We promised a few posts back to discuss how a Limited Derivatives User should apply what we termed the “10% buffer” to determine whether currency and interest-rate derivatives may be excluded from its derivatives exposure. This post begins to tackle the question What is the 10% Buffer? and explain how it might work.

## What is the 10% Buffer?

Our earlier post described the conditions under which a fund seeking to comply with the Limited Derivatives User requirements of Rule 18f-4 could exclude currency and interest-rate hedges (“Hedging Derivatives”) from its derivatives exposure. The third condition is that the notional amount of Hedging Derivatives:

The “10% buffer” refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value or par amount of the hedged investments or principal amount of hedged borrowings.

## Should Funds Adjust the Notional Amounts of Hedged Derivatives?

Our first question is what notional amounts should a fund use to calculate compliance with this third condition? The definition of “derivatives exposure” permits a fund to delta adjust the notional amount of options and use the 10-year bond equivalent of the notional amount of interest-rate derivatives. As reflected in our derivatives exposure equation, we believe a fund should delta adjust the notional amount of options excluded from its derivatives exposure, but should not adjust the notional amount of excluded interest-rate hedges to 10-year bond equivalents.

#### Options

As we understand it, the reason for delta adjustment is that the price of an option typically changes by only a fraction of the change in the price of the underlying asset. This means a fund must acquire options with notional amounts larger than the value of the investment to create an effective hedge. For example, if a fund uses options to hedge a \$1 million investment, and the options have a delta of 0.25, the fund will need to acquire options with a notional amount of \$4 million to effect the hedge. Delta adjusting the options makes the comparison of notional amount to the value of investments “apples-to-apples” in terms of their impact on a fund’s investment performance. In the example, the adjusted notional amount of the hedge would equal the value of the hedged investment and the 10% buffer would not be applicable.

#### Interest-Rate Derivatives

We do not think this is the case for interest-rate hedges, primarily because the par or principal amount of the hedged investments would not be expressed in 10-year bond equivalents. The rule only provides for adjustments to the notional amounts of interest-rate derivatives, and the adopting release does not mention comparable adjustments to the hedged investments. In the only example given in the adopting release, the notional amount of the swap matches the principal amount of the bond. This leads us to think that adjusting the notional amount without a corresponding adjustment to the principal amount would create an “apples-to-oranges” comparison.

We realize the duration of an interest-rate derivative may differ from the duration of the hedged investments in a manner similar to the delta of an option. Assuming that a fund may use a five-year Treasury to hedge a seven-year bond, for example, it may require a larger notional amount of the future to fully offset the longer duration of the bond. While this might support an argument for adjusting the interest-rate hedge to a duration equivalent of the hedged bond, this would require a seven-year, rather than ten-year, equivalent. In any event, the SEC refused to exclude hedges used for general duration management due to the “degree of sophistication [required] to implement and manage” the hedges. Calculating duration equivalents may require more sophistication than the SEC was anticipating for excluded interest-rate hedges.

Further, it has been our experience that interest-rate hedges typically reduce, rather than eliminate, the interest-rate risk of a hedged investment. A fixed-to-floating rate swap, for example, may reduce an investment’s duration to one month or three months, rather than to zero. This suggests that a fund could use Treasury futures to mitigate its risks substantially, even without adjustment of their notional amount.

Next, we examine the 10% buffer “in action” as the value of hedged investments fluctuate.