Rule 18f-4: Trimming Hedges—Hedges Included In Derivatives Exposure – Finance and Banking – United States – mondaq.com

This post continues our examination of how a fund must treat
hedges when calculating its derivatives exposure to qualify as a limited derivatives user.
Commenters on proposed Rule 18f-4 suggested several types of
derivatives hedges, in addition to currency derivatives, that the
Commission might exclude from derivatives exposure. In the release
adopting Rule 18f-4 (the “Adopting Release“), the
Commission agreed to exclude interest rate derivatives from the
calculation of derivatives exposure, but rejected the other
suggestions. These other hedging strategies should therefore be
included in a fund’s derivatives exposure.

We previously discussed covered call options and purchased
option spreads, which are derivatives transactions and should
be included in derivatives exposure. Other potential hedges that
should be included in derivatives exposure include the
following.

Duration Management

Funds may use derivatives to adjust the average weighted
duration of their portfolio. This may provide a more efficient
means of managing the fund’s exposure to changes in general
interest rates or the shape of the yield curve than constantly
adjusting the fund’s other portfolio holdings. When a fund uses
this to reduce its duration, the derivatives should mitigate the
interest rate risk of the portfolio.

Regardless, a fund should include derivatives used for duration
management in its derivatives exposure because:

Moreover, “[d]uration hedging . can require a degree of
sophistication to implement and manage,” which the Commission
believes is better suited to a derivatives risk management program
(assuming that the fund is required to have such a program).

“Synthetic” Securities

A fund can create the equivalent of a security position by, for
example, entering into a swap to receive (if positive) or pay (if
negative) the total return of a designated security during the term
of the swap. If the fund sets aside cash equal to the notional
amount of the swap, this would be equivalent to paying the purchase
price for the underlying security and would assure that the fund
has ready cash for any swap payment even if the security’s
value falls to zero. This would not be a hedge, but the segregation
of the full notional amount in cash should remove the leverage and asset sufficiency
risks that Rule 18f-4 is intended to regulate.

Regardless, such a swap must be included in derivatives exposure
because:

The Adopting Release provides various examples of such events,
such as an early termination event upon a merger or tender
option.

The Commission’s analysis would also seem to require
inclusion of currency and interest rate derivatives used to create
synthetic positions. For example, a global bond fund might try to
create a synthetic euro investment by matching a specific dollar
denominated bond to a euro currency swap with an equivalent
notional amount. The fund would need to include this swap in its
derivatives exposure, first, because a currency derivative may only
be excluded if it hedges a foreign-currency denominated investment
and, second, because the Commission did not intend to exclude
synthetic positions.

Credit Default Swaps

The Commission declined to exclude credit default swaps because
they:

The Commission based its position primarily on the
administration of credit default swaps by the International Swaps
and Derivatives Association, which includes the determination of
when there has been a credit event and the amount payable. Gains on
a credit default swap may not always correspond to the losses
incurred by the fund on the hedged security.

Commodity Hedges

A fund must match an excluded derivative to specific “equity or fixed-income investments,” which does not
include commodities. While a fund may exclude a commodity
derivative that fully closes out another commodity
derivative from its derivatives exposure, the Commission declined
to exclude more complex strategies for “hedging the exposure created from
investments in commodity derivatives with other commodity
derivatives.” One commenter suggested that funds might
want to hedge direct holdings of foreign currencies, but the
Commission declined to make an exception because:

Conclusion

Having reviewed what the Adopting Release tells us about which
hedges to include and exclude when calculating derivatives
exposure, we now move on to some of the interpretive challenges we
have encountered.

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.