Over-the-Counter (OTC) option contracts

GN-5700-21-003
Type: Rules Notice> Guidance Note
Rule connection:
IIROC Rules
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Executive Summary

Effective Date: December 31, 2021

This summary is designed to highlight the background and application of the OTC option margin rules pursuant to Rule 57001 .

  • 1In this Guidance, all rule references are to the IIROC Rules unless otherwise specified.
Table of contents
  1. What is an option?

An option is a contract giving its owner the right, but not the obligation, to buy (call) or sell (put) a specified item at a fixed price (exercise or strike price) during a specified period (American exercise) or at a specified date (European exercise). The buyer pays a non-refundable fee (premium) to the seller (known as the writer).

  1. What differentiates an OTC traded option from an exchange-traded option?

An OTC option is transacted directly between two parties and is not facilitated through an exchange. Before entering into an OTC option contact, the two parties assess their respective counterparties credit worthiness in determining future performance.

Where a Dealer Member (Dealer) may act in a principal role in respect to an OTC option transaction, the Dealer is the counterparty to the long and/or short OTC option transaction and will be required to provide margin subject to any allowable offset provisions.

  1. How are OTC option premiums determined?

The valuation of any option is based on the intrinsic value plus time premium. Intrinsic value can be determined as the difference between the exercise (or strike) price of the option and the market value of the underlying security. Time premium is more difficult to determine since the characteristics of the underlying security such as its volatility must be assessed.

A model for the valuation of options derived by Fisher Black and Myron Scholes (Black-Scholes Model) has led to computer software programs to price option contracts.

For purposes of monitoring daily margin requirements, the option value shall be calculated on a basis consistent with the valuation benchmark or mathematical model used in determining the premium at the time the contract was initially entered.

  1. What are the margin rules for OTC options?

Sections 5780 to 5781 set out the margin requirements, which are to be determined on the following basis:

I.  5780. Long option positions

  1. The minimum Dealer inventory margin required for long over-the-counter option positions is:
    1. where the option’s market price is less than $1.00, the market value of the option,
    2. where the option’s market price is $1.00 or more, and:
      1. the option is a call option, the market value of the call option less 50% of any excess of the market value of the underlying interest over the aggregate exercise value of the call option, or
      2. the option is a put option, the market value of the put option less 50% of any excess of the aggregate exercise value of the put option over the market value of the underlying interest.
  2. The minimum client account margin required for long over-the-counter option positions is the market value of the option.

II. 5781. Short option positions

  1. Subject to subsection 5781(2), the minimum Dealer inventory margin and client account margin required for short over-the-counter option positions is:
    1. a percentage of the market value of the underlying interest determined using the following percentages:
      1. for debt options, the margin rate used for the underlying interest as determined in sections 5210 through 5241,
      2. for equity options, the margin rate used for the underlying interest as determined in section 5310 through 5315,
      3. for index options or index participation unit options, the published floating margin rate for the index or index participation unit calculated according to the formula set out in section 5360,
      4. for currency options, IIROC’s published spot risk margin rate for the currency calculated according to the formula set out in section 5460 through 5469,

        Minus
    2. any out-of-the-money amount associated with the option.
  2. Subsection 5781(1) notwithstanding, the minimum client account margin required for short over-the-counter option positions shall be no less than the amount determined by multiplying:
    1. in the case of a short call option position, the market value of the underlying interest,
    2. in the case of a short put option position, the aggregate exercise value of the option, by 25% of the margin rate used for the underlying interest.

 

  1. How is inventory margin for OTC options determined?

Mark to market of option positions in inventory is required. Margin shall be calculated as noted in (4) above.

  1. In the absence of the client lodging the underlying interest or equivalent, how is client margin for OTC options determined?

Client margin for OTC option contracts shall be determined based on the following categories:

  1. For acceptable institutions, as defined in the General Notes and Definitions to Form 1, no margin is required.
  2. For acceptable counterparties or regulated entities, as defined in the General Notes and Definitions to Form 1, margin will be determined based on the market deficiency (marked to market) of the option position.
  3. Margin will be required for all other clients and calculated in the same manner as noted in (4) above. Adequate margin for a client short OTC option contract consists of: (1) the deposit of the underlying interest in negotiable form in the client margin account. (2) the deposit of an escrow receipt, or (3) the deposit of a put guarantee letter. If inadequate or insufficient margin is deposited by the client, then the Dealer must provide the deficiency out of its own capital. Short options must be written in client margin accounts with proper agreements in place.
  1. Are offsets for OTC options allowed?

For purposes of hedging OTC option contracts, the offset would be allowed in the same manner as is outlined by IIROC for exchange-traded options, provided that the underlying securities are the same.

In the case of spreads involving European exercise over-the-counter options:

  • a margin offset is permitted where the spread consists of long and short European exercise option contracts with the same expiration date, and
  • a margin offset is permitted where the spread consists of a short European exercise option and long American exercise option, however
  • a margin offset is not permitted where the spread consists of a long European exercise option and a short American exercise option.
  1. Applicable Rules

IIROC Rules this Guidance Note relates to:

  • Rule 5200,
  • Rule 5300, and
  • Rule 5700.
  1. Previous Guidance Note

This Guidance Note replaces C-89 - Over-the-Counter (OTC) Option Contracts.

  1. Related documents

This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.