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Hedging Derivatives Under Rule 18f-4: Not An “All Or None” Exclusion – Finance and Banking – United States – Mondaq News Alerts

United States: Hedging Derivatives Under Rule 18f-4: Not An “All Or None” Exclusion

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This post will address another ambiguity in the “10% buffer” Rule 18f-4 provides for
excluding the notional amount of derivative transactions that hedge
currency or interest rate risks (“Hedging Derivatives”)
when calculating the Derivatives Exposure of a Limited Derivatives User. The ambiguity is
whether, once the notional amount of a Hedging Derivative exceeds
the 10% buffer, a fund should add back to its Derivatives Exposure
(a) the entire notional amount of the Hedging Derivative or
(b) only the notional amount in excess of the 10% buffer. We
chose answer (b) in our post on The 10% Buffer and Changes in Hedged
. This post explains why.

The Problematic Situation

In our earlier post, we posited a situation in which a fund had
sold 80 of the September 2022 Euro FX Futures to hedge equity
investments with a value of €10 million, which then fell to
€9 million. As Euro FX Futures have a notional amount of
€125,000, 72 contracts would now be sufficient to fully hedge
the investments. Our post argued that the remaining 8 contracts
should still be regarded as “maintained” for purposes of
hedging the equity investments, so the 10% buffer should allow the
fund to exclude the remaining 8 futures to the extent of
€900,000 in notional amount.

In application, our argument would allow the fund to exclude at
least 7 futures, with a combined notional amount of €875,000.
The question is whether the fund could use the remaining
€25,000 to exclude part of the notional amount of the
remaining contract, or whether the fund must include the entire
€125,000 notional amount of that contract in its Derivatives

Why the 10% Buffer is Ambiguous

Our last post quoted the following sentence
from the adopting release:

According to this sentence, if the 10% buffer is exceeded, “it” will no longer qualify for the exclusion. Does “it” refer to “the notional amount of a
derivatives transaction
” or to “the notional amount
of a derivatives transaction exceed[ing] the value of the
hedged investments by more than 10%

Derivatives Are Multi-Purpose Tools

In our view, the 10% buffer should be interpreted in the context
of the clause that precedes it: that a Hedging Derivative must be “entered into and maintained by the fund for
hedging purposes
.” The sentence in the adopting release
and many of the comment letters seem to presume that a derivative
transaction can serve only one purpose. This is not the case; a
derivative can hedge to the extent the fund has an offsetting
exposure and also create an additional exposure to the underlying
asset. For example, if a fund holds €5 million principal
amount of bonds, a forward contract to sell €10 million will
hedge these bonds as well as create a €5 million short
position in the euro. Our approach would recognize this possibility
by treating €5 million of the forward as entered into for
hedging purposes and including only €5 million of the notional
amount in the fund’s Derivatives Exposure.

Avoiding Arbitrary Distinctions

Recognizing that only part of the notional amount of a
derivative transaction may need to be included in a fund’s
Derivatives Exposure avoids arbitrary differences in applying the
10% buffer to different types of Hedging Derivatives. Because our
initial example involved 80 futures contracts, the impact of
exceeding the 10% buffer could be limited to a single contract.
This would not be the case if the fund entered into a single
€10 million forward and the fund had to include the entire
notional amount in its Derivatives Exposure once the value of the
hedged investments fell below €9.09 million.

A fund could avoid this result by breaking up the euro forward
in advance. For example, the fund could ask for 400 confirmations
of identical €25,000 forwards, and include only 4 of the
forwards in its Derivatives Exposure once the value of the
investments fell to €9 million. We trust the pointlessness of
such an exercise is obvious, and it is better to recognize that
some part of the notional amount of a derivative transaction can
serve a hedging purpose even as the remaining notional amount does

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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