Insurance companies and other users of exotic options will now be able to trade and hedge their exposure and settle trades via two new electronic trading methodologies on a large public options exchange.

The Chicago Board Options Exchange (CBOE) has now integrated Asian and Cliquet style options for its previously announced FLexible EXchange (FLEX) index algorithms. These new parameters will be available on March 21. These types of choices were previously only available in the over-the-counter  marketplace.

First, what is a FLEX option?

FLEX options, originally created by the CBOE in 1993, are customizable options that allow users to define various contract terms such as exercise style, strike price and expiration date. FLEX options also give investors the opportunity to trade on a larger scale with expanded or eliminated position limits.

Insurance companies that write indexed annuity contracts often have exotic option liabilities embedded within their annuity contracts – the two most popular and common types of esoteric exotic options insurers use are so-called Asians and Cliquets.

An Asian option, also known as an “averaging option,” is an option whose 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.

A Cliquet option, sometimes referred to as a “ratchet option,” is a series of at-the-money forward-start options where the total premium is determined in advance. 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.

Matt McFarland, director of business development at the CBOE, told MarketsMedia that the bourse is also set 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.

“Currently when an insurance company issues an indexed annuity to a person, they have only been able to hedge that exposure in the over-the-counter market as Asians and Cliquets have only been available there,” McFarland explained. “Beginning March 21, with FLEX index options with Asian and Cliquet style settlement, insurers will have access to hedging opportunities on the CBOE and enjoy some of the benefits and advantages to using a traditional exchange.”

One advantage to using CBOE versus the OTC markets is that a broader scope of market participants are able to transact at CBOE as compared to OTC (OTC is generally limited to large institutions and select dealer banks).  “At CBOE we have a large market making community that doesn’t trade in the OTC market,” McFarland noted, “but significantly enhances liquidity on the exchange.”

McFarland added that by including Asians and Cliquets on its exchange CBOE hopes to bring a sense of standardization to this esoteric options mart.

“Transacting on an exchange may provide insurance companies with improved execution prices on their hedges, while simultaneously reducing counterparty risk,” McFarland added. “Historically, CBOE has been the place for standardization and the OTC market for customization. This is our answer to the OTC market.”