Rule 18f-4: Trimming Hedges—Hedges Excluded From Derivatives Exposure – Finance and Banking – United States – Mondaq News Alerts

Our post on the derivatives exposure
equation began with a separate equation concerning
interest rate and currency hedges. This post explains the
significance of this equation and what hedges should be excluded
from a fund’s derivatives exposure. Our next post will address
hedges included in derivatives exposures before we raise some
interpretive questions about how the exclusion should be
applied.

Why Hedges Matter

A fund attempting to operate as a “limited derivatives user”
must maintain a derivatives exposure that does not exceed 10% of
its net assets. Rule 18f-4(c)(4)(B) excludes
from a fund’s derivatives exposure currency or interest rate
derivatives transactions that :

• are entered into and maintained by the fund for hedging
  purposes;
• hedge currency or interest rate risks associated with one or
  more specific equity or fixed-income investments held by the fund,
  or a fund’s borrowings; and
• have a notional amount that does not exceed the value of the
  hedged investments (or the par value thereof, in the case of
  fixed-income investments, or the principal amount, in the case of
  borrowing) by more than 10 percent.

We refer to derivatives transactions excluded from derivatives
exposure as (“Hedging Derivatives”).

Excluding these Hedging Derivatives reduces the derivatives
exposure of a fund, thereby making it easier to qualify as a
limited derivatives user. Because any hedge should reduce the “value-at-risk” of a VaR Fund, a VaR Fund should not need
to identify whether a derivatives transaction is a hedge or match
it to a specific investment.

What Is a “Hedging Purpose?”

Despite the significance of hedging, it may (or may not) come as
a surprise that Rule 18f-4 does not explicitly define what
constitutes a “hedging purpose”. Nevertheless, two
statements in the release adopting Rule 18f-4 (the “Adopting Release“) point
to a narrowly defined concept of a “hedging purpose” that
restricts the exclusion of Hedging Derivatives from derivatives
exposure.

First, the Commission provided an exception for currency and
interest rate hedges, and not for other types of hedges:

This suggests to us that the “hedging purpose” should
be simple (not “potentially complex”) and directly linked
(“mechanically”) to the hedged risk. For example, a fund
should include a cross-currency “hedge,” in which the fund shorts another
currency as a proxy for the currency in which an investment is
denominated, in its derivatives exposure because it depends on the
correlation of the two currencies and, thus, does not simply and
directly hedge the investment’s currency risk.

Second, in discussing why derivatives exposure would still
include other types of hedges, the Commission referred to these as
hedges that “could mitigate funds’ portfolio
risks.” This implies that the Commission believes that the
purpose of Hedging Derivatives should be to mitigate currency or
interest rate risk. It may seem obvious that a hedge should
mitigate risk, but portfolio managers sometimes use derivatives to
add risk to their portfolio in order to reduce the tracking error
of a fund relative to its benchmark. This may mitigate “tracking error risk,” but it would not mitigate
portfolio risk and thus would not be an appropriate “hedging
purpose” for a limited derivatives user.

Specific Investments

A Hedging Derivative must hedge risks “associated with one
or more specific equity or fixed-income investments.” In the
case of a currency derivative, the investment must be “foreign-currency-denominated.” As we just explained, we
believe a currency Hedging Derivative must be for the foreign
currency in which these specific investments are denominated.

We believe this will require the compliance procedures of a
limited derivatives user to track which specific investments are
hedged by a Hedging Derivative. It is clear that the matching does
not have to be one-to-one; a fund might use a single currency
derivative to hedge its entire exposure to investments denominated
in that currency. But it will be easier to demonstrate compliance
if the fund maintains a record of those investments has having been
hedged by the derivative.

The 10% Leeway

How to apply the “not more than 10%” of the value of
the specified investments requirement raises important interpretive
issues that we will discuss at length in separate posts. But first,
our next post will examine hedges that the Adopting Release
indicates should be included in a fund’s derivatives
exposure.

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.