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.

]]>A Fund that seeks to qualify as a Limited Derivatives User must satisfy three principal requirements:

- Adopt and implement written policies and procedures reasonably designed to manage the Fund’s derivatives risk;
- Its derivatives exposure should not exceed 10 % of its net assets; and
- Should its derivatives exposure exceed 10% for more than five business days, the Fund must either promptly reduce the derivatives exposure to 10% (within no more than thirty calendar days of first exceeding 10%), in a manner that is in the best interests of the Fund and its shareholders, or else adopt and comply with a DRM Program as soon as reasonably practicable.

So, calculating a Fund’s derivatives exposure is essential to complying with the second and third requirements.

The following is a six-step guide to the information required to calculate a Fund’s derivatives exposure.

You will find a summary of “derivatives transactions,” all of which may be included in a Fund’s derivatives exposure, at our Derivatives Transactions Recap post. We assume that a Limited Derivatives User will not elect to treat reverse repurchase agreements as derivatives transactions because that would increase the Fund’s derivatives exposure.

The following table shows how derivatives transactions should be quantified (their “Exposure Amount”) for purposes of calculating a Fund’s derivatives exposure.

Type of Derivatives Transaction |
Exposure Amount |

Options | Delta adjusted gross notional amount |

Interest rate derivatives (IRDs) | 10-Year bond equivalent of the gross notional amount |

Short sale borrowings | Market value of assets sold short |

All derivatives transactions other than options, IRDs and short sale borrowings | Gross notional amount |

Qualifying IRDs and currency derivatives transactions do not count toward derivatives exposure. These include derivatives transactions that were entered into and maintained in order to hedge currency or interest rate risks associated with one or more specific equity or fixed-income investments held by the Fund or the Fund’s borrowings. For these purposes, a derivatives transaction for foreign currency can only be used to hedge risks associated with an equity or fixed-income investment that is denominated in a currency other than U.S. dollars.

To be excluded from the derivatives exposure calculation, the aggregate Exposure Amounts of these hedging IRDs and currency derivatives may not exceed the value of the hedged equity investments, the par value of the hedged fixed-income investments, or the principal amount of any hedged borrowings by more than 10%.

A Fund should identify derivatives that directly offset and close-out a derivatives transaction with the same counterparty. Note that a derivative that is not a “derivatives transaction” can be used for this purpose. For example, an option purchased by a Fund (which is not a derivatives transaction) can offset an option written by the Fund (which would be). These offset derivatives transactions do not count toward a Fund’s derivatives exposure if they do not result in credit or market exposure to the Fund.

Sum the Exposure Amounts of the Fund’s derivatives transactions after excluding the derivatives transactions identified in Steps 3 and 4. The result is the Fund’s derivatives exposure.

A Fund will be a Limited Derivatives User if its derivatives exposure does not exceed 10% of its net assets.

We will now proceed to unpack steps 2 through 5 based on explanations provided in the adopting release for Rule 18f-4, identifying many questions we cannot answer along the way. But first, for those mathematically inclined, our next post will provide a “derivatives exposure formula.”

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