6 Use of Derivatives by Mutual Funds

The LCGC recommended that mutual funds should be permitted to use derivatives for hedging and portfolio rebalancing:

“Mutual funds should be allowed to use financial derivatives for hedging purposes (including anticipated hedging) and portfolio re-balancing within a policy framework and rules laid down by their Board of Trustees who should specify what derivatives are allowed to be used, within what limits, for what purposes, for which schemes, and also the authorisation procedure.” (Paragraph 7.10)

“The offer documents of mutual fund schemes should disclose whether the scheme permits the use of derivatives and the details in this regard. Also the income and.32 balance sheet of each mutual fund scheme would have to disclose the impact of derivatives trading and of any open position in this regard.” (Paragraph 7.12)

The ACD discussed the issue of mutual funds’ participation in derivatives at great length. On the one hand, there was the question of whether mutual funds should be allowed to go beyond hedging and portfolio rebalancing. On the other hand, there were a number of questions about what the term “hedging and portfolio rebalancing” actually means.

After considerable discussion, the Committee was of the view that it is necessary to distinguish between

1. New funds that have come to the public with full disclosure of their derivative trading strategy. This category would also include existing schemes that undergo the process for changing its fundamental attributes 11 to enable the use of additional derivative strategies.

2. Existing funds whose offer documents did not have a complete disclosure of the derivative strategies that they would adopt or explicitly limited the use of derivatives to “hedging and portfolio rebalancing”.

The ACD believes that for new schemes, the regulatory regime should rely on full disclosure of risks. There should be no bar on innovations by mutual funds so long as investors come into the fund with full knowledge. For existing schemes, it is necessary to stick to “hedging and portfolio rebalancing” and the Committee has tried to elaborate on the meaning of this term.

6.1 New Schemes: Utilising mainstream governance and disclosure mechanisms

Under normal circumstances, the trading strategies and ideas in portfolio management used by the AMC should be fully disclosed in the offer document, and the AMC should be closely interacting with the trustees who perform governance functions on behalf of investors on all aspects of the operations of the scheme. In this environment, the role of SEBI is limited to certain improvements in disclosure norms, using which mutual funds would give investors and potential investors sound information about the portfolio strategies associated with a given scheme.

Hence, the first mechanism through which mutual fund schemes can engage in derivatives trading consists of three steps:

1. Additional text in the prospectus which fully explains the ways in a given scheme would use financial derivatives, including numerical examples,

2. An ongoing dialogue with the trustees, whereby the trustees would establish that the actual functioning of the AMC is consistent with these promises,

3. An enhanced disclosure program (described in 6.3 below).

By these principles, if a mutual fund house can persuade investors that a beta=5 leveraged equity index fund is an attractive product, and thus raise resources which should be deployed through such a strategy, then it should be free to implement this using index futures and/or index options.

This path can be utilised when new schemes are created. For existing mutual fund schemes, utilising this path involves a modification to the offer document, which entails obtaining the consent of existing unit-holders.

6.2 Existing Schemes: Rules governing hedging and portfolio rebalancing.

The bulk of mutual fund assets today are in existing open-end schemes. It is likely that the bulk of new resources coming into mutual funds in the future will come into open-end schemes that exist as of today. In the absence of any changes to a mutual fund prospectus, the rules governing derivatives trading by mutual funds should limit mutual funds to certain strategies:

1. Portfolio rebalancing

2. Hedging

The following paragraphs (6.2.1, 6.2.2 and 6.2.3) illustrate in more detail some of the portfolio strategies that could be classified as constituting ‘portfolio rebalancing’ or ‘hedging’ as well some strategies that cannot be so classified. These illustrations are not intended to be exhaustive.

6.2.1 What does hedging mean?

The term hedging is fairly clear. It would cover derivative market positions that are designed to offset the potential losses from existing cash market positions. Some examples of this are as follows:

• An income fund has a large portfolio of bonds. This portfolio stands to make losses when interest rates go up. Hence, the fund may choose to short an interest rate futures product in order to offset this loss.

• An income fund has a large portfolio of corporate bonds. This portfolio stands to make losses when credit spreads of these bonds degrade or when defaults take place. Hence, the fund may choose to buy credit derivatives which pay when these events happen.

• Every equity portfolio has exposure to the market index. Hence, the fund may choose to sell index futures, or buy index put options, in order to reduce the losses that would take place in the event that the market index drops.

The regulatory concerns are about (a) the effectiveness of the hedge and (b) its size. 

“Hedging” a Rs.1 billion equity portfolio with an average beta of 1.1 with a Rs. 1.3 billion short position in index futures is not an acceptable hedge because the over hedged position is equivalent to a naked short position in the future of Rs. 0.2 billion. Similarly, “hedging” a diversified equity portfolio with an equal short position in a narrow sectoral index would not be acceptable because of the concern on effectiveness. A hedge of only that part of the portfolio that is invested in stocks belonging to the same sector of the sectoral index by an equal short position in the sectoral index futures would be acceptable.

“Hedging” an investment in a stock with a short position in another stocks’ futures is not an acceptable hedge because of effectiveness concerns. This would be true even for merger arbitrage where long and short positions in two merging companies are combined to benefit from deviations of market prices from the swap ratio.

Hedging with options would be regarded as over-hedging if the notional value of the hedge exceeds the underlying position of the fund even if the option delta is less than the underlying position. For example, a Rs.2 billion index put purchased at the money is not an acceptable hedge of a Rs.1 billion, beta=1.1 fund though the option delta of approximately Rs. 1 billion is less than the underlying exposure of the fund of Rs. 1.1 billion.

Covered call writing is hedging if the effectiveness and size conditions are met. Again the size of the hedge in terms of notional value and not option delta must not exceed the underlying portfolio.

The position is more complicated if the option position includes long calls or short puts. The worst-case short exposure considering all possible expiration prices (see 6.2.3 below) should meet the size condition.

6.2.2 What does portfolio rebalancing mean?

The use of derivatives for portfolio rebalancing covers situations where a particular desired portfolio position can be achieved more efficiently or a lower cost using derivatives rather than cash market transactions. The basic idea is that the mutual fund has a fiduciary obligation to its unit holders to buy assets at the best possible price.

Thus if it is cheaper (after adjusting for cost of carry) to buy a stock future rather than the stock itself, the fund does have a fiduciary obligation to use stock futures unless there are other tangible or intangible disadvantages to using derivatives. Similarly, if a synthetic money market position created using calendar spreads is more attractive than a direct money market position (after adjusting for the credit worthiness of the clearing corporation), the fund would normally have a fiduciary obligation to use the calendar spread. If a fund can improve upon a buy-and-hold strategy by selling a stock or an index portfolio today, investing the proceeds in the money market, and having a locked-in price to buy it back at a future date, then it would have a fiduciary obligation to do so.

The general principle here would be that a fund is permitted to do using derivatives whatever it could have done directly - no more and no less. For example, a fund’s position in a stock -underlying and derivatives taken together - should be within the fund’s maximum permissible limit in the stock. For this purpose, stock option long calls should be counted as notional value. The position is more complicated if there are short calls or long puts. The worst-case long exposure considering all possible expiration prices (see 6.2.3 below) should be less than the fund’s permissible limit.

There is another complication in case of long index positions. One could regard this as an equivalent exposure in each constituent of the index. This may be severely limiting where the fund already has a long position in a stock which has a long weight in the index. Another possibility is to say that a fund is permitted to deploy any part of its assets in a broad index and a sectoral fund is permitted to do the same in a sectoral index. Then the stock wise limits would be applied to the remaining part of the portfolio.

In any case, a long index position cannot be used to leverage a portfolio beyond the leverage that is otherwise permissible. Thus a fund with Rs.1 billion assets cannot have a Rs. 1.5 billion notional value of long index futures and index options.

6.2.3 Computation of worst case exposure for complex option positions

We use a simple example to illustrate the worst case exposure method of determining whether a portfolio of option positions on the same underlying is an acceptable “hedging and portfolio rebalancing” strategy. Considering the following stock option strategy:

a. Long call options on 5 million shares at a strike price of Rs 80.

b. Long put options on 2 million shares at a strike price of Rs 90

c. Short call options on 1 million shares at a strike price of Rs 110.36

d. Long put options on 3 million shares at a strike price of Rs 120

e. Long call options on 4 million shares at a strike price of Rs 130

f. Short call options on 3 million shares at a strike price of Rs 140

Since the fund has a bullish position on 9 million shares (a plus e) and a bearish position on 9 million shares (b plus c plus d plus f), its option delta could be comparatively small especially when the stock price is not far from the weighted average strike price. However, depending on what the stock price turns out to be at expiry, only some of the options will end up in the money and will therefore get exercised by or against the fund. Consequently, the fund could end up with a long or short position in the stock at expiry depending on what the stock price turns out to be at that point of time. The worst case long and short exposures can be worked out as follows:

The worst case short exposure arises when the share price at expiry is below 80 and the fund ends up delivering 5 million shares to exercise the in-the-money puts. This would be an acceptable level of hedging only if the fund’s position in the underlying and the futures were at least 5 million shares.

Its worst case long position (8 million shares) is when the share price is above 130 and below 140. The fund receives 9 million shares from exercising its in-the-money calls (a and e) and delivers 1 million shares against its short calls (c) which are also in the money. This means that the fund can take up this option strategy only if this 8 million shares plus its position in the underlying shares and futures is together less than the maximum permissible limit for the fund’s holding in the stock.

The fund must therefore satisfy two conditions before it can take up this option strategy as part of “hedging and portfolio rebalancing”:

• the fund’s position in the underlying and the futures must be at least 5 million shares so that the position does not become over-hedged

• the fund’s existing position in the underlying shares and futures plus the 8 million shares worst case long exposure of the option strategy must together be less than the maximum permissible limit for the fund’s holding in the stock

Some fund managers may regard the worst case exposure analysis as an excessively harsh view of what they might consider a legitimate and relatively low risk derivative strategy. In particular, it might be objected that the worst case long exposure of 8 million shares should be treated more leniently since it applies only in a narrow range of share prices (130-140). The Committee is however of the view that even if strategies of this kind are attractive and low risk ways of creating and profiting from gamma and vega exposures to a stock, the creation of such exposures does not per se constitute “hedging and portfolio rebalancing”. To justify the strategy in a “hedging and portfolio rebalancing” framework, it is necessary to show that the worst case short position resulting from the strategy is an acceptable hedging activity and that the worst case long position resulting from it is an acceptable portfolio rebalancing activity.

6.3 Ongoing disclosure requirements

In addition to the existing disclosures, each mutual fund scheme should make the following information available to investors and to the public at large on its website at a monthly frequency:

• Gross turnover on derivatives, reported separately by product categories (such as index futures, index options, stock futures, etc.).

• Outstanding position on derivatives as of the end-of-month, reported separately by product categories.

• Lowest, median and highest values in the month of the overall scheme delta with respect to the market index. This should report the sensitivity of the portfolio to a unit change in the market index, incorporating direct equity holdings, index derivatives positions and stock derivatives positions. Internally, these values would be computed by each scheme which uses derivatives every day at closing prices. The three summary statistics (min, median, max) over the month would be publicly reported.

• If adding the derivative positions to the positions in the underlying would significantly change the list or ranking of the top 10 stocks in the portfolio, the top 10 holdings on the basis of underlying plus single stock derivative positions should be disclosed alongside the disclosure of the top 10 holdings of the scheme. For this purpose, option positions will be converted into equivalent positions in the underlying on the basis of the option deltas. The same procedure should be adopted if the scheme’s positions in derivatives on any “narrow” index are such as to significantly change the list or ranking of the top 10 stocks in the portfolio.

7 SEBI Related Issues

7.1 Derivatives Cell and Advisory Committee

The LCGC very rightly emphasised the need for SEBI to build competencies in the area of derivatives:

“SEBI should immediately create a special Derivatives Cell because derivatives demand special knowledge. It should encourage its staff members to undergo training in derivatives and also recruit some specialised personnel.

A Derivatives Advisory Council may also be created to tap the outside expertise for independent advice on many problems which are bound to arise from time to time in regard to derivatives.” (Paragraph 4.11(b))

The Advisory Committee on Derivatives has been in existence for a year now. Prior to that there was a Technical Group on Derivatives for about a year. Most of the ground work on derivatives has been completed in these two years. Going forward, two sets of issues will arise:

• Operational issues will continue to come up on various aspects of the derivatives markets. The ACD is of the view that SEBI must now gear up to handle this with in-house staff. The SEBI Derivatives Cell has been in existence for several years now and has acquired significant expertise in the area. While LCGC felt the need for external advice to handle the “many problems which are bound to arise from time to time in regard to derivatives”, the ACD thinks that the derivatives cell is now ready to accept this additional responsibility. If necessary, the Derivatives Cell can be further strengthened through new recruitment and skills upgradation.

• A number of issues will arise regarding the interrelationship between the cash and derivatives markets particularly in the areas of risk containment and surveillance. Surveillance issues must largely be an in-house function and this report has recommended unified surveillance of the two markets (see 5.4 above). In the area of risk management, there is a need to create mechanisms that can facilitate an integrated view of risk management in both cash and derivative markets simultaneously 

Accordingly, the ACD recommends:

• Strengthening of the Derivative Cell both quantitatively and qualitatively to shoulder most of the responsibility for operational issues regarding the derivatives market.

• Strengthened unified surveillance of the cash and derivative markets as described in 5.4 above.

• Develop mechanisms to facilitate an integrated view of risk management in both cash and derivative markets simultaneously.

7.2 SEBI and RBI

The Committee recommends that SEBI and RBI should work together on moving towards exchange traded derivatives in the area of interest rates and currencies as outlined in 3.1 above.

                ----------------------------------------End Of Report----------------------------------------

                    Appendix A: Methodology for Corporate Adjustments

Methodology laid down in SEBI Circular of June 2001

Bonus, Stock Splits and Consolidations:

For Bonus, Stock Splits and Consolidations:

• The new strike price shall be arrived at by dividing the old strike price by the adjustment factor as under.

• The new market lot / multiplier shall be arrived at by multiplying the old market lot by the adjustment factor as under.

· The new position shall be arrived at by multiplying the old position by the

adjustment factor as under.

Bonus

Ratio = A:B Adjustment factor = (A+B)/B

Stock Splits and Consolidations

Ratio = A:B Adjustment factor = A/B

Right

Ratio = A:B Premium = C Face Value = D Existing Strike Price = X

New Strike Price = ((B * X) + A * (C + D))/(A+B)

Existing Market Lot / Multiplier / Position = Y

New issue size = Y * (A+B)/B

Rounding of fractional adjustments

The above methodology may result in fractions due to the corporate action e.g. a bonus ratio of 3:7. With a view to minimizing fraction settlements, the following methodology is proposed:

1. Compute value of the position before adjustment

2. Compute value of the position taking into account the exact adjustment factor

3. Carry out rounding off for the Strike Price and Market Lot

4. Compute value of the position based on the revised strike price and market lot.

The difference between 1 and 4 above, if any, shall be by adjusted in the Strike Price or Market Lot, so that no forced closure of open position is mandated.

Dividends

Dividends which are below 10% of the market value of the underlying stock would be deemed to be ordinary dividends and no adjustment in the Strike Price would be made for ordinary dividends. For extra-ordinary dividends, above 10% of the market value of the underlying stock, the Strike Price would be adjusted.

Decisions of the erstwhile sub group on corporate adjustments

Adjustment of the Extra Ordinary dividend in Stock Options

• To decide whether the dividend is ‘Extra Ordinary’ (i.e. over 10% of the market price of the underlying stock), the market price would mean the closing price of the scrip on the day previous to the date on which announcement of the dividend is made by the company after the meeting of the Board of directors. However, in cases where the announcement is made after the close of the market hours, the same day’s closing prices would be taken as the market price. Further, if the shareholders of the company in the AGM change the rate of dividend declared by the Board of Directors, than to decide whether the dividend is extra ordinary or not would be based on the rate of the dividend communicated to the exchange after AGM and the closing price of the scrip on the day previous to the date of AGM.

• In case of declaration of extra ordinary dividend by any company the total dividend amount (special and/or ordinary) would be reduced from all of the strike prices of the option contracts on that stock.

• The revised strike prices would be applicable from the ex-dividend date specified by the exchange.

Adjustment of the Extra Ordinary dividend in Stock Futures

An adjustment should be made in the reference price of Single Stock Futures Contracts on ex-dividend date for extra ordinary dividends, in line with the policy followed for Stock options. The adjustment should be such that the buyer of the Single Stock Futures contracts receives the dividend. Consequently, the reference rate for the purpose of Mark to Market settlement of Single Stock Futures on the ex-dividend date would be reduced by the value of the extra ordinary dividend.

Adjustments of the derivatives contracts due to mergers of two companies

• During the announcement of the record date, the last cum-date would be known; the announcement giving the exact date of expiration may be informed to the market in individual cases.

• After the announcement of the record date, no fresh contracts would be introduced in that underlying which would cease to exist subsequent to the merger.

• Un-expired contracts outstanding as on the last cum-date would be compulsorily settled at the settlement price. The settlement price shall be the closing price of the underlying.

• In case of the introduction of contracts of longer duration, this policy along with other policies of corporate adjustment may require a review.

    
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