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Derivatives Exposure: Why It Matters And How To Calculate It – Finance and Banking – United States – Mondaq News Alerts

United States: Derivatives Exposure: Why It Matters And How To Calculate It

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Our last post outlined the essential differences
between VaR Funds and Limited Derivatives Users: primarily that the
former must adopt a derivatives risk management program (a “DRM Program”) while the latter need only have policies
and procedures. Our post observed that the less prescriptive
regulatory requirements may make operating as a Limited Derivative
User an attractive alternative for many management investment
companies (including business development companies but excluding
money market funds, a “Fund”). As promised at the end of
that post, this post initiates our exploration of the challenges of
qualifying as a Limited Derivatives User. We begin by providing a
high-level step-by-step guide to calculating a Fund’s “derivatives exposure.”

Why Derivatives Exposure Matters

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.

Calculating Derivatives Exposure: The Big Picture

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

Step 1: Identify Derivatives Transactions

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
because that would increase the Fund’s
derivatives exposure.

Step 2: Quantify the Derivatives Transactions

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
Interest rate derivatives (IRDs) 10-Year bond equivalent of the gross notional amount
Short sale borrowings Market value of assets sold
derivatives transactions other than options, IRDs and short sale
notional amount

Step 3: Identify Excluded Currency and Interest Rate

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

Step 4: Identify Closed-Out Positions

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.

Step 5: Calculate the Fund’s Derivatives

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.

Step 6: Determine Whether the Fund is a Limited Derivatives

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.”

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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