CADerivatives. Table of contents BAX OBX ONX CGZ CGF CGB OGB LGB SCF SXF SXM SXA SXB SXH SXY EQUITY OPTIONS CURRENCY OPTIONS INDEX OPTIONS ETF OPTIONS

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1 The Montréal Exchange s Quarterly Derivatives Newsletter 2011, volume 2 BAX OBX ONX CGZ CGF CGB OGB LGB SCF SXF SXM SXA SXB SXH SXY EQUITY OPTIONS CURRENCY OPTIONS INDEX OPTIONS ETF OPTIONS Table of contents Season s Greetings... 2 CADC 2011: A Resounding Success... 4 Volatility Opportunities through OBX Options on BAX Futures... 6 The Montréal Exchange to Open its Doors in New York City First Quarter 2012 Initiatives Trading Data Upcoming Events... 22

2 2 3 Season s Greetings On behalf of everyone at MX, it gives me great pleasure to wish you and your family all the best for this upcoming holiday season, and for the new year to come. With your continued loyalty and support MX has enjoyed yet another banner year, expanding our international presence through the European office we opened in London, launching new products and making great technological strides. We also set numerous trading volume records, including the world s biggest rise in volume for the first half of the year with our Options on Three-Month Canadian Bankers Acceptance Futures. This summer we implemented the groundbreaking Yield Curve Project, a five-year initiative dedicated to developing a full sovereign yield curve. Several market makers were contracted to ensure ample liquidity for all market participants. We also amended our option fee schedule, introducing rebates on retail trades as an incentive for brokers to develop the market and implementing a fee cap at 10,000 contracts to encourage institutional clients to execute larger size trades at greater cost efficiency. Beyond this, we are working on building tailored solutions for the upcoming reforms to the OTC derivatives space and also to improve market efficiencies further to the 2008 financial crisis. Extensive work has gone into the CDCC clearing solution for the repo market, which we expect to come online early in In collaboration with Finance Montréal, we are also taking part in high value-added activities for the benefit of Quebec s entire financial sector. Thank you for helping to make this our best year to date. As we embark on a new year, be on the lookout for still further development and expansion as we strive to show the world why they should be trading Canada. Alain Miquelon President and Chief Executive Officer, Montréal Exchange Head of Derivatives Markets, TMX Group

3 4 5 CADC 2011: A Resounding Success Held at Fairmont Le Château Frontenac in Québec City on November 29 and 30, the Montréal Exchange s 12 th annual Canadian Annual Derivatives Conference welcomed a record 225 participants, with a vast array of specialties in the derivatives industry. The Montréal Exchange is pleased to be able to once again provide a forum where buy-side and sell-side professionals, as well as technology vendors, gather to discuss global and Canadian industry trends, said Alain Miquelon, President and Chief Executive Officer, Montréal Exchange. Video recordings of all CADC 2011 presentations will be made available at during the month of December. Tickets sold out well in advance of this year s event, so be on the lookout for announcements on the next edition, CADC We look forward to seeing you all there. Expert panellists were on hand to provide timely insights into such topics as regulatory reforms in Canada, the US and Europe, and developments in the clearing space with a highlight on clearing OTC derivatives.

4 6 7 Volatility Opportunities through OBX Options on BAX Futures Given the large and frequent shifts in volatility experienced in such periods as 2008, 2009, and more recently 2011, interest rate instruments which manage the volatility risk inherent in interest rate futures have become more relevant. In contrast to interest rate futures contracts, interest rate option contracts provide greater flexibility since they can be used to manage volatility risk as well as interest rate risk. Generally, volatility works its way through every strategy. Implied volatility and historical volatility can gyrate significantly and quickly, moving above or below an average or normal level, and then eventually revert to the mean. In Canada, we have seen a large upswing in the implied volatility of OBX options on BAX futures contracts (a key indicator of market expectations for the future direction of the Bank of Canada s overnight rate target). Implied volatility has been at the upper end of the historical range since When implied volatility (as measured by the price of OBX options) is above its historical norm and expected to fall, a short straddle or short volatility trade comes in useful. This strategy consists of the simultaneous sale of a call option and a put option with the same strike price (generally an at-the-money strike) and expiry month. A short straddle is effective when participants expect the Bank of Canada to keep its benchmark interest rate on hold for an extended period, and when implied volatility is expected to fall in the future. It is considered a non-directional strategy because the short straddle profits when the price of underlying BAX futures only moves modestly before expiration of the straddle. The short straddle may also be classified as a credit spread because the sale of a straddle results in a credit of the premiums collected from the put and call options.

5 8 9 Going into the second quarter of 2011, participants factored several Bank of Canada rate increases (against a backdrop of robust economic data in Canada) into the prices of options on futures (OBX) and futures (BAX) contracts, with a quite steep BAX forward curve relative to the forward curve of other international short-term interest rate futures contracts where the prospects for economic growth were much softer. In Canada, market uncertainty was due to timing concerns as in when exactly the Bank of Canada would raise rates. This all changed abruptly during spring and summer when many participants had to re-price their interest rate expectations as a result of unexpectedly dovish comments by the Bank of Canada, along with the impact on future economic growth prospects due to the worsening sovereign debt crisis in Europe. The result was a huge shift to lower and flatten the BAX curve, with a large re-pricing on deferred BAX futures whose prices had previously factored in several rate increases in 2011 and As a result, participants have recognized the relevance of the OBX contract in terms of managing volatility risk and interest rate risk, such as we have seen this year. More often, participants manage volatility risk, or vega, at the portfolio level where the overall vega position is adjusted using straddles. Participants buy and sell straddles - or similar options strategies - to adjust a portfolio s exposure to interest rate volatility, without changing exposure to other market risks. Vega, just like the other Greeks, tells us about risk from a volatility perspective. Traders refer to option positions as either long or short volatility, though of course it is possible to be flat volatility as well. The terms long and short here refer to the same relationship pattern as when speaking of being long or short an interest rate futures contract, or an option contract. That is, if volatility rises, a position that is short volatility will experience losses; and if volatility falls, that same position will experience immediate unrealized gains. Likewise, with a position that is long volatility, when implied volatility rises, there will be unrealized gains; while if volatility falls, losses will result. Hence, short call and short put traders benefit from an expected decline in implied volatility. This is demonstrated by the following short volatility trade with OBX options. The short straddle or short volatility trade This trade consists of the sale of a call option and a put option with the same strike price (at-the-money) and the same expiry month. Initial data June 2012 BAX futures price: (implied rate of 1.07%) June 2012 OBX options: Strike Price June 2012 June 2012 (at-the-money) Call Options Price Put Options Price (in basis points) (in basis points) (implied volatility of 76%) (volatilité implicite de 74 %)

6 10 11 Based on a notional of C$50 million (or 50 option contracts), the strategy consists of selling 50 June calls at a strike of and selling 50 June puts at a strike of Revenue collected from the strategy: Sale of 50 $99-strike June call options for a premium of 19.5 basis points: Multiplier of $25 per basis point per contract 19.5 basis points 50 contracts = $24, A note on volatility: If implied volatility of the option position (as measured by vega) moves higher by one percent, the short straddle position would be expected to lose $726. Vega is defined as the expected rate of change in an option s value for a one-unit change in implied volatility. Sale of 50 $99-strike June put options for a premium of 26.0 basis points: Multiplier of $25 per basis point per contract 26.0 basis points 50 contracts = $32, At the initiation of the trade, the investor has a credit of $56,875.

7 12 13 Market expectations Suppose the market is neutral on interest rates and bearish on volatility. With the underlying June 2012 BAX futures contract trading at 98.93, and anticipations of low or decreasing volatility moving forward, the underlying June 2012 BAX futures contract is not expected to move dramatically. Suppose volatility reverts back to lower levels (where implied volatility falls to 40% at options expiration) We observe in March 2012 that the price of the options will move sharply lower before expiration if implied volatility drops from 75% to 40% a level closer to the mean. Results Profit and loss characteristics Break-even points: and at June 2012 expiration 2012 Futures and Options Expiration Calendars Available» Futures Market Futures Expiration Calendar (PDF)» Options Market Options Expiration Calendar (PDF) View the online version

8 14 15 The Montréal Exchange to Open its Doors in New York City MX is announcing plans to open a new office in New York City, demonstrating a steadfast commitment to serving the needs of the international trading community. Plans to develop operations in the US were initiated as a direct result of rising interest from international participants in Canadian dollar-denominated assets. MX will offer the New York trading community timely and relevant information, guiding new and experienced market participants through the Canadian market. The New York office will be located at: The 30 Broad Street 30 Broad Street, 22 nd Floor New York, NY A cocktail reception for the opening is scheduled in February Details to follow. Don t miss it! The new office, tasked with promoting MX products and services, will be the company s second foreign office. The Montréal Exchange has already opened a UK office in London earlier this year. Aside from being a global financial centre, New York City has a rich and unique history of derivatives trading, making it a perfect spot for our US operations. This office represents the Montréal Exchange s first key development for 2012; in fact, we are also planning an advance into the Asian market later in the year.

9 16 17 First Quarter 2012 Initiatives New Derivatives Products Reactivation of Share Futures on individual Canadian stocks Overnight Index Swap Futures referenced to Bank of Canada fixed announcement dates These new futures products are expected to launch in January 2012, subject to final regulatory approval by the Autorité des marchés financiers of Quebec and the Ontario Securities Commission. Clients wishing to test their internal applications can refer to the following technical notices:» Share Futures on Individual Canadian Stocks» Overnight Index Swap Futures New Order Type Available: Committed Orders MX will launch a new Committed Order Functionality (COF) for the options and futures markets on SOLA. Committed Orders will be implemented in the production environment on January 16, 2012, subject to the self-certification process as established in the Derivatives Act (R.S.Q., chapter I-14.01) The COF provides a facility for executing those prearranged transactions and cross transactions that may be executed with a zero-second time delay between the input of two opposing orders, in accordance with MX s Rules and Procedures. The COF achieves this by allowing participants to enter Committed Orders that will only match with corresponding opposite side Committed Orders. MX Trading Records September 2011 On September 14, 216,982 equity option contracts were traded, bettering the previous record of 205,910 contracts on January 21. Two record days for overall open interest were set in September: on the 14th, open interest reached 4,839,699 contracts and at the end of month, it reached 4,404,867 contracts (previous record of 4,361,887 contracts was set in June 2011). End-of-month open interest was up 4% over August 2011, and increased 33% compared to September Volume was up 39% over the same month a year earlier, though was down 10% compared to August Year-to-date, both volume and open interest were significantly ahead of 2010 levels. November 2011 On November 15, 269,879 equity option contracts were traded; previous record of 216,982 contracts was set on September 14. Overall open interest reached 4,956,320 contracts on November 16, improving upon the 4,839,699 contracts on September 14.

10 18 19 A Committed Order may be used only for those products that are eligible for zero-second pre-arranged and cross transactions (excluding those transactions on strategy trades or delta trades) above the applicable minimum quantity threshold in accordance with MX s Rules and Procedures. In addition, Committed Orders can only be executed within the bid-ask at the time the orders are entered into the system. A Committed Order that does not meet these requirements will be rejected by the trading system. More information on Committed Orders is available in Circular Furthermore, UDS will be created, listed and disseminated intraday to all market participants in real time, providing accessibility, transparency, and furthering liquidity for all futures strategies. The activation of implied pricing on strategies on futures market, allowing individual leg orders to imply strategy orders, will enhance liquidity further still, as will the interaction of strategy orders and individual contract orders to imply other leg orders. More information on User-Defined Strategies is available in Circular User-Defined Strategies on the Futures Market MX will introduce User-Defined Strategies (UDS) on the futures market, and also allowing approved participants to create inter-group and intra-group strategies on some futures products through SOLA s existing UDS functionality. Approved participants will be able to create customized strategies adapted to their trading and risk management needs; strategies which cannot currently be executed on the MX trading engine. This will enhance both liquidity and market efficiency. The use of UDS limits the execution risk that participants face when trading individual legs. New Approved Participants We are pleased to welcome the following new participants: Citadel Securities LLC Jump Trading International Limited

11 20 21 Trading Data... Fall of 2011 Interest Rate DERIVATIVES Index DERIVATIVES 732,471 (Change YoY: 2%) 2,001,539 (Change YoY: 37%) 758,070 (Change YoY: 49%) 2,022,479 (Change YoY: 31%) 828,455 (Change YoY: 33%) 2,166,894 (Change YoY: 3%) 148,829 (Change YoY: -5%) 628,128 (Change YoY: 17%) 156,884 (Change YoY: 1%) 290,076 (Change YoY: 47%) 158,654 (Change YoY: 4%) 255,053 (Change YoY: -1%) September October November Month End Open Interest Monthly Volume September October November Month End Open Interest Monthly Volume Equity and ETF DERIVATIVES 3,521,962 (Change YoY: 34%) 2,941,422 (Change YoY: 97%) 3,087,067 (Change YoY: 19%) 2,233,335 (Change YoY: 26%) 3,830,709 (Change YoY: 46%) 2,938,645 (Change YoY: 45%) September October November Month End Open Interest Monthly Volume

12 Connecting to Montréal Exchange New Connecting to the Montréal Exchange Guide UPCOMING EVENTS 7 th Annual Advanced Forum on Derivatives Toronto, Ontario January 24-25, 2012 The Investment Show Toronto, Ontario February 2012 TMX Group Equities Toronto Stock Exchange TSX Venture Exchange TMX Select Equicom Derivatives Montréal Exchange CDCC Montréal Climate Exchange Fixed Income Shorcan Energy NGX Data TMX Datalinx TMX Atrium PC Bond Global Chinese Financial Forum Vancouver, British Columbia February 4, 2012 Download the latest version (PDF) of our guide on how to connect to the SOLA trading platform. Options Education Day Toronto, Ontario March 3, th Annual International Futures Industry Conference Boca Raton, Florida March 13-16, Bourse de Montréal Inc. This document is sent to you on a general information basis only. The information provided in this document, including financial and economic data, quotes and any analysis or interpretation thereof, is provided solely on an information basis and shall not be interpreted in any jurisdiction as an advice or a recommendation with respect to the purchase or sale of any derivative instrument, underlying security or any other financial instrument or as a legal, accounting, tax, financial or investment advice. Bourse de Montréal Inc. recommends that you consult your own advisors in accordance with your needs. All references in this document to specifications, rules and obligations concerning a product are subject to the Rules and Policies of Bourse de Montréal Inc. and its clearinghouse, the Canadian Derivatives Clearing Corporation. Although care has been taken in the preparation of this document, Bourse de Montréal Inc. and/or its affiliates take no responsibility for errors or omissions and reserve the right to amend or review, at any time and without prior notice, the content of this document. CONTACT Michelle MacAdam Project Manager, Financial Markets Tel: mmacadam@m-x.ca Bourse de Montréal Inc., its affiliates, directors, officers, employees and agents will not be liable for damages, losses or costs incurred as a result of the use of any information appearing in this document. S&P and Standard & Poor s are registered trademarks of Standard & Poor s Financial Services LLC and TSX is a trademark of TSX Inc. ( TSX ). The products mentioned in this presentation are not sponsored, endorsed, sold or promoted by S&P or TSX; and S&P and TSX make no representation, warranty or condition regarding the advisability of investing in them. BAX, OBX, ONX, CGZ, CGF, CGB, LGB, OGB, SXF, SXM, SCF, SXA, SXB, SXH, and SXY are trademarks of Bourse de Montréal Inc.