Our earlier post described the conditions under which a fund seeking to comply with the Limited Derivatives User requirements of Rule 18f-4 could exclude currency and interest-rate hedges (“Hedging Derivatives”) from its derivatives exposure. The third condition is that the notional amount of Hedging Derivatives:

The “10% buffer” refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value or par amount of the hedged investments or principal amount of hedged borrowings.

Our first question is what notional amounts should a fund use to calculate compliance with this third condition? The definition of “derivatives exposure” permits a fund to delta adjust the notional amount of options and use the 10-year bond equivalent of the notional amount of interest-rate derivatives. As reflected in our derivatives exposure equation, we believe a fund should delta adjust the notional amount of options excluded from its derivatives exposure, but should not adjust the notional amount of excluded interest-rate hedges to 10-year bond equivalents.

As we understand it, the reason for delta adjustment is that the price of an option typically changes by only a fraction of the change in the price of the underlying asset. This means a fund must acquire options with notional amounts larger than the value of the investment to create an effective hedge. For example, if a fund uses options to hedge a $1 million investment, and the options have a delta of 0.25, the fund will need to acquire options with a notional amount of $4 million to effect the hedge. Delta adjusting the options makes the comparison of notional amount to the value of investments “apples-to-apples” in terms of their impact on a fund’s investment performance. In the example, the adjusted notional amount of the hedge would equal the value of the hedged investment and the 10% buffer would not be applicable.

We do not think this is the case for interest-rate hedges, primarily because the par or principal amount of the hedged investments would not be expressed in 10-year bond equivalents. The rule only provides for adjustments to the notional amounts of interest-rate derivatives, and the adopting release does not mention comparable adjustments to the hedged investments. In the only example given in the adopting release, the notional amount of the swap matches the principal amount of the bond. This leads us to think that adjusting the notional amount without a corresponding adjustment to the principal amount would create an “apples-to-oranges” comparison.

We realize the duration of an interest-rate derivative may differ from the duration of the hedged investments in a manner similar to the delta of an option. Assuming that a fund may use a five-year Treasury to hedge a seven-year bond, for example, it may require a larger notional amount of the future to fully offset the longer duration of the bond. While this might support an argument for adjusting the interest-rate hedge to a duration equivalent of the hedged bond, this would require a seven-year, rather than ten-year, equivalent. In any event, the SEC refused to exclude hedges used for general duration management due to the “degree of sophistication [required] to implement and manage” the hedges. Calculating duration equivalents may require more sophistication than the SEC was anticipating for excluded interest-rate hedges.

Further, it has been our experience that interest-rate hedges typically reduce, rather than eliminate, the interest-rate risk of a hedged investment. A fixed-to-floating rate swap, for example, may reduce an investment’s duration to one month or three months, rather than to zero. This suggests that a fund could use Treasury futures to mitigate its risks substantially, even without adjustment of their notional amount.

Next, we examine the 10% buffer “in action” as the value of hedged investments fluctuate.

]]>At a high level, the article:

- Provides a background on the limitations on senior securities under the Investment Company Act of 1940 (the “1940 Act“);
- Affords readers with an overview of Rule 18f-4 under the 1940 Act;
- Summarizes how a fund qualifies as a limited derivatives fund (including a six-step process for calculating derivatives exposure); and
- Describes the key elements of a derivatives risk management program that is required to be implemented by a fund that does not qualify as a limited derivatives fund (i.e., a VaR Fund).

Regular readers of this blog have already read about all of this in more detail. But the article provides a handy summary, including many of the tables found in our posts.

We are grateful for the opportunity to have contributed the article to the IAA Newsletter.

]]>- exclude any closed-out positions;
- delta adjust the notional amounts of options contracts; and
- convert the notional amount of interest rate derivatives to 10-year bond equivalents.

We anticipate that a fund seeking to qualify as a “limited derivatives user” would make these adjustments to lower its derivatives exposure.

The definition of derivatives exposure provides that a closed-out position must:

- be closed out with the same counterparty; and
- result in no credit or market exposure to the fund.

For example, if a fund sold a Globex Euro FX futures contract for delivery in July 2021 and subsequently purchased the identical futures contract, it could exclude both contracts because they are centrally cleared through CME and thereby have the same counterparty.

On the other hand, the fund could not offset the July 2021 contract by purchasing the August 2021 contract, because, although both contracts have the CME as their counterparty, the fund would still be exposed to differences in changes in the price of the July 2021 contract as compared to the August 2021 contract. A fund also could not offset a fixed-to-floating rate swap with one dealer against a floating-to-fixed rate swap with another dealer, even if the swaps had identical notional amounts and reference rates, because the counterparties would not be the same. In these cases, the fund would have to include the notional amounts of both futures contracts or both swaps in its derivatives exposure.

The release adopting Rule 18f-4 explains adjusting the notional amount of an option for its delta as follows:

For example, if a fund writes an option for shares with a notional amount of $1 million, and the option has a delta of 0.25, the fund would include a notional amount of $250,000 in its derivatives exposure. As we previously explained, an option’s delta increases as the market value of the underlying asset approaches the option’s strike price, so the delta for each option must be recalculated and the notional amount readjusted each time a fund calculates its derivatives exposure.

In contrast to delta, the adopting release does not explain how to calculate the 10-year bond equivalent of an interest rate derivatives transaction. Some of the comment letters on the originally proposed Rule 18f-4 (the release with Table 1 showing how to calculate notional amounts) provided the following example:

The alternative approach may be more complicated, as the actual duration would need to be recalculated whenever a Fund’s derivatives exposure is determined to account for changes in market yields.

The adopting release does not consider the possibility of an interest rate derivative that is an option. If the relationship of the option to the underlying security or reference rate (its delta) differs from the relationship of the duration (whether nominal or actual) to a referenced 10-year bond, then we think that the option should be both adjusted for its delta and translated to a 10-year bond equivalent.

Our next post will consider an adjustment not considered in the release, namely the need to adjust for multiplied reference rates.

]]>According to the Adopting Release, the SEC:

Item C.11 of Form N-PORT (among other items), requires funds to report the “notional amount” of certain derivatives. Although the term “gross” does not appear in N-PORT, the Adopting Release refers to these reported notional amounts when estimating the “gross notional amount” of derivatives held by funds. So, the Adopting Release equates the “notional amount” reported in N-PORT with the “gross notional amount” of derivatives transactions.

Form N-PORT was first promulgated in October 2016. To assist in implementing the new form, the SEC staff issued FAQs in July 2017. Question 15 is: “Is there a prescribed calculation of notional amount that funds should follow?” The staff responded:

The Commission staff understands that funds currently use different methods for calculating notional amount of a derivatives investment. For example, the staff understands that some common methods used by funds for determining a derivative transaction’s notional amount may include the methods listed in Table 1 on page 69 of the Derivatives Proposing Release.”

The staff’s response was hardly unequivocal, but this Table 1 would seem to provide examples of how a fund may calculate the gross notional amount of some derivatives transactions.

Anyone who reaches for the proposing release for the final version of Rule 18f-4, which was issued over two years after the FAQ, and flips to page 69 will not find any tables. This is because the FAQ is referring to the release that originally proposed Rule 18f-4 in December 2015. This means that the best guidance we have found for calculating gross notional amounts comes from a rule proposal that the SEC abandoned when it re-proposed Rule 18f-4 in late 2019.

Rather than force readers to click the link to the original release, we reproduce Table 1 below.

We have several concerns regarding this table. For example, it is incomplete (e.g., no mention of interest rate swaps other than cross currency ones, although our assumption is that these would be measured consistently with cross currency swaps and forward rate agreements). In addition, many of the notional amounts are not expressed in dollars, so the table does not completely answer the question of what price to use to calculate a notional dollar value. We have other reservations about using N-PORT notional amounts to calculate derivatives exposure that we will discuss in subsequent posts. But for now, this is the best guidance we could find.

]]>With a limited exception that we will explain in a subsequent post, a fund cannot net the notional amounts of short positions against the notional amounts of long positions in the same underlying asset when calculating its derivatives exposure. In other words:

This means that none of the numbers on the right side of the derivatives exposure equation will be negative.

As we learned in middle school (or maybe earlier), an equation cannot be true unless it has the same units on each side. For example:

One apple ≠ Two oranges.

We can fix this by multiplying each side by the same units. So, if an apple weighs 100 grams and an orange weighs 50 grams, we can say one apple weighs as much as two oranges.

100 grams x one apple = 50 grams x two oranges

The left side of the derivatives exposure equation is 10% of a fund’s net assets. Net assets are expressed in dollars, which means the right side of the equation (which adds up all the adjusted gross notional amounts of derivatives transactions) must be in dollars as well.

Some derivatives transactions (particularly swaps) are expressed in dollars, so their notional amounts will already use the right units. But other derivatives transactions (particularly futures contracts and options) are contracts for a specified amount of the underlying asset. For example:

- A stock option or future will be for so many shares.
- The standard futures contract for West Texas Intermediate Light Sweet Crude Oil is for 1000 barrels.
- A deliverable currency forward will be for an amount of foreign currency, and 1 million yen is not more in dollar terms than 10,000 euros.

To transform these contracts into dollars, we will need to multiply the underlying assets by a price (or exchange rate in the case of a foreign currency). So, which price we use is an essential aspect of any definition of a derivatives transaction’s “gross notional amount.”

There will generally be three prices to choose from: (1) the current market price of the underlying asset, (2) the market price of the underlying asset at the time a fund enters into the derivatives transaction, and (3) the contract price of the derivatives transaction. For example, if a fund buys a Globex Euro FX Future for August 2021 delivery at a price of $1.2271, this would be the contract price of the future. The market price of the underlying euros at the time the future was purchased would be $1.225, while the current market price would change from moment to moment until the future is closed out.

Our next post will provide the best answer we could find to this question based on guidance from the SEC. After trying to explain the other elements of the derivatives exposure equation, we will return to consider whether this is a sensible approach to identifying a limited derivatives user.

]]>A Fund that seeks to qualify as a Limited Derivatives User must satisfy three principal requirements:

- Adopt and implement written policies and procedures reasonably designed to manage the Fund’s derivatives risk;
- Its derivatives exposure should not exceed 10 % of its net assets; and
- Should its derivatives exposure exceed 10% for more than five business days, the Fund must either promptly reduce the derivatives exposure to 10% (within no more than thirty calendar days of first exceeding 10%), in a manner that is in the best interests of the Fund and its shareholders, or else adopt and comply with a DRM Program as soon as reasonably practicable.

So, calculating a Fund’s derivatives exposure is essential to complying with the second and third requirements.

The following is a six-step guide to the information required to calculate a Fund’s derivatives exposure.

You will find a summary of “derivatives transactions,” all of which may be included in a Fund’s derivatives exposure, at our Derivatives Transactions Recap post. We assume that a Limited Derivatives User will not elect to treat reverse repurchase agreements as derivatives transactions because that would increase the Fund’s derivatives exposure.

The following table shows how derivatives transactions should be quantified (their “Exposure Amount”) for purposes of calculating a Fund’s derivatives exposure.

Type of Derivatives Transaction |
Exposure Amount |

Options | Delta adjusted gross notional amount |

Interest rate derivatives (IRDs) | 10-Year bond equivalent of the gross notional amount |

Short sale borrowings | Market value of assets sold short |

All derivatives transactions other than options, IRDs and short sale borrowings | Gross notional amount |

Qualifying IRDs and currency derivatives transactions do not count toward derivatives exposure. These include derivatives transactions that were entered into and maintained in order to hedge currency or interest rate risks associated with one or more specific equity or fixed-income investments held by the Fund or the Fund’s borrowings. For these purposes, a derivatives transaction for foreign currency can only be used to hedge risks associated with an equity or fixed-income investment that is denominated in a currency other than U.S. dollars.

To be excluded from the derivatives exposure calculation, the aggregate Exposure Amounts of these hedging IRDs and currency derivatives may not exceed the value of the hedged equity investments, the par value of the hedged fixed-income investments, or the principal amount of any hedged borrowings by more than 10%.

A Fund should identify derivatives that directly offset and close-out a derivatives transaction with the same counterparty. Note that a derivative that is not a “derivatives transaction” can be used for this purpose. For example, an option purchased by a Fund (which is not a derivatives transaction) can offset an option written by the Fund (which would be). These offset derivatives transactions do not count toward a Fund’s derivatives exposure if they do not result in credit or market exposure to the Fund.

Sum the Exposure Amounts of the Fund’s derivatives transactions after excluding the derivatives transactions identified in Steps 3 and 4. The result is the Fund’s derivatives exposure.

A Fund will be a Limited Derivatives User if its derivatives exposure does not exceed 10% of its net assets.

We will now proceed to unpack steps 2 through 5 based on explanations provided in the adopting release for Rule 18f-4, identifying many questions we cannot answer along the way. But first, for those mathematically inclined, our next post will provide a “derivatives exposure formula.”

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