[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]
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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.
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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 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.
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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.
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\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.
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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.
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\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.
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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 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\
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\7\ See PCX Rule 2.16(c) for margin requirements for standard
index options.
\8\ See Amendment No. 1, supra, note 3.
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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.
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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
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\
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\11\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-11600 Filed 5-7-99; 8:45 am]
BILLING CODE 8010-01-M