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United States: Derivatives Exposure: Adjusting For Multipliers

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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

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

$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

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

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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