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

Our last post examined examples of currency hedges that we
believe Rule 18f-4(c)(4)(i)(B) should allow a fund seeking to
comply with the Limited Derivatives User requirements to
exclude from its derivatives exposure. This post struggles with
examples of interest-rate hedges that may, or may not, be
excluded.

A Paradigmatic Bond Hedge

As originally proposed, Rule 18f-4 would have excluded only
currency hedges. The final rule added the exclusion of
interest-rate hedges based on commenters who:

As the SEC added the exclusion of interest-rate hedges to
accommodate these commenters, it is reasonable to conclude that
such a fixed-to-floating rate swap could be excluded from a
fund’s derivatives exposure. We are less sure about the “vice versa,” as a floating-to-fixed rate swap would
increase, rather than mitigate, a fund’s interest-rate risk. We
do not believe the SEC would view using derivatives to increase
duration as a “hedging purpose.”

A Less Perfect Hedge

The swaps in the commenters’ example matched the principal
amount and maturity of the hedged investment exactly. What about an
interest-rate derivative with a different maturity? For example,
could a fund hedge a seven-year fixed-rate corporate note with
Treasury futures? Only five- and ten-year futures are available
on the Chicago Board of Trade, so it would not be possible to match
the note’s maturity.

As noted in our previous posts, the SEC intended to exclude only
interest-rate hedges that:

Using a five- or ten-year Treasury future to hedge the interest
rate risk of a seven-year corporate note will introduce some basis
risk. Whether such futures should be excluded from a fund’s
derivatives exposure appears to depend on whether this risk should
be managed as part of a Rule 18f-4 DRM Program. Perhaps a simple
policy of using the future with the lowest historical basis risk
would adequately address the risk without requiring 
the other elements of a DRM Program. While we expect that many
fund complexes would seek to exclude this common form of
interest-rate hedge, we found little support for that position in
the rule or its adopting release.

The Option Option

We have previously explained that an option purchased by a fund is not a “derivatives transaction” under Rule 18f-4
because it does not obligate the fund to make any future payment or
delivery. Thus, a fund could hedge its interest rate risk by
purchasing put options on Treasury futures without adding to their
derivatives exposure. Funds may resort to this expedient if they
cannot exclude Treasury futures from their derivatives exposure. We
do not know whether options would be a close substitute for the
underlying future, but it would be unfortunate if the technical
limitations of Rule 18f-4 encouraged funds to use a potentially
less efficient means of hedging interest rate risk, particularly if
the options might also introduce increased basis risk.

Next up, we tackle issues relating to the “10% buffer”
permitted for excluding currency and 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.