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This post continues our discussion of the calculation of “gross notional amounts” included in a fund’s “derivatives exposure” under Rule 18f-4. Previously, we

identified the best guidance we could find on

how to calculate a derivatives transaction’s gross notional

amount, and three adjustments to such

amounts permitted by the rule’s definition of derivatives

exposure. In this post, we discuss another adjustment not

anticipated by Rule 18f-4, but which we believe is necessary to

avoid a fund that purports to be a limited derivatives user from

circumventing the 10% limit on its derivatives exposure.

### The Distributive Property and Swaps

A swap is essentially an equation for calculating payments. For

example, if a fund enters into a swap to pay one-month LIBOR and

receive 1% on a notional amount of $2,000,000, then the fund would

receive (or pay if the result is negative) on an annual basis:

$2,000,000 *x* (1% – one-month

LIBOR).

Now suppose a fund enters into a swap to pay twice one-month

LIBOR and receive 2% on a notional amount of $1,000,000. The annual

payments for this swap would be:

$1,000,000 *x* (2% – (2

*x* one-month LIBOR)).

Although nominally the second swap has one-half the notional

amount of the first swap, they are in fact identical swaps. This is

because:

$1,000,000 *x* (2% – (2

*x* one-month LIBOR)) =

$1,000,000 *x* 2 *x*

(1% – one-month LIBOR) =

$2,000,000 *x* (1% – one-month

LIBOR).

This is another application of middle school math to derivatives

exposure. If a fund can use the distributive property [a *x*

(b + c) = (a *x* b) + (a *x* c)] to divide the

notional amount into two factors and then multiply the reference

rate by one of the factors, then the fund could reduce the notional

amount to circumvent the 10% derivatives exposure limit imposed on

a limited derivative user.

### Compliance Implications

Generally, when a derivatives transaction multiplies a reference

price, return or rate by a coefficient, the coefficient should be

factored out and applied to the nominal notional amount. So, the

two swaps in our example would both have a gross notional amount of

$2,000,000 after the second swap is adjusted by factoring the 2 out

of the one-month LIBOR and fixed rate and multiplying it times the

$1,000,000 nominal notional amount.

This adjustment would be consistent with the CFTC’s

requirements for calculating net notional values under its Rule 4.5, which exempts certain

persons managing qualified entities (including an investment

adviser to a registered investment company) from the definition of “commodity pool operator.” The rule requires notional

values to:

be calculated for each futures position by multiplying the

number of contracts by the size of the contract, in contract units

(taking into account any multiplier specified in the contract)

….”

An exception to the foregoing mathematical principles would be

when the derivatives transaction has more than one variable

reference rate, and the same coefficient is not applied to all of

the rates. For example, a swap of the total return on a 2-year

Treasury index for the total return on a 10-year Treasury index

might multiply only the 2-year return by a factor that compensates

for the greater expected volatility of the 10-year return. In this

example, the multiplier would be intended to affect only the rate

of return and not to disguise the true notional amount of the

swap.

*The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.*

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Duane Morris LLP

With all the regulator and market focus on SOFR as the LIBOR replacement of choice, it’s easy to forget that there are other replacement rates vying for market attention.