Tel Aviv Stock Exchange Is Aligning The Calculation Method Of The Daily Settlement Price For Derivatives With International Standards

TASE is Aligning the Calculation Method of the Daily Settlement Price for Derivatives with International Standards
Under the new method, a daily settlement price will be determined for the derivative at the end of every trading day, based on current market data or a theoretical calculation, to reflect the economic value of the derivative, in line with common global practice
The transition to the new calculation method will simplify the revaluation, review and return comparison of investment portfolios by fund managers, TASE members, investors and the public, thereby improving the accessibility of the derivatives market

The Tel Aviv Stock Exchange Board of Directors has decided to align the method of calculation of the daily settlement price for derivatives traded on TASE with international standards. For every derivative, a price that reflects its economic value will be determined at the end of each trading day. If transactions or price quotes that meet the stipulated criteria are available for the derivative, the daily settlement price will be based on those. If such transactions or price quotes are not available for the derivative, TASE will calculate and publish a theoretical settlement price for such derivative.

This change is intended to align the method of calculation of the daily settlement price for derivatives with that applied to derivatives in stock exchanges globally. That is, where current market data is not available, the daily settlement price will be calculated based on the theoretical value of the derivative.

The existing method

The existing algorithm that is used in calculating the daily settlement price of derivatives prioritizes prices of transactions that were carried out close to the end of the trading day, as these prices embody information that was available in the market shortly before the close of trading on that day. However, in the absence of such transactions, the calculation is based on prices of transactions that were carried out earlier that day. Consequently, the daily settlement price of a derivative may be based on the prices in transactions that were carried out at the beginning of the trading day or even in prior trading days, which could render the daily settlement price irrelevant.

The existing calculation method of the daily settlement price for derivatives has bearing on many capital market players and participants: for instance, mutual fund managers prefer not to purchase options for the funds under their management, in view of the complexity of pricing illiquid options.

Additionally, the existing method could potentially distort the revaluation of a portfolio that contains a certain composition of derivatives. Thus, for example, the value of a portfolio containing options that were in the money and later came out of the money as a result of a change in the price of the underlying asset, leaving the options “stranded" at a high price due to their illiquidity. Accordingly, those transacting in derivatives may find it difficult to revaluate a portfolio based on daily settlement prices alone, as this requires the identification of derivatives for which the settlement price substantially diverges from the economic value and the application of an accepted revaluation model to those derivatives.

Furthermore, the existing pricing method poses a barrier to the development of a liquid market for futures. Modification of the method will make futures more attractive, as is generally the case in international derivatives markets.

The new calculation method

Further to requests received from capital market players to change the method of calculating the daily settlement price for derivatives, the TASE professional staff has formulated a proposal for modification of the algorithm.

Presented below are the principals of the proposed change for options:

a. The daily settlement price calculation will be based, to the extent possible, on market data, i.e., transaction prices or buy and sell quotes in the order book shortly before the end of trading.

b. In the event that market data (transactions or quotes) is unavailable or is not current, the daily settlement price will be determined based on the theoretical value of the derivative - PCP model or theoretical value under the B&S formula, combined with data from a model that is used to establish a volatility surface. Where the standard deviation deriving from the volatility surface cannot be applied, the uniform standard deviation used to calculate collaterals of the MAOF Clearing House will be applied.

The principals of the proposed change for Futures:

The daily settlement price for Futures will be calculated based on the forward price formula applicable to the underlying assets.

Main advantages to the new calculation method:

The transition to the new method of calculation of the daily settlement price for derivatives is beneficial to all parties in the capital market, as described below:

Mutual Funds- will no longer need to reevaluate illiquid derivatives on the basis of an internal model. Instead, they will use the daily settlement price calculated and published by TASE, which will serve as a benchmark for all parties in the capital market.
TASE members and investors - The transition will improve the monitoring of investment portfolios containing derivatives, this on the basis of a more accurate daily gain/loss.
The public - The application of the same price by all investment managers in revaluating derivatives will simplify the comparison of returns achieved by the various managers on investment portfolios containing derivatives.
Institutional Investors - The proposed change is expected to motivate institutional investor to return to the derivatives market, which they have mostly been avoiding, among others, due to the revaluation issues. TASE's discussions with institutional investor suggest that the fact that the daily settlement price does not always reflect the economic value of a derivative, makes them reluctant to participate in the derivatives market.
Standardization - To the best of TASE knowledge, derivative exchanges calculate a daily settlement price for derivatives, but do not publish the calculation algorithm. Nevertheless, it appears that exchanges prefer to use market data (transactions/quotes) and only in the absence of those opt for calculation of a theoretical price. The proposed model is based on similar principles.

TASE has decided that, in the first year of application of the proposed method of calculation of a daily settlement price for derivatives, the TASE staff will examine the quality of the prices and the contribution of their publication to expanding the use of the derivatives that are traded on TASE. At the end of one year, the findings of the examination will be presented to the TASE Board of Directors, accompanied by the professional staff's recommendations for changes or adjustments to the calculation method, to the extent that such are found to be necessary.

These changes are subject to approval by the Israel Securities Authority (ISA).