Limited Derivatives Users—Applying The Currency Hedging Exclusion – Finance and Banking – United States – Mondaq News Alerts

Our last two posts surveyed what Rule 18f-4 and its adopting release (the “Release“) tell us about excluding
currency and interest-rate derivatives from the derivatives
exposure of a fund seeking to comply with the Limited Derivatives User requirements of
Rule 18f-4(c)(4). The Release indicates that the SEC intends to
exclude only those derivatives that:

This post considers questions we have encountered in applying
this exacting standard to currency hedging strategies.

A Paradigmatic Bond Hedge

We begin with an example of a “perfect” currency
hedge. A fund holds a non-coupon bearing one-year note for €10
million. To hedge its currency risk, the fund enters into a
deliverable forward contract to exchange €10 million for $11.8
million on the same day the note matures. This hedge effectively
locks in the fund’s return as the difference between the dollar
value of the purchase price and $11.8 million. The return before
maturity should be the accreted discount (or, in the negatively
yielding euro world, amortized premium) based on this
difference.

If held to maturity, the fund can apply €10 million
received from the note to the forward contract and receive $11.8
million, which will “mechanically” produce the predicted
return. We are less sure that the return from selling the note
before maturity and closing out the currency forward will be as
predictable or necessarily correspond to the accreted (or
amortized) value of the note. But if this currency hedge were not
excluded from a fund’s derivatives exposure, we find it hard to
imagine a hedge that would be excluded.

Equity Hedges

The next example involves a fund holding euro-denominated stocks
with a current value of €10 million. The fund enters into
80 of the September 2022 Euro FX Futures to sell a total of
€10 million for a total of $11.8 million. Unlike the bond
example, there is no fixed date on which the fund expects to
receive €10 million; this is just the amount it could raise by
selling the stocks for their last traded price. So, this does not
seem to be a “mechanical” hedge.

Nevertheless, paragraph (c)(4)(i)(B) explicitly excludes
currency hedges of equity investments from a fund’s derivatives
exposure and uses the value of such investments to measure the
notional amount excluded. This suggests that a fund could also
exclude currency derivatives that settle or expire before the
maturity date of a hedged fixed-income investment. Excluding
currency derivatives with terms extending beyond the maturity date
may be problematic, however, if the hedge would entail
material basis risk.

Hedging Purchases

Our examples assume a fund is hedging investments it already
holds, since paragraph (c)(4)(i)(B) covers derivatives that
hedge currency or interest rate risks of a specific investment held
by the fund. But what about a derivative that hedges a commitment
to purchase an investment? What if a fund agrees to purchase
€10 million of securities on a “when-issued” basis
with settlement to occur within 30 days? If the euro appreciates
against the dollar in the interim, the fund could pay more (in
dollar terms) than it bargained for. To hedge this risk, the fund
could enter into a 30-day currency forward to purchase €10
million for $11.7 million. Should this forward count towards the
fund’s derivatives exposure?

Note that the “when-issued” trade would not be a senior security under
18f-4(f) so long as the fund expects to physically settle
within 35 days. But paragraph (f) only permits a fund to “invest in a security on a when-issued or
forward-settling basis.” Euros are not securities, so
paragraph (f) would not apply to the currency forward. The
forward contract also would not qualify as an unfunded commitment
under paragraph (e) because: (1) currency forwards are derivative contracts,
and (2) the forward is not a commitment to make a loan or invest in
equity.

Nonetheless, we believe the fund may exclude this type of
currency forward from its derivatives exposure. Paragraph
(c)(4)(i)(B) allows a Limited Derivatives User to exclude
derivatives that “hedge currency …
risks associated with one or more specific …
investments held by the fund.” The when-issued trade, which
would be included in the fund’s net assets not later than the next business
day after the trade, should be an “investment held by
the fund,” and appreciation in the dollar value of its
purchase price is a risk “associated” with this
investment, so the fund should be permitted to exclude a currency
forward hedging this risk from its derivatives exposure.

Our next post examines even knottier problems regarding
interest-rate hedges.

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.