80 FR 42139 - Self-Regulatory Organizations; The Options Clearing Corporation; Order Granting Approval of Proposed Rule Change Concerning the Implementation of New Risk Models in Order To Support the Clearance and Settlement of Asian-Style Flexibly Structured Options and Flexibly Structured Cliquet Options

SECURITIES AND EXCHANGE COMMISSION

Federal Register Volume 80, Issue 136 (July 16, 2015)

[Federal Register Volume 80, Number 136 (Thursday, July 16, 2015)]
[Notices]
[Pages 42139-42141]
From the Federal Register Online  [www.thefederalregister.org]
[FR Doc No: 2015-17400]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-75427; File No. SR-OCC-2015-010]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Order Granting Approval of Proposed Rule Change Concerning the 
Implementation of New Risk Models in Order To Support the Clearance and 
Settlement of Asian-Style Flexibly Structured Options and Flexibly 
Structured Cliquet Options

July 10, 2015.

I. Introduction

    On May 1, 2015, The Options Clearing Corporation (``OCC'') filed 
with the Securities and Exchange Commission (``Commission'') the 
proposed rule change SR-OCC-2015-010 pursuant to section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder.\2\ The proposed rule change was published for comment in 
the Federal Register on May 22, 2015.\3\ The Commission received no 
comment letters regarding the proposed change. For the reasons 
discussed below, the Commission is granting approval of the proposed 
rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 34-74966 (May 14, 2015), 
80 FR 29784 (May 22, 2015) (SR-OCC-2015-010). The proposed rule 
change was published in the Federal Register on May 22, 2015, but 
was deemed published on May 1, 2015, pursuant section 19b(2)(E) of 
the Act.
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II. Description

    OCC is proposing to implement new risk models to support the 
clearance and settlement of Asian-style and Cliquet flexibly structured 
options \4\ (``Asian Options'' and ``Cliquet Options,'' respectively). 
OCC already clears other flexibly structured options (``Current Index 
Flex Options'') \5\ on various securities indices \6\ and risk manages 
clearing member positions (i.e., computes margin requirements) through 
its STANS methodology.\7\
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    \4\ Flexibly structured options permit the buyer and seller to 
negotiate and customize certain variable terms pursuant to exchange 
rules. See OCC By-Laws Article 1, section 1(F)(5). For example, 
parties may select from a variety of underlying indices, pick a 
strike price and expiration date as well as pick the exercise-style 
of the option--i.e., American or European exercise. Options with an 
American style exercise may be exercised at any time prior to, and 
including, expiration. Options with a European style exercise may 
only be exercised at expiration.
    \5\ The exercise settlement amount for Current Index Flex 
Options is determined based entirely on the strike price of a given 
option and the current underlying interest value on the day of 
exercise, in the case of American style Current Index Flex Options, 
or final day of trading, in the case of European style Current Index 
Flex Options.
    \6\ OCC clears Current Index Flex Options on the S&P 500 Index, 
S&P 100 Index, Nasdaq 100 Index and Russell 2000 Index, among other 
underlying indexes.
    \7\ See http://www.theocc.com/risk-management/margins/ for a 
description of OCC's margin methodology. See also OCC Rule 601.
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    Asian Options use an ``Asian-style'' methodology for determining 
the exercise settlement amount of an option, which is the difference 
between the aggregate exercise price and the aggregate current 
underlying interest value, which is based on the average of twelve 
monthly price ``observations.'' OCC states that traders of Asian 
Options will select an observation date as well as an expiration 
date.\8\
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    \8\ OCC provides that, since Expiration dates must be within 50 
to 53 calendar weeks from the date of listing, all Asian Options 
that it will clear will have a term of approximately one year. OCC 
explains that if the expiration date precedes the observation date 
in the final month, then the final ``observation'' will be the 
current underlying interest value on expiration date and not the 
observation date, and if one of the observation dates falls on a 
weekend or holiday, the value used will be from the previous 
business day.
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    Cliquet Options use a cliquet \9\ method for determining the 
exercise settlement amount of the option, which is the greater of: (i) 
Zero (i.e., the underlying index had negative returns during the 
option's tenor); and, (ii) the difference between the aggregate 
exercise price and the aggregate current underlying interest value, 
which is based on the sum of the Capped Returns of the underlying index 
on 12 predetermined ``observation dates'' \10\ (each an ``Observation 
Date,'' and the computed value an ``Observation'').\11\
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    \9\ Cliquet style settlement provides for payout based on the 
(positive) sum of ``capped'' returns of an index on pre-determined 
dates over a specified period of time.
    \10\ OCC states that the parties to a Cliquet Option will 
designate a set of Observation Dates for each contract as well as an 
expiration date. According to OCC, Observation Dates will generally 
be a given date each month for the twelve months preceding the 
expiration date, with the last Observation Date being the expiration 
date. If the Observation Date chosen by the parties to a Cliquet 
Option precedes the expiration date then OCC states that there will 
be two Observation Dates in the final month (i.e., the expiration 
date will always be an Observation Date) and ten other Observation 
Dates; one date in each of the ten months preceding the expiration 
month that will coincide with the Observation Date that was chosen 
by the parties to a Cliquet Option (not the expiration date). OCC 
explains that expiration dates must be within 50 to 53 calendar 
weeks from the date of listing, and that if one of the Observation 
Dates falls on a weekend or holiday, the previous business day will 
be deemed to be the Observation Date.
    \11\ OCC explains that, on each Observation Date, the exchange 
on which the Cliquet Options is listed will determine the actual 
return of the underlying index from observation period-to-
observation period, which will be compared to the observation cap, 
an amount designated the parties to the Cliquet Option. OCC further 
states that the Capped Return for a given Observation Date will be 
the lesser of the actual observation period-to-observation period 
return or the observation cap. For example, if the actual return of 
the underlying index was 1.75% and the designated capped return for 
a Cliquet Option was 2%, the 1.75% value will be included (and not 
the 2%) as the value for the Observation Date. Using this same 
example, if the actual return of the underlying index was 3.30%, the 
2% value will be included (and not the 3.30%) as the value for the 
Observation Date.

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[[Page 42140]]

    OCC states that both Asian Options and Cliquet Options will be only 
available in European style exercises, and will be subject to OCC's 
expiration exercise procedures set forth in OCC Rule 805, as 
supplemented by OCC Rule 1804. In addition, OCC represents that it will 
initially clear Asian Options and Cliquet Options on the S&P 500 Index, 
Nasdaq 100 Index, Russell 2000 Index and Dow Jones Industrial Average 
Index and it may clear Asian Options and Cliquet Options on other 
indices in the future.

New Risk Models

    As noted above, OCC will risk manage clearing member positions in 
Asian Options and Cliquet Options through its STANS methodology. Due to 
certain features of Asian Options and Cliquet Options described below, 
OCC proposed adding new pricing models into its STANS methodology so 
that OCC may compute appropriate margin requirements for clearing 
members holding positions in Asian Options and Cliquet Options.\12\
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    \12\ OCC explains that it currently computes the price of 
Current Index Flex Options on indices through standard pricing 
models (i.e., the Black-Scholes pricing model) that consider: (i) 
The value of the option's underlying index, (ii) the implied 
volatility of an option's underlying index, (iii) time until 
expiration, (iv) risk-free interest rate, and (v) the strike price 
of the option.
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Asian Options
    Asian Options differ from the Current Index Flex Options currently 
cleared by OCC due to the option's exercise settlement amount being a 
function of the arithmetic average of the underlying index on certain 
observation dates, rather than the value of the underlying index of a 
given option on the exercise date or expiration date. Based on this 
phenomenon, OCC proposed to add a new pricing model for Asian Options 
that will be a shifted lognormal model \13\ to accommodate the fact 
that Asian Options will have an arithmetic average value of the 
underlying index within the final exercise settlement amount 
calculation. OCC states that the shifted lognormal model will account 
for the fact that the current underlying interest value on the 
expiration date of an Asian Option is based on an arithmetic average of 
prices, and not the value of the underlying index on the option's 
expiration date, which introduces non-normality into the probability 
distribution of contract payoffs.
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    \13\ See Andreasen, J., ``The pricing of discretely sampled 
Asian and lookback options: a change of numeraire approach,'' 
Journal of Computational Finance, September 2000. See also Brigo, 
D., Mercurio, F., Rapidsarda, F., Scotti, R., ``Approximated moment-
matching dynamics for basket-options simulation,'' EFMA Lugano 
meetings, November 2001. See also Haug, E.G. and Margrabe, W., 
``Asian Pyramid Power,'' Wilmott Magazine, March 2003.
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    With respect to the Asian Option shifted lognormal pricing model, 
OCC proposed to utilize a modified Black-Scholes pricing model with a 
shift parameter that employs the first three statistical ``moments.'' 
In accordance with such model, OCC states that the first moment is the 
expected value of an Asian Option's value based on the option's implied 
volatility, the second moment accounts for the statistical volatility 
of the option's value, and the third moment accounts for the 
statistical skewness of the option's value. OCC represents that the 
moments are intended to account for variability in the arithmetic 
average value of an Asian Option's underlying index. OCC states that 
the shifted lognormal distribution (i.e., the lognormal probability 
distribution derived using the first through third moments above) is 
then priced through the standard Black-Scholes equation.\14\ OCC 
further states that the shift parameters are then adjusted out of the 
Black-Scholes price in order to derive a price for a given Asian Option 
that is appropriate to be utilized within the STANS methodology for the 
purposes of computing clearing member margin on Asian Options.
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    \14\ In connection with using the standard Black-Sholes 
equation, OCC will also compute each of the three moments using a 
random shifted lognormal variable.
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Cliquet Options
    Similar to Asian Options, the price of a given Cliquet Options is 
based on monthly Observations of an underlying index. OCC states that 
while a shifted lognormal model is an appropriate pricing model for 
Asian Options, the capped return feature of Cliquet Options makes the 
numerical solution to the Black-Scholes Partial Differential Equation 
\15\ the appropriate pricing model for Cliquet Options.\16\ OCC 
therefore proposed to add a Cliquet Option pricing model to its STANS 
methodology that will compute the numerical solution to the Black-
Scholes Partial Differential Equation. OCC represents that such a 
solution will provide OCC with the price of a given Cliquet Option that 
will be utilized within the STANS methodology for the purposes of 
computing clearing member margin requirements.
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    \15\ OCC represents that the differential equation model 
incorporates boundary conditions, which are necessary in order to 
solve differential equations, to ensure that the value of a given 
Cliquet Option is consistent throughout the equation.
    \16\ See Andreasen, J., ``The pricing of discretely sampled 
Asian and lookback options: a change of numeraire approach.'' 
Journal of Computational Finance (2000). See also Bernard, C., & Li, 
W. V., ``Pricing and Hedging of Cliquet Options and Locally Capped 
Contracts.'' SIAM Journal on Financial Mathematics, 353-371 (2013). 
See also Hagan, P. S., Kumar, D., & Lesniewski, A. S., ``Managing 
Smile Risk.'' Wilmott Magazine, 84-108 (2002). See also Hull, John 
C., ``Options Futures and other Derivatives.'' McGraw Hill (2000). 
See also Kjaer, M., ``Fast pricing of cliquet options with global 
floor.'' Journal of Derivatives, 14(2), 47-60 (2006).
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    With respect to the pricing of a given Cliquet Option, and based on 
the capped return feature of Cliquet Options, OCC states that it will 
identify the known implied volatility skew of standard options with the 
same underlying interest, a similar tenor and a similar amount of 
forward moneyness \17\ of the given Cliquet Option. OCC represents that 
its calculation of forward moneyness will include an adjustment to 
account for any known Observations of the underlying interest for a 
given Cliquet Option. OCC further states that the known implied 
volatility skew will subsequently be utilized within the Black-Scholes 
Partial Differential Equation so that OCC will be able to derive the 
price of a given Cliquet Option, which will then be utilized within the 
STANS methodology for purposes of computing clearing member margin 
requirements on a Cliquet Options.
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    \17\ OCC describes forward moneyness as the ratio of the strike 
to the current value of the implied forward for the index.
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III. Discussion and Commission Findings

    Section 19(b)(2)(C) of the Act \18\ directs the Commission to 
approve a proposed rule change of a self-regulatory organization if the 
Commission finds that such proposed rule change is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to such self-regulatory organization. Section 17A(b)(3)(F) 
of the Act \19\ requires, among other things, that the rules of a 
clearing agency are designed to assure the safeguarding of securities 
and funds which are in the custody or control of the clearing agency or 
for which it is responsible. In addition,

[[Page 42141]]

Rule 17Ad-22(b)(2) \20\ requires registered clearing agencies, among 
other things, to establish, implement, maintain, and enforce written 
policies and procedures reasonably designed to use margin requirements 
to limit its credit exposures to participants under normal market 
conditions and use risk-based models and parameters to set margin 
requirements.
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    \18\ 15 U.S.C. 78s(b)(2)(C).
    \19\ 15 U.S.C. 78q-1(b)(3)(F).
    \20\ 17 CFR 240.17Ad-22(b)(2).
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    The Commission finds that the proposed rule change is consistent 
with Section 17A of the Act \21\ and the rules thereunder applicable to 
OCC. The proposal will integrate new pricing models into the STANS 
methodology to accommodate the manner in which the exercise settlement 
amount for Asian Options and Cliquet Options is determined. The 
Commission believes these changes are designed to enable OCC to 
accurately compute margin requirements for Asian Option and Cliquet 
Option positions through its STANS methodology, therefore reducing the 
risk that clearing member margin assets would be insufficient should 
OCC need to use such assets to close-out the positions of a defaulted 
clearing member. The Commission therefore believes that the proposed 
rule change is reasonably designed to limit OCC's credit exposures to 
participants under normal market conditions and use risk-based models 
and parameters to set margin requirements, consistent with the 
requirements of Rule 17Ad-22(b)(2).\22\ Accordingly, the Commission 
believes that the proposed rule change is designed to assure the 
safeguarding of securities and funds in OCC's custody or control or for 
which it is responsible, consistent with section 17A(b)(3)(F) of the 
Act.\23\
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    \21\ 15 U.S.C. 78q-1.
    \22\ 17 CFR 240.17Ad-22(b)(2).
    \23\ 15 U.S.C. 78q-1(b)(3)(F).
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IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposal is consistent with the requirements of the Act and in 
particular with the requirements of section 17A of the Act \24\ and the 
rules and regulations thereunder.
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    \24\ 15 U.S.C. 78q-1.
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    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\25\ that the proposed rule change (File No. SR-OCC-2015-010) be, 
and hereby is, approved.\26\
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    \25\ 15 U.S.C. 78s(b)(2).
    \26\ In approving the proposed rule change, the Commission 
considered the proposal's impact on efficiency, competition and 
capital formation. 15 U.S.C. 78c(f).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\27\
Jill M. Peterson,
Assistant Secretary.
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    \27\ 17 CFR 200.30-3(a)(12).
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[FR Doc. 2015-17400 Filed 7-15-15; 8:45 am]
BILLING CODE 8011-01-P