[Federal Register Volume 69, Number 77 (Wednesday, April 21, 2004)]
[Notices]
[Pages 21589-21591]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-9003]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49563; File No. SR-CBOE-2003-40]


Self Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Granting Approval to Proposed Rule Change and Notice of 
Filing and Order Granting Accelerated Approval to Amendment No. 2 
Relating to Options on Certain CBOE Volatility Indexes

April 14, 2004.

I. Introduction

    On September 12, 2003, the Chicago Board Options Exchange, Inc. 
(''CBOE'' or ``Exchange''), filed with the Securities and Exchange 
Commission (''Commission''), pursuant to section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend certain of its rules to 
provide for the listing and trading of options on the following 
volatility indexes: the CBOE Volatility Index (``VIX''), the CBOE 
Nasdaq 100 Volatility Index (``VXN''), and the CBOE Dow Jones 
Industrial Average Volatility Index (``VXD''). On November 18, 2003, 
the CBOE filed Amendment No. 1 to the proposed rule change.\3\ On 
December 22, 2003, the CBOE filed Amendment No. 2 to the proposed rule 
change.\4\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Jim Flynn, Attorney, CBOE, to Florence 
Harmon, Senior Special Counsel, Division of Market Regulation 
(``Division''), Commission, dated November 18, 2003 (``Amendment No. 
1''). Amendment No. 1 revised the original rule filing by defining 
the reporting authority and terms of these index option contracts, 
including that the interval between strike prices shall be no less 
than $2.50.
    \4\ See letter from Jim Flynn, Attorney, CBOE, to Florence 
Harmon, Senior Special Counsel, Division, Commission, dated December 
18, 2003 (``Amendment No. 2''). Amendment No. 2 made a technical 
change to a paragraph contained in a sub-section (``Exercise and 
Settlement'') in Item 3 of the Form 19b-4 originally filed by CBOE 
and made corresponding changes to Exhibits B, C, and D. 
Specifically, Amendment No. 2 clarified that ``the options on each 
respective volatility index will expire on the Wednesday immediately 
prior to the third Friday of the month that immediately precedes the 
month in which the options used in the calculation of that index 
expire.''
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    The proposed rule change was published for comment in the Federal 
Register on November 26, 2003.\5\ The Commission received one comment 
letter from the Chicago Mercantile Exchange (``CME'') on the 
proposal.\6\
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    \5\ See Securities Exchange Act Release No. 48807 (November 19, 
2003), 68 FR 66516 (November 26, 2003).
    \6\ See letter dated December 17, 2003 from Craig S. Donohue, 
CME, Office of the CEO, to Jonathan G. Katz, Secretary, Commission 
(``CME Letter'').
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II. Description of the Proposed Rule Change

    The purpose of the proposed rule change is to permit the Exchange 
to list and trade cash-settled, European-style options on the VIX, VXN, 
and VXD. The calculation of each index is based on a recently developed 
methodology that builds upon the calculation of the original CBOE 
Market Volatility Index, which was based on S&P 100 Index option 
quotes. Introduced by CBOE in September 2003, the revised VIX is an 
index that uses the quotes of certain S&P 500 Index (``SPX'') option 
series to derive a measure of the volatility of the U.S. equity market. 
It provides investors with up-to-the-minute market estimates of 
expected volatility by extracting implied volatilities from real-time 
index option bid/ask quotes. The VIX is quoted in percentage points per 
annum. For example, an index level of 30.34 (the closing value from 
December 31, 2002) represents an annualized volatility of 30.34%. This 
new methodology will also be used to calculate VXN and VXD values.
    Each index--VIX, VXN, and VXD--will be calculated using real-time 
quotes of the nearby and second nearby index puts and calls of the SPX, 
the Nasdaq 100 Index (``NDX''), and the Dow Jones Industrial Index 
(``DJX''), respectively. For options on each respective volatility 
index, the nearby index option series are defined as the series with 
the shortest time to expiration, but with at least eight (8) calendar 
days to expiration. The second nearby index option series are the 
series for the subsequent expiration month. Thus, with eight days left 
to expiration, an index will ``roll'' to the second and third contract 
months. For each contract month, CBOE will determine the at-the-money 
strike price. It will then select the at-the-money and out-of-the money 
series with non-zero bid prices and determine the midpoint of the bid-
ask quote for each of these series. The midpoint quote of each series 
is then weighted so that the further away that series is from the at-
the-money strike, the less weight that is accorded to the quote. Then, 
to compute the index level, CBOE will calculate a volatility measure 
for the nearby options and then for the second nearby options using the 
weighted mid-point of the prevailing bid-ask quotes for all included 
option series with the same expiration date. These volatility measures 
are then interpolated to arrive at a single, constant 30-day measure of 
volatility.
    Strike prices will be set to bracket the index in 2\1/2\ point 
increments; thus, the interval between strike prices will be no less 
than $2.50. The minimum tick size for series trading below $3 will be 
0.05 and for series trading above $3 the minimum tick will be 0.10. The 
proposed options on each index will expire 30 days prior to the 
expiration date of the options used in the calculation of that index. 
Exercise will result in delivery of cash on the business day following 
expiration. VIX, VXN and VXD options will be A.M.-settled. The exercise 
settlement value will be determined by a Special Opening Quotation 
(``SOQ'') of each respective volatility index calculated from the 
sequence of opening prices of the options that comprise that index. The 
opening price for any series in which there is no trade shall be the 
average of that option's bid price and ask price as determined at the 
opening of trading. The exercise-settlement amount is equal to the 
difference between the exercise-settlement value and the exercise price 
of the option, multiplied by $100.
    The position limits for options on each volatility index will be 
25,000 contracts on either side of the market and no more than 15,000 
of such contracts may be in series in the nearest expiration month.\7\
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    \7\ This is consistent with CBOE Rule 24.4 (Position Limits for 
Broad-Based Index Options).
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    Except as modified herein, the Exchange Rules in Chapter XXIV will 
be applicable to the VIX, VXN, and VXD options. Each volatility index 
will be

[[Page 21590]]

classified as a ``broad-based index'' and, under CBOE margin rules, 
specifically, Exchange Rule 12.3(c)(5)(A), the margin requirement for a 
short put or call on the respective volatility indexes shall be 100% of 
the current market value of the contract plus up to 15% of the 
respective underlying index value.
    Additionally, CBOE affirms that it possesses the necessary systems 
capacity to support new series that would result from the introduction 
of VIX, VXN and VXD options. CBOE also has been informed that OPRA has 
the capacity to support such new series.\8\
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    \8\ See, Exhibit E to the proposed rule change filed by CBOE, 
which set out the contract specifications for each product.
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III. Summary of Comment

    The Commission received one comment letter from the CME on the 
proposal.\9\ The CME contends that by proposing the position limits, 
exercise limits, and margin requirements applicable to options on 
broad-based indexes, as defined in CBOE's rules, the CBOE's proposed 
rule change implicitly requests the Commission to acknowledge that 
these volatility indexes should be classified as ``broad-based'' 
security indexes for purposes of the definition of narrow-based 
security index in the Act and the Commodity Exchange Act (``CEA'').\10\ 
The CME further argues that the volatility indexes are narrow-based 
security indexes under these statutory definitions. As the CME notes, 
the definition of narrow-based security index was established by the 
Commodity Futures Modernization Act of 2000 (``CFMA'') for purposes of 
determining whether futures on indexes are security futures subject to 
the jurisdiction of the Commission and the Commodity Futures Trading 
Commission (``CFTC'').
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    \9\ See CME Letter, supra note 6.
    \10\ See Section 3(a)(55)(B) of the Exchange Act and Section 
1a(25) of the Commodity Exchange Act (``CEA'').
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IV. Commission's Findings and Order Granting Accelerated Approval of 
Amendment No. 2.

    After careful review, the Commission finds that the CBOE's proposal 
to permit trading in options based on certain volatility indices (VIX, 
VXN, and VXD), as amended, is consistent with the requirements of the 
Act and the rules and regulations thereunder applicable to a national 
securities exchange \11\ and, in particular, the requirements of 
section 6 of the Act \12\ and the rules and regulations thereunder. The 
Commission believes that the CBOE's proposal gives options investors 
the ability to make an additional investment choice in a manner 
consistent with the requirements of section 6(b)(5) of the Act.\13\ The 
Commission further believes that trading options on these volatility 
indexes provides investors with an important trading and hedging 
mechanism.
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    \11\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
    \12\ 15 U.S.C. 78f.
    \13\ 15 U.S.C. 78f(b)(5).
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    The Commission finds that it is consistent with the Act for the 
CBOE to apply its rules for trading of broad-based index options to 
apply to the VIX, VXN and VXD. The Commission believes that because 
these three volatility indexes are composed of the puts and calls on 
indexes which the Commission has previously determined are appropriate 
to treat as broad-based for purposes of CBOE's rules,\14\ it is 
appropriate to apply to the volatility index options the position 
limits, exercise limits and margin requirements that apply to CBOE's 
component index options.
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    \14\ See Securities Exchange Act Release Nos. 40969 (January 22, 
1999), 64 FR 4911 (February 1, 1999); 44994, (October 26, 2001), 66 
FR 55772 (November 2, 2001).
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    The Commission also finds that CBOE has adequate surveillance 
procedures in place to monitor for manipulation of the volatility index 
options. The Exchange states that it will use the same surveillance 
procedures currently utilized for each of the Exchange's other index 
options to monitor trading in options on each volatility index. The 
Exchange represents that these surveillance procedures are adequate to 
monitor the trading of options on these volatility index. For 
surveillance purposes, the Exchange will have complete access to 
information regarding trading activity in the pertinent underlying 
securities.
    The Commission also finds the CBOE's trading rules and other 
product specifications appropriate, including strike prices that will 
be set to bracket the index in 2\1/2\ point increments and minimum tick 
size. Because the exercise of these options will be cash settled, VIX, 
VXN and VXD options will be A.M.-settled on the business day following 
expiration, in a manner that will deter manipulation.
    The Commission also finds determinative CBOE's representations that 
it possesses the necessary systems capacity to support new series that 
would result from the introduction of VIX, VXN and VXD options and that 
CBOE also has been informed that OPRA has the capacity to support such 
new series.
    In its comment letter, the CME expressed concern that approval of 
the CBOE's proposal would imply that the Commission believed that the 
VIX, VXN and VXD volatility indexes were not ``narrow-based security 
indexes'' as defined in the Act and the CEA. The CFMA established a 
regulatory framework under which the Commission and the CFTC jointly 
regulate futures on single securities and narrow-based security indexes 
(``security futures''). To distinguish between security futures on 
narrow-based security indexes, which are jointly regulated by the CFTC 
and the Commission, and futures contracts on broad-based security 
indexes, which are under the exclusive jurisdiction of the CFTC, the 
CEA and the Act, each includes an objective definition of the term 
``narrow-based security index.'' A futures contract on an index that 
meets the definition of a narrow-based security index is a security 
future. A futures contract that does not meet the definition of a 
narrow-based security index is a futures contract on a broad-based 
security index.\15\
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    \15\ See 17 CFR 41.1(c).
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    In approving the CBOE's proposed rule change, the Commission is not 
determining whether the volatility indexes are ``narrow-based'' 
security indexes as that term is defined in the Act. Moreover, the 
Commission notes that the CEA does not apply to the volatility index 
options CBOE proposes to list and trade.\16\
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    \16\ Separately, the Commission and the CFTC issued an order 
excluding from the definition of the term ``narrow-based security 
index'' certain indexes comprised of options series on broad-based 
security indexes. See Securities Exchange Act Release No. 49469 
(March 25, 2004).
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    The Commission finds good cause, consistent with section 19(b)(2) 
of the Act,\17\ to approve Amendment No. 2 to the proposed rule change 
prior to the thirtieth day after the date of publication of notice of 
filing thereof in the Federal Register. The Commission believes that 
accelerating the approval of the changes proposed in Amendment No. 2 is 
appropriate because the changes are technical in nature, are provided 
for the purpose of clarification and to eliminate confusion among 
investors, and because the amendment raises no new issues.
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    \17\ 15 U.S.C. 78s(b)(2).
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the Amendment No. 2, including whether Amendment 
No. 2 is consistent with the Act.

[[Page 21591]]

Comments may be submitted by any of the following methods:
    Electronic comments:
     Use the Commission's Internet comment form 
(http://www.sec.gov/rules/sro.shtml); or
     Send an E-mail to [email protected]. Please 
include File No. SR-CBOE-2003-40 on the subject line.
    Paper comments:
     Send paper comments in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, 
NW., Washington, DC 20549-0609.
    All submissions should refer to File No. SR-CBOE-2003-40. This file 
number should be included on the subject line if e-mail is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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 Section, 450 Fifth Street, 
NW., Washington, DC 20549. Copies of such filing also will be available 
for inspection and copying at the principal office of the CBOE. All 
comments received will be posted without change; the Commission does 
not edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly. All 
submissions should refer to File No. SR-CBOE-2003-40 and should be 
submitted on or before May 12, 2004.

VI. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\18\ that the proposed rule change (File No. SR-CBOE-2003-40), as 
amended, be, and it hereby is, approved.
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    \18\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-9003 Filed 4-20-04; 8:45 am]
BILLING CODE 8010-01-P