[Federal Register Volume 61, Number 97 (Friday, May 17, 1996)]
[Notices]
[Pages 24979-24982]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-12382]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37196; File No. SR-CBOE-96-18]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change and Amendment No. 
1 to the Proposed Rule Change by the Chicago Board Options Exchange, 
Inc., Relating to a Hedge Exemption for Industry (Narrow-Based) Index 
Options

May 10, 1996.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on March 18, 1996, the 
Chicago Board Options Exchange, Inc. (``CBOE'' or ``Exchange'') filed 
with the Securities and Exchange Commission (``SEC'' or ``Commission'') 
the proposed rule change as described in Items I and II below, which 
Items have been prepared by the self-regulatory organization.\2\ The

[[Page 24980]]

Commission is approving this proposal on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1) (1988).
    \2\ On April 15, 1996, the Exchange amended its proposal to 
indicate that, in connection with the narrow-based index hedge 
exemption, the CBOE's Department of Market Regulation will monitor 
daily to determine that each exempted option contract is hedged by 
the equivalent dollar amount of component securities and for unusual 
option and stock activity. In addition, the CBOE notes that the 
hedge exemption account must promptly notify the Exchange of 
material changes in the portfolio. See Letter from Margaret G. 
Abrams, Senior Attorney, CBOE, to Yvonne Fraticelli, Attorney, 
Commission, dated April 10, 1996 (``Amendment No. 1'').
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The CBOE proposes to amend CBOE Rule 24.4A, ``Position Limits for 
Industry Index Options,'' to establish a hedge exemption from industry 
(narrow-based) index option position and exercise limits.\3\ The 
Commission previously has approved similar proposals by the 
Philadelphia Stock Exchange, Inc. (``PHLX'') and the Pacific Stock 
Exchange, Inc. (``PSE'').\4\
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    \3\ Position limits impose a ceiling on the number of option 
contracts which an investor or group of investors acting in concert 
may hold or write in each class of options on the same side of the 
market (i.e., aggregating long calls and short puts or long puts and 
short calls). Exercise limits prohibit an investor or group of 
investors acting in concert from exercising more than a specified 
number of puts or calls in a particular class within five 
consecutive business days.
    \4\ See Securities Exchange Act Release Nos. 36858 (February 16, 
1996), 61 FR 7295 (February 27, 1996) (order approving File No. SR-
PHLX-95-45) (``PHLX Approval Order''); and 36981 (March 15, 1996), 
61 FR 11929 (March 22, 1996) (order approving File No. SR-PSE-95-28) 
(``PSE Approval Order'').
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    The text of the proposed rule change is available at the office of 
the Secretary, CBOE, and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the 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

    The CBOE proposes to adopt new Interpretation and Policies .01 and 
.02 to CBOE Rule 24.4A to establish an industry hedge exemption based 
on the industry index hedge exemptions filed by the PHLX and the PSE, 
which were approved recently by the Commission.\5\ Interpretation and 
Policy .02 establishes certain compliance requirements for industry 
index hedge exemption accounts.
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    \5\ See PHLX Approval Order and PSE Approval Order, supra note 
4.
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    Currently, the Exchange has an equity option hedge exemption and a 
broad-based option index hedge exemption, but no hedge exemption for 
positions in CBOE industry index options. The CBOE states that its 
proposal will adopt the same formula used by the PHLX and the PSE for 
their industry index hedge exemptions, with minor modifications. The 
proposed narrow-based hedge exemption will be available to both broker-
dealers and customers.
    In order to qualify for the proposed hedge exemption, a position 
must be ``hedged'' by share positions in at least 75% of the number of 
component stocks of the index, or securities convertible into such 
stock. The proposed exemption is in addition to the standard limit and 
other exemptions and may not exceed twice the standard limit 
established under CBOE Rule 24.4A. The underlying value of the option 
position may not exceed the value of the underlying portfolio. The 
value of the underlying portfolio is determined as follows: (1) The 
total market value of the net stock position; and (2) for positions in 
excess of the standard limit, subtract the underlying market value \6\ 
of (a) any offsetting calls and puts in the respective index option 
class; (b) any offsetting positions in stock index futures; and (c) any 
economically equivalent position (assuming no other hedges for these 
contracts exist).
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    \6\ The CBOE uses the term ``underlying market value,'' instead 
of the equivalent term ``notional value,'' which the PHLX uses in 
its proposal, for consistency with a pending CBOE proposal to amend 
the CBOE's broad-based index hedge exemption. See Securities 
Exchange Act Release No. 36738 (January 19, 1996), 61 FR 2324 
(January 25, 1996) (notice of filing of File No. SR-CBOE-96-01) 
(``Broad-Based Index Option Proposal'').
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    Further, the proposal requires that both the options and stock 
positions be initiated and liquidated in an orderly manner. 
Specifically, a reduction of the options position must occur at or 
before the corresponding reduction in the stock portfolio position.
    The CBOE notes that its proposal makes minor modifications to the 
PHLX's narrow-based index hedge exemption requirements to conform the 
CBOE's language to a pending CBOE proposal to amend broad-based index 
options position limits and exemptions.\7\ According to the CBOE, the 
Exchange's modifications do not affect the hedge exemption definition 
or the calculation of the value of the portfolio, but will impose 
uniform CBOE Department of market Regulation monitoring requirements 
for both the proposed narrow-based and broad-based index hedge 
exemptions.
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    \7\ See Broad-Based Index Option Proposal, supra note 6.
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    Under the proposal, exercise limits will continue to correstpond to 
position limits, so that investors may exercise the number of contracts 
set forth as the position limit, as well as those contracts exempted by 
this proposal, during five consecutive business days.
    As of March 1, 1996, the CBOE trades the following industry index 
options, with limits as shown:
    (1) S&P Banking Index--12,000 contracts;
    (2) S&P Chemical Index--9,000 contracts;
    (3) S&P Health Care Index--9,000 contracts;
    (4) S&P Insurance Index--9,000 contracts;
    (5) S&P Retail Index--9,000 contracts;
    (6) S&P Transportation Index--9,000 contracts;
    (7) CBOE Software Index--9,000 contracts;
    (8) CBOE Environmental Index--9,000 contracts;
    (9) CBOE Gaming Index--9,000 contracts;
    (10) CBOE Global Telecommunications Index--12,000 contracts;
    (11) CBOE Israel Index--9,000 contracts;
    (12) CBOE Mexico Index--12,000 contracts;
    (13) CBOE REIT Index--12,000 contracts;
    (14) CBOE Telecommunications Index--12,000 contracts;
    (15) CBOE Biotech Index--9,000 contracts;
    (16) CBOE Latin 15 Index--12,000 contracts; and
    (17) CBOE High Technology Index--12,000 contracts.
    The CBOE will require that documentation regarding the qualified 
stock portfolio be filed with the CBOE's Department of Market 
Regulation on behalf of a hedge exemption account seeking an exemption. 
Proposed Interpretation and Policy .02 contains compliance requirements 
for industry hedge exemption accounts which are identical to the 
compliance requirements proposed in a pending CBOE proposal for broad-
based index hedge exemption accounts.\8\ The Exchange states that its 
Department of Market Regulation will continue to monitor trading 
activity in industry index options to detect potential abuses, and 
review to ensure that closing positions subject to an exemption is

[[Page 24981]]

conducted in a fair and orderly manner. In addition, the CBOE's 
Department of Market Regulation will monitor daily to determine that 
each exempted option contract is hedged by the equivalent dollar amount 
of component securities and for unusual option and stock activity.\9\
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    \1\ See Broad-Based Index Option Proposal, supra note 6.
    \2\ See Amendment No. 1, supra note 2.
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    The CBOE notes that the proposed industry index hedge exemption 
contains build-in safeguards. Specifically, the ``basket'' of stocks 
constituting the hedge must be comprised of at least 75% of the stocks 
underlying the index. The hedge exemption account must promptly notify 
the Exchange of any material changes in the value of the portfolio.\10\ 
Further, both the options and stock positions must be initiated and 
liquidated in an orderly manner, so that a reduction of the options 
position must occur at or before the corresponding reduction in the 
stock portfolio position. Finally, the aggregate underlying value of 
the industry index option position cannot exceed the market value of 
the underlying hedging portfolio, to ensure that stock transactions are 
not used to manipulate the market in a manner benefiting the option 
position.
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    \10\ Id.
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    The Exchange believes that the proposal is consistent with Section 
6 of this Act, in general, and, in particular, with Section 6(b)(5), in 
the narrow-based hedge exemption should increase the depth and 
liquidity of narrow-based index options markets and allow more 
effective hedging by investors without increasing the potential for 
market disruption, thereby removing impediments to and perfecting the 
mechanism of a free and open market and a national market system in a 
manner consistent with the protection of investors and the public 
interest.

(B) Self-Regulatory Organization's Statement on Burden on Competition

    The CBOE does not believe that the proposed rule change will impose 
any burden on competition.

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

    No written comments were solicited or received with respect to the 
proposed rule change.

III. Commission's Findings and Order Granting Accelerated Approval of 
Proposed Rule Change

    The CBOE has requested that the proposed rule change be given 
accelerated effectiveness pursuant to Section 19(b)(2) of the Act. The 
CBOE believes that approval on an accelerated basis would promote fair 
competition among exchanges and eliminate the risk, in a multiple-
exchange trading environment, of investor confusion respecting hedge 
exemptions for industry index options. As noted above, the Commission 
has previously approved similar proposals submitted by the PHLX and the 
PSE.\11\ The CBOE believes that the proposal presents no significant 
new issues.
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    \11\ See PHLX Approval Order and PSE Approval Order, supra note 
4.
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    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, the requirements of Section 6(b)(5).\12\ The Commission 
concludes, as it has found previously,\13\ that providing for increased 
position and exercise limits for narrow-based index options in 
circumstances where those excess positions are fully hedged with 
offsetting stock positions will provide greater depth and liquidity to 
the market and will allow investors to hedge their stock portfolios 
more effectively, without significantly increasing concerns regarding 
inter-market manipulations or disruptions of either the options market 
or the underlying stock market.
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    \12\ 15 U.S.C. 78f(b) (1988 & Supp. V 1993).
    \13\ See PHLX Approval Order and PSE Approval Order, supra note 
4.
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    Specifically, the CBOE proposal contains safeguards that should 
make it difficult to use the exempted positions to disrupt or 
manipulate the market. First, requests for the exemption must be 
approved by the CBOE, which should ensure that the hedges are 
appropriate for the position being taken and are in compliance with 
CBOE rules. Second, the stock portfolio must consist of at least 75% of 
the number of component securities underlying the index, and must 
correspond in value to the value of the options position hedged, so 
that the increased positions are less likely to be used in a leveraged 
manner in any manipulative scheme. As noted above, the value of the 
hedging portfolio is equal to (1) the total market value of the net 
stock position; less (2) the value of (a) any offsetting calls and puts 
in the respective index option class; (b) any offsetting positions in 
stock index futures; and (c) any economically equivalent positions 
(assuming no other hedges for these contracts exist).\14\ Third, both 
the options and the stock positions must be initiated and liquidated in 
an orderly manner. Moreover, a reduction of the options position must 
occur at or before the corresponding reduction in the stock portfolio 
position, thereby helping to ensure that the stock transactions are not 
used to impact the market so as to benefit the options positions. 
Fourth, the CBOE must be notified of any material change in the 
portfolio.\15\ Fifth, the maximum hedge exemption position is two times 
the existing limit. The ``two times the limit'' is not automatic and 
the CBOE has the authority to approve a hedge limit for less than that 
amount.
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    \14\ If a hedge position ceases to exist, this would be viewed 
as a material change which must be reported promptly to the CBOE. In 
such a case, the value of the stock portfolio would be reduced 
accordingly and therefore the hedged options position must also be 
reduced. As noted above, a reduction of the options position must 
occur at or before the corresponding reduction in the stock 
portfolio position.
    \15\ See Amendment No. 1, supra note 2.
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    The Commission notes that the CBOE's survelliance procedures are 
designed to detect as well as deter manipulation and market 
disruptions. In particular, the CBOE's Department of Market Regulation 
will monitor the options position of a person utilizing the hedge 
exemption on a daily basis to determine that each option contract is 
hedged by the equivalent dollar amount of component securities.\16\ In 
addition, the CBOE's Department of Market Regulation will continue to 
monitor trading activity in industry index options to detect potential 
abuses, and will review such activity and ensure that closing positions 
subject to an exemption is conducted in a fair and orderly manner. 
Violation of any of the provisions of CBOE Rule 24.4A and the 
interpretations and policies thereunder, absent reasonable 
justification or excuse, will result in the withdrawal of the hedge 
exemption and subsequent denial of an application for a hedge exemption 
thereunder.
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    \16\ See Amendment No. 1, supra note 2. Market participants 
granted a hedge exemption must promptly notify the Exchange of 
material changes in the portfolio.
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    The Commission believes that it is reasonable for the CBOE to allow 
broker-dealers, as well as public customers, to utilize the proposed 
hedge exemption.\17\ The Commission believes that extending the narrow-
based index option hedge exemption to broker-

[[Page 24982]]

dealers may help to increase the depth and liquidity of the market for 
industry index options and may help to ensure that public customers 
receive the full benefit of the exemption. Moreover, the CBOE's 
monitoring procedures, as described above, should be able to detect any 
abuses and ensure that the options position, whether broker-dealer or 
customer, is properly hedged.
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    \17\ The Commission notes that broker-dealers and public 
customers may utilize the CBOE's equity hedge exemption. See CBOE 
Rule 4.11, Interpretation and Policy .04, and Securities Exchange 
Act Release No. 35738 (May 18, 1995), 60 FR 27573 (May 24, 1995) 
(order approving File Nos. SR-Amex-95-13, SR-CBOE-95-13, SR-NYSE-95-
04, SR-PSE-95-05, and SR-PHLX-95-10) (permanently approving hedge 
exemption pilot programs).
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    The Commission finds good cause for approving the proposed rule 
change and Amendment No. 1 to the proposed rule change prior to the 
thirtieth day after the date of publication of notice of filing thereof 
in the Federal Register. As noted above, the Commission previously has 
approved similar proposals submitted by the PHLX and the PSE.\18\ The 
PHLX's and PSE's proposals were published for the full notice and 
comment period and the Commission received no comments on their 
proposals. The CBOE's proposal raises no new regulatory issues. 
Amendment No. 1 strengthens the CBOE's proposal by indicating that the 
CBOE's Department of Market Regulation will monitor hedge exemption 
accounts daily to determine that each exempted option contract is 
hedged by the equivalent dollar amount of component securities. 
Accordingly, the Commission believes it is consistent with Sections 
6(b)(5) and 19(b)(2) of the Act to approve the proposed rule change and 
Amendment No. 1 to the proposed rule change on an accelerated basis.
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    \18\ See PHLX Approval Order and PSE Approval Order, supra note 
4.
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., 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 at the 
Commission's Public Reference Section, 450 Fifth Street, NW., 
Washington, D.C. Copies of such filing will also be available for 
inspection and copying at the principal office of the above-mentioned 
self-regulatory organization. All submissions should refer to the file 
number in the caption above and should be submitted by [insert date 21 
days after the date of this publication].
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\19\ that the proposed rule change (SR-CBOE-96-18), as amended, is 
approved.

    \19\ 15 U.S.C. 78f(b)(2) (1988).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12) (1995).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-12382 Filed 5-16-96; 8:45 am]
BILLING CODE 8010-01-M