United States: Derivatives Exposure: Adjusting Notional Amounts
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Our previous post gave the best
account we could of what the SEC staff has said about calculating
the “gross notional amount” of derivatives transactions.
In this post, we examine three adjustments that a fund may (but is
not required to) make when calculating its “derivatives
exposure.” Specifically, a fund may:
- 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.
Closed-Out Positions
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.
Delta Adjustment
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.
10-Year Bond Equivalent
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.
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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