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

[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