At a high level, the article:

- Provides a background on the limitations on senior securities under the Investment Company Act of 1940 (the “1940 Act“);
- Affords readers with an overview of Rule 18f-4 under the 1940 Act;
- Summarizes how a fund qualifies as a limited derivatives fund (including a six-step process for calculating derivatives exposure); and
- Describes the key elements of a derivatives risk management program that is required to be implemented by a fund that does not qualify as a limited derivatives fund (i.e., a VaR Fund).

Regular readers of this blog have already read about all of this in more detail. But the article provides a handy summary, including many of the tables found in our posts.

We are grateful for the opportunity to have contributed the article to the IAA Newsletter.

]]>According to the Adopting Release, the SEC:

Item C.11 of Form N-PORT (among other items), requires funds to report the “notional amount” of certain derivatives. Although the term “gross” does not appear in N-PORT, the Adopting Release refers to these reported notional amounts when estimating the “gross notional amount” of derivatives held by funds. So, the Adopting Release equates the “notional amount” reported in N-PORT with the “gross notional amount” of derivatives transactions.

Form N-PORT was first promulgated in October 2016. To assist in implementing the new form, the SEC staff issued FAQs in July 2017. Question 15 is: “Is there a prescribed calculation of notional amount that funds should follow?” The staff responded:

The Commission staff understands that funds currently use different methods for calculating notional amount of a derivatives investment. For example, the staff understands that some common methods used by funds for determining a derivative transaction’s notional amount may include the methods listed in Table 1 on page 69 of the Derivatives Proposing Release.”

The staff’s response was hardly unequivocal, but this Table 1 would seem to provide examples of how a fund may calculate the gross notional amount of some derivatives transactions.

Anyone who reaches for the proposing release for the final version of Rule 18f-4, which was issued over two years after the FAQ, and flips to page 69 will not find any tables. This is because the FAQ is referring to the release that originally proposed Rule 18f-4 in December 2015. This means that the best guidance we have found for calculating gross notional amounts comes from a rule proposal that the SEC abandoned when it re-proposed Rule 18f-4 in late 2019.

Rather than force readers to click the link to the original release, we reproduce Table 1 below.

We have several concerns regarding this table. For example, it is incomplete (e.g., no mention of interest rate swaps other than cross currency ones, although our assumption is that these would be measured consistently with cross currency swaps and forward rate agreements). In addition, many of the notional amounts are not expressed in dollars, so the table does not completely answer the question of what price to use to calculate a notional dollar value. We have other reservations about using N-PORT notional amounts to calculate derivatives exposure that we will discuss in subsequent posts. But for now, this is the best guidance we could find.

]]>With a limited exception that we will explain in a subsequent post, a fund cannot net the notional amounts of short positions against the notional amounts of long positions in the same underlying asset when calculating its derivatives exposure. In other words:

This means that none of the numbers on the right side of the derivatives exposure equation will be negative.

As we learned in middle school (or maybe earlier), an equation cannot be true unless it has the same units on each side. For example:

One apple ≠ Two oranges.

We can fix this by multiplying each side by the same units. So, if an apple weighs 100 grams and an orange weighs 50 grams, we can say one apple weighs as much as two oranges.

100 grams x one apple = 50 grams x two oranges

The left side of the derivatives exposure equation is 10% of a fund’s net assets. Net assets are expressed in dollars, which means the right side of the equation (which adds up all the adjusted gross notional amounts of derivatives transactions) must be in dollars as well.

Some derivatives transactions (particularly swaps) are expressed in dollars, so their notional amounts will already use the right units. But other derivatives transactions (particularly futures contracts and options) are contracts for a specified amount of the underlying asset. For example:

- A stock option or future will be for so many shares.
- The standard futures contract for West Texas Intermediate Light Sweet Crude Oil is for 1000 barrels.
- A deliverable currency forward will be for an amount of foreign currency, and 1 million yen is not more in dollar terms than 10,000 euros.

To transform these contracts into dollars, we will need to multiply the underlying assets by a price (or exchange rate in the case of a foreign currency). So, which price we use is an essential aspect of any definition of a derivatives transaction’s “gross notional amount.”

There will generally be three prices to choose from: (1) the current market price of the underlying asset, (2) the market price of the underlying asset at the time a fund enters into the derivatives transaction, and (3) the contract price of the derivatives transaction. For example, if a fund buys a Globex Euro FX Future for August 2021 delivery at a price of $1.2271, this would be the contract price of the future. The market price of the underlying euros at the time the future was purchased would be $1.225, while the current market price would change from moment to moment until the future is closed out.

Our next post will provide the best answer we could find to this question based on guidance from the SEC. After trying to explain the other elements of the derivatives exposure equation, we will return to consider whether this is a sensible approach to identifying a limited derivatives user.

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