[Federal Register Volume 64, Number 89 (Monday, May 10, 1999)]
[Notices]
[Pages 25093-25096]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-11600]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41353; File No. SR-PCX-98-62]


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

April 30, 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 December 18, 1998, the Pacific Exchange, Inc. (``PCX'' 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 No. 1 \3\ and 2 \4\ to the proposed rule change on April 8, 
1999. The Commission is publishing this notice to solicit comments on 
the proposed rule change as amended from interested persons.
---------------------------------------------------------------------------

    \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 Robert P. Pacileo, PCX, dated April 7, 
1999 (``Amendment No. 1''). Amendment No. 1 makes certain technical 
changes to the proposed rule change. Amendment No. 1 also specifies 
the procedures the Exchange will follow if an underlying 
differential index previously approved for options trading does not 
meet the Exchange's requirements for continued approval. In 
addition, Amendment No. 1 clarifies the conditions under which 
Exchange Rule 6.11, relating to restrictions on Exchange options 
transactions and exercises, will be applicable to Differential Index 
Options.
    \4\ See Letter to Michael A. Walinskas, Division of Market 
Regulation, Commission, from Robert P. Pacileo, PCX, dated April 7, 
1999 (``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 specifies that if the Exchange chooses as 
either a designated or benchmark index an index that has been 
approved for index warrant trading only, to establish the 
appropriate position limit the Exchange will (i) use the procedures 
set forth in its narrow-based index options rules with respect to 
differential options using a narrow-based index warrant and (ii) 
consult with the Commission with respect to differential options 
using a broad-based index warrant. Furthermore, Amendment No. 2 
indicates the Exchange's intent to trade flexible exchange-traded 
options on Differential index options and provides the proposed rule 
language governing these options.
---------------------------------------------------------------------------

I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange is proposing to trade a standardized index option, the 
Differential Index Option, whose value at expiration will be 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.

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
    Proposal. The Exchange is proposing to trade a new type of 
standardized index option, the Differential Index Option, that will 
offer new investment and hedging opportunities.\5\ Differential Index 
Options will have a value at expiration based on an index, called the 
``differential index,'' that measures the relative performance of (1) A 
designated index versus a benchmark index over a specific time period 
(``Index Differential Option''); (2) a designated stock versus a 
benchmark index over a specific time period (``Equity Differential 
Option''); or (3) a designated stock versus a benchmark stock over a 
specific period of time (``Paired Stock Differential Option''). If the 
percent gain in the level

[[Page 25094]]

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 out-performance of a designated index or 
stock versus a benchmark index or stock (a Differential Call Option) or 
the relative under-performance 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.
---------------------------------------------------------------------------

    \5\ The proposal is similar to filings of the American Stock 
Exchange and the Chicago Board Options Exchange, Inc. See Exchange 
Act Release No. 40537 (October 8, 1998), 63 FR 56052 (October 20, 
1998); SR-CBOE-98-50.
---------------------------------------------------------------------------

    For example, an investor may feel that Microsoft will out-perform 
the technology sector for the next few months, but is unsure whether 
the overall technology sector will move higher or lower. If the 
investor were to buy an at-the-money standardized Microsoft call 
option, and the stock declined, the option would expire worthless, even 
if the stock declined by a much smaller percentage than the technology 
sector. On the other hand, if the investor were to purchase an at-the-
money Equity Differential Call Option on the relative performance of 
Microsoft versus the PSE Technology 100 Index (``Tech 100''), a 
benchmark measure of the technology sector, and Microsoft declined by a 
smaller percentage than the Tech 100, the Equity Differential Call 
Option would have a positive value at expiration. Conversely, an 
investor who believes that Microsoft will under-perform the Tech 100 
may purchase at-the-money Equity Differential Put Options. If Microsoft 
under-performs the Tech 100, the Differential Put Options will have a 
positive value at expiration, regardless of whether Microsoft itself 
has increased or decreased on an absolute basis. This example can be 
applied to the other types of Differential Options; the different in 
the relative performance of a designated stock versus a benchmark 
stock, such as Microsoft versus Compaq (``Paired Differential Stock 
Option''), or the relative performance between two indexes, such as the 
PSE Technology 100 and the Wilshire Small Cap Index (``Differential 
Index Option'').
    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 that 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 out-performed the 
benchmark by 7%, and the fixed value, f, is set at 100, the 
differential index value would be 107; if it has under-performed 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 a 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 that meet the current Exchange Rules for 
listing standardized equity options will be eligible designated stocks 
in Equity Differential Options. Only stocks that 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 that 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 7:00 a.m. and 1:15 p.m., Pacific Time. All other Differential 
Index Options will trade between 7:00 a.m. and 1:02 p.m., Pacific 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.
    While the Exchange seeks approval to list series of Differential 
Index Options as set forth in proposed PCX Rules 7.20 through 7.31 and 
Rule 8.102, the Exchange anticipates that it 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

[[Page 25095]]

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 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.
    d. Applicable Exchange Rules. Proposed PCX Rules 7.20 through 7.31 
and Rule 8.102 will apply to Differential Index Options contracts. 
These Rules cover issues such as surveillance, exercise price and 
position limits. Differential Index Options will also be subject to (1) 
the PCX's surveillance procedures currently used to monitor trading in 
each of the Exchange's index and equity options, and (2) sales practice 
and suitability rules applicable to standardized options. The Exchange 
currently intends to create Differential Index Options using the 
indexes and options currently traded on the PCX.
    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, subject to prior approval by the 
Commission.
    e. Position Limits. The Exchange proposes that the position limits 
for Differential Index Options be set at the lower of the separate 
position limits for standardized index options trading on the 
designated index or 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.\6\ For Equity Differential Options, the 
Exchange proposes that the limits be set at the position limit of 
standardized options trading on the designated stock. In the event that 
standardized options currently do not trade on the designated stock, 
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 or 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.
---------------------------------------------------------------------------

    \6\ 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 
PCX's narrow-based index options rules. See PCX Rule 7.3. The 
Exchange will consult with the Commission to establish a position 
limit for a differential option using a broad-based index warrant. 
See Amendment No. 2, supra note 4.
---------------------------------------------------------------------------

    The Exchange also proposes, for position and exercise limit 
purposes, to require that positions in Differentials 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 
Microsoft Corporation stock as the benchmark and Compaq, 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 Microsoft or Compaq as the benchmark or 
designated stock 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 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 
PSE Tech 100 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 of 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 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 
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 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 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 that, 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. May 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 exercise, cash settlement and 
represent

[[Page 25096]]

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, 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 proposes to apply standard index 
options margin treatment to Differential Index Options.\7\ Differential 
Index 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 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 Differential 
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 options plus 10% of the Index. The 
Exchange believes that this method of determining customer margin is 
appropriate because the range of volatities expected for Differential 
Indexes should not be significantly different than the expected rage 
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.\8\
---------------------------------------------------------------------------

    \7\ See PCX Rule 2.16(c) for margin requirements for standard 
index options.
    \8\ See Amendment No. 1, supra, note 3.
---------------------------------------------------------------------------

2. Basis
    The Exchange believes the proposed rule change is consistent with 
Section 6(b) of the Act,\9\ in general, and furthers the objectives of 
section 6(b)(5),\10\ in particular, because it is designed to promote 
just and equitable principles of trade, to facilitate transactions in 
securities, and to remove impediments to and perfect the mechanisms of 
a free and open market and a national market system, and to protect 
investors and the public interest.
---------------------------------------------------------------------------

    \9\ 15 U.S.C. 78f(b).
    \10\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

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

    The Exchange did not solicit or receive written comments on the 
proposed rule change.

II. 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, NW, Washington, DC 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 inspection and copying in the 
Commission's Public Reference Room. Copies of the filing will also be 
available for inspection and copying at the principal office of the 
PCX. All submissions should refer to File No. SR-PCX-98-62 and should 
be submitted by June 1, 1999.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\11\
---------------------------------------------------------------------------

    \11\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-11600 Filed 5-7-99; 8:45 am]
BILLING CODE 8010-01-M