

[Federal Register: October 30, 2006 (Volume 71, Number 209)]
[Notices]               
[Page 63367-63370]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr30oc06-138]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54643; File No. SR-CBOE-2006-73]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Notice of Filing of Proposed Rule Change and Amendment 
No. 1 Thereto To Amend Certain of its Rules To Provide for the Listing 
and Trading of Options on the CBOE Russell 2000 Volatility Index \sm\ 
(``RVX \sm\'')

 October 23, 2006.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934

[[Page 63368]]

(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on August 31, 2006, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') the proposed rule change as described in 
Items I, II and III below, which Items have been prepared by the 
Exchange. On October 20, 2006, the Exchange filed Amendment No. 1 to 
the proposed rule change. 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.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    CBOE proposes to amend certain of its rules to provide for the 
listing and trading of options on the CBOE Russell 2000 Volatility 
Index\sm\ (``RVX\sm\''). Options on the RVX will be cash-settled and 
will have European-style expiration. The text of the proposed rule 
change is available on CBOE's Web site, http://www.cboe.org, at CBOE's 

Office of the Secretary, and at the Commission's Public Reference Room.

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

    In its filing with the Commission, CBOE 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. CBOE 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 the 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The purpose of the proposed rule change is to permit the Exchange 
to list and trade cash-settled, European-style options on the RVX.
Index Design and Calculation
    The Exchange states that the calculation of this index is based on 
a methodology that is an up-to-the-minute market estimate of expected 
volatility that is calculated by using real-time Russell 2000 Index 
(``RUT'') option bid/ask quotes. RVX uses nearby and second nearby 
options with at least 8 days left to expiration and then weights them 
to yield a constant, 30-day measure of the expected volatility of the 
RUT.
    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. This is 
done 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.\3\
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    \3\ The RVX is calculated in the same manner as other volatility 
indexes (e.g., the CBOE Volatility Index (``VIX'')), upon which 
options have been based and previously approved by the Commission. A 
more detailed explanation of the method used to calculate VIX may be 
found on CBOE's Web site at the following Internet address: http://www.cboe.com/micro/vix/vixwhite.pdf
.

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    As described above, the RVX option will be structured as an option 
on a group of securities, namely options on the RUT and by extension 
the stocks underlying the RUT. CBOE will use the actual quotes of the 
index options to derive the corresponding volatility index. The 
underlying index options are themselves securities and are based on an 
index of the broader number of underlying securities.\4\ Thus, the 
pricing components underlying the RVX options will include the RUT 
options and, by extension, the component stocks of the RUT. These 
pricing components will provide a measure of the volatility of price 
movements of the RUT. The Exchange states that this structure is 
similar to the approach used by CBOE for its interest rate options.\5\ 
Those products use the quotes of debt securities to derive an interest 
rate yield, which is converted into a measure that serves as the 
underlying for options. Similarly, quotes from index option securities, 
which reflect a measure of stock price movements of the RUT, will be 
used to derive a measure of volatility that will be the underlying for 
the respective volatility index options.
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    \4\ RUT measures the performance of the 2000 smallest companies 
in the Russell 3000 Index, which represent approximately 8% of the 
total market capitalization of the Russell 3000.
    \5\ See Securities Exchange Act Release Nos. 26938 (June 15, 
1989), 54 FR 26285 (June 22, 1989) (SR-CBOE-87-30) and 33106 
(October 26, 1993), 58 FR 58358 (November 1, 1993) (SR-CBOE-93-21).
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    CBOE will compute the index on a real-time basis throughout each 
trading day, from 8:30 a.m. until 3:15 p.m. CST. CBOE has calculated 
historical index values for the new RVX back to January 2004. 
Volatility index levels will be calculated by CBOE and disseminated at 
15-second intervals to market information vendors via the Options Price 
Reporting Authority.
Index Option Trading
    RVX is quoted in absolute numbers that represent the volatility of 
the RUT in percentage points per annum. For example, an index level of 
20.47 (the closing value of the RVX on October 9, 2006) represents an 
annualized volatility of 20.47% in the RUT. The Exchange states that 
the RVX level fluctuates quite differently than individual equity 
securities or indexes of individual equity securities. Specifically, 
the Exchange states that indexes such as the RVX that track volatility 
are ``mean-reverting,'' a statistical term used to describe a strong 
tendency for the volatility index to move toward its long-term 
historical average level. In other words, at historically low 
volatility index levels, there is a higher probability that the next 
big move will be up rather than down. Conversely, at historically high 
volatility index levels, the next big move is more likely to be down 
rather than up.
    Thus, as exemplified by RVX, the Exchange states that volatility 
indexes tend to move within set ranges, and even when a level moves 
outside that range, the tendency towards mean-reversion often results 
in the volatility index returning to a level within the range. In the 
case of RVX, the historical average index value is 20.89. Since January 
2004, RVX has fluctuated in a narrow range between a low of 15.95 to a 
high of 34.02. Furthermore, RVX closed under 25 for 89% of the days on 
which the level was calculated since 2004 (621 days out of a total of 
695 days) and has closed under 30 for 99% of the days on which the 
level was calculated since 2004 (689 days out of a total of 695 days). 
RVX has closed between 18 and 24 for 78% of the days on which the level 
was calculated since 2004 (544 days out of a total of 695 days).
    Because of the generally limited range in which RVX has fluctuated, 
the Exchange believes that investors will be better served if the 
Exchange is able to list $1 strike price intervals in RVX option 
series. To address this, the Exchange is proposing to list series at $1

[[Page 63369]]

or greater strike price intervals for each expiration on up to 5 RVX 
option series above and 5 RVX option series below the current index 
level. Additional series at $1.00 or greater strike price intervals 
could be listed for each expiration as the current index level of RVX 
moves from the exercise price of the RVX options series that already 
have been opened for trading on the Exchange in order to maintain at 
least 5 RVX option series above and 5 RVX option series below the 
current index level. For purposes of adding strike prices at $1.00 or 
greater strike price intervals, as well as at $2.50 or greater strike 
price intervals, the ``current index level'' would be defined as the 
``implied forward level'' of RVX for each expiration.\6\ The Exchange 
intends to determine implied forward levels of RVX through the use of 
RVX futures prices. Its reasons for using this approach are explained 
below.
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    \6\ With respect to $2.50 or greater strikes, the $2.50 or 
greater strike price intervals will be reasonably related to the 
current index value of RVX at or about the time such series are 
first opened for trading. The term ``reasonably related to the 
current index value of the underlying index'' means that the 
exercise price is within 30% of the current index value. The 
Exchange may also open additional $2.50 or greater strike price 
series that are more than 30% away from the current index value, 
provided that demonstrated customer interest exists for such series, 
as expressed by institutional, corporate, or individual customers or 
their brokers. See Interpretations and Policies .01(d) and .04 of 
CBOE Rule 24.9.
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    By way of background, option prices reflect the market's 
expectation of the price of the underlying at expiration, which is 
referred to as the ``forward'' level. For stock indexes such as the SPX 
and the S&P 100 (``OEX''), the best estimate of the forward level is 
the current, or ``spot,'' price adjusted for the ``carry,'' which is 
the financing cost of owning the component stocks in the index less the 
dividends paid by those stocks. For volatility indexes such as RVX, the 
Exchange states that a better estimate than the standard ``cash and 
carry'' model for calculating the forward levels of RVX at each 
expiration is reflected in the prices of the options that will be used 
to calculate RVX on that expiration day. For example, December RUT 
options will be used to calculate RVX on the November RVX expiration 
date. Likewise, February 2007 RVX options are tied to the implied 
volatility of March 2007 RUT options, and so on.
    The Exchange states that one important property of implied 
volatility is that it exhibits a ``term structure.'' In other words, 
the implied volatility of options expiring on different dates can trade 
at different levels and can move independently. Another property 
related to the term structure is that implied volatility tends to trend 
toward the market's expectation of a long-term ``average'' value. As a 
result, a large spike in one-month implied volatility might not affect 
implied volatility of longer-dated options very much at all.
    The CBOE Futures Exchange does not currently list RVX futures; 
however, CBOE expects that RVX futures corresponding to each RVX 
options expiration month will be available prior to launch. As a 
result, the Exchange believes that traders will likely use RVX futures 
prices as a proxy for forward RVX levels. CBOE believes that using 
these prices is an accurate and transparent method for determining the 
``current index level'' used to center the limited range in which $1 or 
greater strikes in RVX options will be listed and the broader range in 
which $2.50 or greater strikes in RVX options will be listed.
    Additionally, the Exchange is proposing that it would not list 
series with $1 intervals within $0.50 of an existing $2.50 strike price 
with the same expiration month (e.g., if there is an existing $12.50 
strike, the Exchange would not list a $12.00 or $13.00 strike). 
Finally, the interval between strike prices for RVX long-term option 
series (``LEAPs[supreg]'') will continue to be no less than $2.50.
    The Exchange states that $1 strike price intervals will more 
closely bracket the level of RVX when it remains locked within a static 
range, as currently exists, and will enable investors to assume more 
dynamic volatility index option positions that reflect greater 
possibilities of settling in-the-money.
    The Exchange also notes that the Commission has approved the 
listing of options on the CBOE Volatility Index (``VIX'') at $1.00 
strike intervals within certain parameters.\7\
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    \7\ See Securities Exchange Act Release No. 34-54192 (July 21, 
2006), 71 FR 43251 (July 31, 2006) (SR-CBOE-2006-27).
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    CBOE has analyzed its capacity and represents that it believes the 
Exchange and the Options Price Reporting Authority have the necessary 
systems capacity to handle the additional traffic associated with the 
listing and trading of $1 strike RVX options as proposed herein.
    The trading hours for options on the volatility indexes will be 
from 8:30 a.m. to 3:15 p.m. CST. Exhibit 2 to CBOE's filing presents 
proposed contract specifications for RVX options.
Exercise and Settlement
    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. 
For example, September 2006 RVX options would expire on Wednesday, 
September 20, 2006, exactly 30 days prior to the third Friday of the 
calendar month immediately following the expiring month. Trading in the 
expiring contract month will normally cease at 3:15 p.m. CST on the 
last day of trading. Exercise will result in delivery of cash on the 
business day following expiration. RVX options will be a.m.-settled. 
The exercise settlement value will be determined by a Special Opening 
Quotation (SOQ) of the RVX calculated from the sequence of opening 
prices of the RUT options that comprise that index on the settlement 
date. The opening price for any series in which there is no trade would 
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. When the last trading day is moved because of 
Exchange holidays, the last trading day for expiring options will be 
the day immediately preceding the last regularly-scheduled trading day.
Surveillance
    The Exchange 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 further 
represents that these surveillance procedures will be adequate to 
monitor trading in options on these indexes. For surveillance purposes, 
the Exchange states that it will have complete access to information 
regarding trading activity in the pertinent underlying securities.
Position Limits
    The Exchange proposes to establish position limits for options on 
the RVX at 50,000 contracts on either side of the market, and no more 
than 30,000 of such contracts may be in series in the nearest 
expiration month. The Exchange states that these position limits for 
options on the RVX are consistent with the position limits for options 
on the underlying RUT set forth in CBOE Rule 24.4.\8\
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    \8\ Telephone conversation between Jennifer L. Klebes, Senior 
Attorney, CBOE, and Florence E. Harmon, Senior Special Counsel, 
Division of Market Regulation, Commission, on October 23, 2006.
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Exchange Rules Applicable
    Except as modified herein, the CBOE Rules in Chapter XXIV will be 
applicable to the RVX options. The RVX

[[Page 63370]]

will be classified as a ``broad-based index'' and, under CBOE margin 
rules, specifically CBOE Rule 12.3(c)(5)(A), the margin requirement for 
a short put or call on the respective volatility indexes will be 100% 
of the current market value of the contract plus up to 15% of the 
respective underlying index value.
    Finally, CBOE has analyzed its capacity and represents that it 
believes the Exchange and the Options Price Reporting Authority have 
the necessary systems capacity to handle the additional traffic 
associated with the listing and trading of RVX options as proposed 
herein.
2. Statutory Basis
    The Exchange believes that the proposal is consistent with Section 
6(b) of the Act,\9\ in general, and Sections 6(b)(5) of the Act,\10\ in 
particular, in that it will permit trading in options based on the RVX 
pursuant to rules designed to prevent fraudulent and manipulative acts 
and practices and to promote just and equitable principles of trade, 
and thereby will provide investors with the ability to invest in 
options based on an additional index.
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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 any written comments with 
respect to the proposed rule change.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    A. By order approve the 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. 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 rule-comments@sec.gov. Please include 

File Number SR-CBOE-2006-73 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, Station Place, 100 F 
Street NE., Washington, DC 20549-1090.
    All submissions should refer to File Number SR-CBOE-2006-73. 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 Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of the Exchange. 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 Number SR-CBOE-2006-73 and should be submitted on or before 
November 20, 2006.

    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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Nancy M. Morris,
Secretary.
[FR Doc. E6-18081 Filed 10-27-06; 8:45 am]

BILLING CODE 8011-01-P
