[Federal Register Volume 63, Number 202 (Tuesday, October 20, 1998)]
[Notices]
[Pages 56052-56055]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-28002]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40537; File No. SR-Amex-98-12]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the American Stock Exchange, Inc. Relating to the Trading of 
Differential Index Options

October 8, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Exchange Act'' or ``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice 
is hereby given that on March 5, 1998, the American Stock Exchange, 
Inc. (``Amex'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') the proposed rule change as 
described in Items I, II and III below, which Items have been prepared 
by the self-regulatory organization. The Exchange filed with the 
Commission amendments to the proposed rule change on April 21, 1998,\3\ 
and September 3, 1998.\4\ The Commission is publishing this notice to 
solicit comments on the proposed rule change 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 Walinskas, Division of Market 
Regulation, Commission, from Claire P. McGrath, Amex, dated April 
20, 1998 (``Amendment No. 1''). Amendment No. 1 amends the portion 
of the proposal that refers to settlement values for Differential 
Index Options where the designated or benchmark security is traded 
through the Nasdaq system. Amendment No. 1 provides that the price 
of a Nasdaq security used in determining the settlement value of a 
Differential Index Option will be equal to the first reported 
regular-way sale that occurs after the best bid and best offer for 
that security are unlocked and uncrossed and is greater than or 
equal to the best bid and less than or equal to the best offer at 
the time of the reported sale. For designated and benchmark indices, 
the settlement value of the Differential Index Option will continue 
to be used on the settlement value for standardized options on the 
index. Amendment No. 1 also indicates the Exchange's intent to trade 
flexible exchange-traded options on Differential Index options.
    \4\ See Letter to Richard Strasser, Division of Market 
Regulation, Commission, from Claire P. McGrath, Amex, dated 
September 2, 1998 (``Amendment No. 2''). Amendment No. 2 provides 
information as to what the Exchange will do to make adjustments in 
value for differential index options contracts when certain 
corporate events take place in the case of Equity Differential and 
Paired Stock Differential options, or when significant action has 
been taken by the publisher of an index in the case of Index 
Differential options. Amendment No. 2 also clarifies that 
Differential Index options will open for trading at 10:00 a.m. 
Furthermore, Amendment No. 2 states that transactions may be 
effected until 4:15 p.m. for Index Differential options where both 
the designated and benchmark indexes are broad stock index groups, 
unless the Board of Governors has established different hours of 
trading for certain Differential Index options. Amendment No. 2 also 
provides that, 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 Amex's narrow-based index option 
rules. Amendment No. 2 also clarifies that the restrictions of Amex 
Rule 909I(b) will apply to designated or benchmark stock in Equity 
Differential or Paired Stock Differential options. Lastly, Amendment 
No. 2 provides the proposed rule language allowing for flexible 
exchange-traded options to be traded on Differential Index options.
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    The Amex 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, Amex 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 self-regulatory organization 
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 self-regulatory organization 
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 (``Paired Stock Differential Option'') over a specific 
time period. 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 Put 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 absolute performance of the designated index or 
stock.
    For example, an investor may feel that pharmaceutical 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 Pharmaceutical Index 
(``DRG'') 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 perforce 
of the Pharmaceutical Index versus the Standard & Poor's 500 Stock 
Index (``S&P 500''), a benchmark measure of large capitalization stock 
broad market performance, and DRG declined by a smaller percentage than 
the S&P 500, the Index Differential Call Option would have a positive 
value at expiration. Conversely, an investor who believes that DRG will 
underperform the S&P 500 may purchase at-the-money Index Differential 
Put Options, perhaps to hedge a portfolio of pharmaceutical stocks 
against such market underperformance. If DRG

[[Page 56053]]

underperforms the S&P 500, the Index Differential Put Options will have 
a positive value at expiration, regardless of whether the DRG index 
level itself has increased or decreased on an absolute basis.
    a. 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 December 31 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/I0)-(Bt/
B0)) 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;
0=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 under separate symbol every 15 
seconds over the Consolidated Tape Association's Network B.
    b. Designated Indexes, Designated Stocks, Benchmark Indexes and 
Benchmark Stocks. Only stocks which meet the current Exchange Rules for 
listing standardized 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 the most liquid, actively traded stocks will 
be considered.
    Similarly, only indexes which meet the current Exchange Rules for 
listing standardized index options and 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.
    c. 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 10:00 a.m. and 4:15 p.m., New York time.\5\ All other 
Differential Index Options will trade between 10:00 a.m. and 4:02 p.m., 
New York time. Differential Index Options will expire on the Saturday 
following the third Friday of the expiration month (``Expiration 
Friday''). The last trading day in an expiring option 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.
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    \5\ See also Amendment No. 2, supra, note 4.
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    While the Exchange seeks approval to list series of Differential 
Index Options as set forth in Rule 9031(a)(i), (ii) and (iii), 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 Differential Index 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 the primary exchange 
regular-way opening sale price of the designated stock, or, if the 
stock is traded through the Nasdaq system, the first reported regular-
way sale that occurs after the best bid and best offer for that 
security are unlocked and uncrossed and is greater than or equal to the 
best bid and less than or equal to the best offer at the time of the 
reported sale,\6\ and 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, if the stock is 
traded through the Nasdaq system, the first reported regular-way sale 
that occurs after the best bid and best offer for that security are 
unlocked and uncrossed and is greater than or equal to the best bid and 
less than or equal to the best offer at the time of the reported 
sale.\7\
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    \6\ See Amendment No. 1, supra, note 3.
    \7\ See Amendment No. 1, supra, note 3.
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    d. Applicable Exchange Rules. AMEX Rules 900I through 9800I will 
apply to the trading of Differential Index Option contracts. These 
Rules cover issues such as surveillance, exercise prices, and position 
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.
    The Exchange currently intends to create Differential Index Options 
using, among others, indexes it has licensed from the Standard & Poor's 
Corporation. Thus, Rule 902I includes in paragraph (c) a limitation of 
liability for the Standard & Poor's Corporation. If the Exchange enters 
into license arrangements with other organizations it may amend Rule 
902I to include a similar limitation of liability for other 
organizations.
    Differential Index Options are ``securities'' under Section 
3(a)(10) of the Exchange Act, and therefore are exempt pursuant to 
Section 28(a) of the Exchange 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

[[Page 56054]]

discussed herein, which are subject to prior approval by the 
Commission.
    e. Position Limits. The Exchange proposes that the position limits 
for Index Differential Options be set at the lower of the separate 
positions 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, but rather has been approved for index warrant trading 
only, 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.\8\ 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 positions limits as the lesser of 
those that would be in effect for standardized options on the stocks if 
such options were trading.
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    \8\ In the event that one or both of the indexes is the subject 
of index warrant trading only, the position limit for a differential 
option using a narrow-based index warrant will be established using 
Amex's narrow-based index option rules. See Amex Rule 904C(c). The 
Exchange will consult with the Commission to establish a position 
limit for a differential option using a broad-based index warrant. 
Telephone call between Claire P. McGrath, Vice President and Special 
Counsel, Amex, and Christine Richardson, Attorney, Commission, 
September 29, 1998. See also Amendment No. 2, supra, note 4.
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    The Exchange also proposes, for position and exercise limit 
purposes, to require that positions in Differentials with the same 
designated or benchmark stock or narrowbased index be aggregated. For 
example, if a Paired Stock Differential option has been created using 
Intel Corporation stock as the benchmark and Motorola, Inc. as the 
designated stock, positions in that differential option will be 
aggregated for position and exercise limit compliance purposes with 
positions in other Paired Stock Differentials that use one of these two 
stocks. Furthermore, Equity Differential options using narrow-based 
indexes versus either Intel or Motorola as the benchmark or designated 
stocks also will be aggregated for position and exercise limit 
compliance purposes with positions in Paired Stock Differential options 
using one of those two stocks. However, with respect to the use of 
board-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 500 Index as the benchmark index and Apple Computer, Inc., Philip 
Morris Companies, Inc. and Telecommunications, Inc. as designated 
stocks, members will not be required to aggregate positions in those 
differentials to determine whether an account is in compliance with 
position and exercise limit rules.
    The Exchange further proposes that Differential Index Options not 
be aggregated with other standardized options on the underlying 
designated stock or index nor 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 and foremost, 
the value Differential Index Options will be calculated in a different 
manner from the value of other currently trading standardized equity 
and index options. In fact, because of the subtraction of the benchmark 
from the designated stock or index, the value of a Differential Index 
Options 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 
Option 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 currently). This correlation 
component of the Different Index Option price is not considered in 
determing the value of other standardized options on either the 
designated or benchmark stock or index. As a result, the Differential 
Index Options 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 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. Differential Index 
Options are cash settled, based on opening prices of the designated 
stock or index and the benchmark and feature European exercise. 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 underiving stock, worth $5,000 per 
contract for a $50 stock, and feature American exercise. Standardized 
index options typically feature European 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 established 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 establishing 
product for a limited amount of potential volume. Thus, in the 
Exchange's view, with aggregated position limits, new products cannot 
``grow the pie'' and increase overall liquidity in all the products; 
they start at a disadvantage which may be impossible to overcome.
    f. Customer Margin. Since Differential Index Options are similar to 
other index options, the Exchange proposed 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 Options 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

[[Page 56055]]

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 options 
plus 10% of the Index.
    The Exchange believes that this method of determining customer 
margin is appropriate since the range of volatilities expected for 
Differential Indexes should not be significantly different than the 
expected range for other indexes and equities. 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. The 
Exchange has constructed two-year Differential Index series for 44 of 
its most actively traded equity option stocks versus the S&P 500 and 
for two different index pairs. These combinations cover the range for 
negatively correlated pairs through uncorrelated pairs to highly 
correlated pairs. The table included in the Exchange's proposal 
demonstrates that the volatilities of the Differential Indexes are not 
significantly different than the underlying indexes and equities, and 
thus should be margined similarly.
2. Basis
    The Exchange believes that the proposal is consistent with Section 
6(b) \9\ of the Act, in general, and Section 6(b)(5) \10\ of the Act, 
in particular, in that it is 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.
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    \9\ 15 U.S.C. 78f(b).
    \10\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition that is not necessary or appropriate 
in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments on the proposed rule change were neither solicited 
nor received.

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., Washington, D.C. 20549. 
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 inspection and copying in the 
Commission's Public Reference Room, located at the above address. 
Copies of such filing will also be available for inspection and copying 
at the principal office of the self-regulatory organization. All 
submissions should refer to File No. SR-Amex-98-12 and should be 
submitted by November 10, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\11\
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    \11\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-28002 Filed 10-19-98; 8:45 am]
BILLING CODE 8010-01-M