 25935]]
stock or index or on the underlying benchmark stock or index for
purposes of determining whether an account is in compliance with
position and exercise limit rules. The Exchange believes this policy is
appropriate for the following reasons. First foremost, the value of
Differential Index Options will be calculated in a different manner
from the value of other currently traded standardized equity and index
options. In fact, because of the subtraction of the performance of the
benchmark from the designated stock or index, the value of a
Differential Index Option may appreciate (depreciate) even as the value
of the corresponding standardized option on the designated stock or
index decreases (increases). Further, the value of a Differential Index
Options is in part a function of the correlation between the designated
stock or index and the benchmark (i.e., the tendency of the designated
stock or index and the benchmark to move concurrently). This
correlation component of the Differential Index Option price is not
considered in determining the value of other standardized options on
either the designated or benchmark stock or index. As a result, the
Differential Index Option is likely to be more or less sensitive to
movements in the designated stock or index than the other standardized
options on that stock or index, and changes in the Differential Index
Option's price may be in the opposite direction from changes in other
standardized options prices. Therefore, any attempt to aggregate
Differential Index Options with other standardized options for
determination of position limits would be combining contracts which, by
nature, can change in value quite differently.
Differential Index Options also have certain terms not found in
many other standard equity and index options. Each Differential Index
Option contract changes in value as a function of the differential
performance of a $10,000 long position in the designated stock or index
and a $10,000 short position in the benchmark. Many standardized equity
options are settled by physical delivery of 100 shares of the
underlying stock, worth $5,000 per contract for a $50 stock, and
feature American exercise. Standardized index options typically feature
European-style exercise, cash settlement, and represent approximately
$25,000 worth of a basket of stocks (with the index at the 250 level).
Any meaningful aggregation of positions in contracts with different
terms would be difficult to establish as a simple rule, and would
require a case-by-case analysis of the terms for each Differential
Index Option contract compared to other standardized contracts on the
designated and/or benchmark stock or index.
The Exchange also believes that the aggregation of position limits
hinders the probability of success of any new product. The aggregation
of positions in Differential Options with positions in standardized
options will result in the new product competing with the established
product for a limited amount of potential volume. Thus, with aggregated
position limits, new products cannot ``grow the pie'' and increase
overall liquidity in all of the products; they start at a disadvantage
which may be impossible to overcome.
FLEX Options. The Exchange is modifying its FLEX rules to provide
for trading of FLEX options on Differential Index Options. In addition,
the Exchange is deleting the list of index options on which it may
trade FLEX options set forth in Rule 24A.4(b)(1) and is replacing it
with a statement that the Exchange may trade FLEX options on any index
or differential index (as defined in Chapter XXVIII) for which the
Exchange has been approved to trade options or warrants. This change is
consistent with American Stock Exchange Rule 903G(a)(1).
Customer Margin. The Exchange proposes to apply standard index
options margin treatment to Differential Index Options. Index
Differential Options on the relative performance of one broad-based
index versus another will be margined as broad-based index options and
short positions therein will require margin equal to the current market
value of the Differential Index Option plus an amount equal to 15% of
the market value of the Differential Index reduced by any out of the
money amount to a minimum of the current market value of the option
plus 10% of the Index. All other Index Differential Options, Equity
Differential Options and Paired Stock Differential Options will be
margined as narrow-based index options and short positions therein will
require an amount equal to the current market value of the Differential
Index Option plus an amount equal to 20% of the market value of the
Differential Index reduced by any out of the money amount to a minimum
of the current market price of the option plus 10% of the Index. The
Exchange believes that this method of determining customer margin is
appropriate because the range of volatilities expected for Differential
Indexes should not be significantly different than the expected range
for other indexes and equities. This is because the volatility of a
Differential Index is based upon the volatilities of the designated and
benchmark indexes or stock and the correlation of these components.
2. Statutory Basis
The Exchange believes the proposed rule change is consistent with
Section 6(b) of the Act,\5\ in general, and furthers the objectives of
Section 6(b)(5),\6\ in particular, in that it will permit the trading
of Differential Index Options pursuant to Exchange Rules designed to
prevent fraudulent and manipulative acts and practices, to promote just
and equitable principles of trade, to foster cooperation and
coordination with persons engaged in facilitating transactions in
securities; and to remove impediments to and perfect the mechanism of a
free and open market and a national market system, and to protect the
public interest.
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\5\ 15 U.S.C. 78f(b).
\6\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organizations Statement on Burden on Competition
The CBOE does not believe that the proposed rule change will impose
any burden on competition.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
The Exchange did not solicit or receive written comments on the
proposed rule change.
III. Date of Effectiveness of the Proposed Rule Change and Timing
for Commission Action
Within 35 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if it finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which the self-regulatory organization consents, the Commission will:
(A) By order approve such proposed rule change, or
(B) Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed rule
change is consistent with the Act. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W.,
[[Page 25936]]
Washington, D.C. 20549-0609. Copies of the submission, all subsequent
amendments, all written statements with respect to the proposed rule
change that are filed with the Commission, and all written
communications relating to the proposed rule change between the
Commission and any person, other than those that may be withheld from
the public in accordance with the provisions of 5 U.S.C. 552, will be
available for insepction and copying in the Commission's Public
Reference Room. Copies of such filing will also be available for
inspection and copying at the principal office of the CBOE. All
submissions should refer to File No. SR-CBOE-98-50 and should be
submitted by June 3, 1999.
For the Commission by the Division of Market Regulation,
pursuant to delegated authority.\7\
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\7\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-12066 Filed 5-12-99; 8:45 am]
BILLING CODE 8010-01-M
