The Chicago Board Options Exchange (CBOE) is gearing up to launch 'flexible exchange' (Flex) index options with Asian and cliquet style settlement beginning Monday, March 21. The introduction of Asian and cliquet Flex index options is expected to provide insurers with an alternative hedging tool to OTC market products, while also providing traditional exchange-traded benefits such as enhanced price discovery, transparency and centralized clearing.
Insurance companies that write indexed annuity contracts often have exotic option liabilities embedded within those annuity contracts which have been historically hedged exclusively in the over-the-counter (OTC) market, according to Matt McFarland (pictured), director at CBOE.
"We are primarily targeting the product towards insurance companies involved in issuing large amounts of indexed annuity products providing upside to the equity capital markets through embedded options within the annuity," said McFarland. "The most popular options traded at CBOE for indexed annuities are vanilla and binary options, but we believe that Asian and cliquet options are also in demand by insurance companies. We work closely with insurance companies, and they hedge the capital markets exposure on an over the counter (OTC) basis. However, these insurance companies have expressed to CBOE that they would like to hedge the embedded exotic option risk on exchange to benefit from what the exchange environment offers (clearance, post-trading, transparency, price discovery...)."
According to McFarland, transacting on-exchange could provide insurance companies with improved execution prices on their hedges, while simultaneously reducing counterparty risk. "CBOE's business development efforts have been very much focused on providing support to insurance companies but there is scope beyond insurance companies for this kind of products such as structured products issuers which may see value in embedding these exchange-traded options in their structured notes or other types of wrappers such as unit investment trusts (UIT), as well as mutual funds and ETFs," said McFarland. "We pay very close attention at what is going on in the OTC market and what is driving activity in the OTC market. Some OTC instruments develop in such a way that they become suitable for exchange trading and some others don't. In this particular case, we feel these options are appropriate for exchange trading, but we are looking at other products (other exotic options) to make an assessment to see if they are appropriate to make them available on exchange."
Other exotic options being monitored by CBOE include options with non-standard payoffs which could complement the first offering around exotic options, according to McFarland. "We want to test how these Asian and cliquet options, and if they meet our expectations we would entertain the possibility to offer other similar options," said McFarland.
Once the new Flex options are available, insurance companies will be able to settle Asian options, also known as 'averaging options', where the settlement value is based on an average of the underlying index closing prices throughout the contract's life, as opposed to the single price at expiration; as well as cliquet options, sometimes referred to as a 'ratchet options', where a series of at-the-money forward-start options have the total premium determined in advance. CBOE is expected to offer a specific type of cliquet known as the monthly sum cap with a global floor where the option holder receives the greater of zero or the sum of monthly capped returns.
Both Asian and cliquet Flex index options have a term of approximately one year with 12 monthly observation dates, but each contract type has a different method for determining the exercise settlement value.
This launch makes part of recent developments at CBOE in and around the structured products market such as the acquisition of Vest Financial, said McFarland. "For these particular options we think they make sense for some of the products they are looking to bring to market although we don't know what their immediate plans are," said McFarland. "The Vest acquisition is aimed at bringing CBOE closer to the structured products side of the market, as the firm's background is in structured products, and ETFs. Through this acquisition we can now look at popular payoffs within structured notes, make them available on exchange and wrap them up in different products."
Flex options, created by CBOE in 1993, are customizable options that allow users to define various contract terms such as exercise style, strike price and expiration date, and give investors the opportunity to trade on a larger scale with expanded or eliminated position limits.
The options' exchange has also reached an agreement with Bloomberg to establish direct connectivity between CBOE's Pulse trader workstation (Pulse) and Bloomberg's execution management system (EMSX).
Under the terms of the agreement, Bloomberg EMSX users will be able to send, execute and confirm orders electronically with CBOE floor brokers and other Pulse users. CBOE's Pulse trader workstation is a 'next-generation execution management system' that allows traders to simultaneously and electronically access the markets via Direct Market Access (DMA), advanced routing and high-touch broker relationships. The Pulse Execution Management System (EMS) offers connectivity to CBOE, C2 Options Exchange (C2) and CBOE Futures Exchange (CFE), as well as other equity and options exchanges in one low-cost platform.
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