Define and describe the significance of NR 81-102
- NI 81-102 permits mutual funds to use derivatives to reduce risk and ensures they aren’t used to speculate
- includes specific details that apply to all derivative positions such as a minimum credit rating for counter parties to OTCC derivatives contracts, maximum exposure rules, and exposure limited to individual holdings
N1 81-104 permits a broader use of derivatives by funds that fall into the definition of commodity pools which are….
- funds that buy and sell futures contracts
- structured and sold as MF but permitted to use aggressive derivatives strategies and leverage
- regulators require more disclosure and higher proficiency from companies and brokers that offer them
- NI 81-104 was designed to permit commodity pools to operate without changing NI 81-102
Under NI 81-102, MFs may use derivatives for hedging or risk reduction. To qualify as a hedge, the derivative must:
- be intended to offset or reduce a specific risk associated with all or part of a position or positions in the fund
- have a value with a high degree of negative correlation to the value of the position being hedged
- Not be expected to offset more than the changes in the value of the position being hedged
According to NI 81-102, what is the easiest way for a MF manager to establish a hedge?
-take a position in a derivatives contract with a payoff that is opposite to, or offset by, that of the position or exposure to be hedged
What is a currency cross-hedge?
- a transaction in which a mutual fund substitutes its exposure to one currency risk for exposure to risk from another currency, as one as neither is the currency in which the MFs NAC is determined and the aggregate amount of currency risk to which the MF is exposed is not increased by the substitution
- NI 81-102 allows currency cross-hedges to qualify as hedge transactions
What is the most common use of derivatives for non-hedging purposes?
-to gain exposure to a market without having to own the underlying securities
Common uses of derivatives for non-hedging purposes in fund management fall into what 3 categories?
- the sale of call or put options to earn additional income
- the purchase of options, forward, futures or swaps to gain exposure
- the sale of forwards, futures, or swaps to reduce exposure
Describe a covered call option
- a call that is sold with the underlying asset already owned in the portfolio
- the manager receives the option premium and in exchange agrees to sell the underlying security at the strike price if the option is exercised
- writing covered call options is a defensive strategy that is designed to offset losses in long stock positions with income from call option premiums
Writing cash-secured put options is a ________ strategy designed to add _______ if an underlying asset _____ in value
- bullish
- income
- rallies
Describe a cash-secured put option
-NI 81-102 states that a MF manager is not allowed to write a put option without having the cash to buy the shares therefore a fund must have adequate cash to purchase the shares if the put is exercised `
What is the key distinction between using bond futures and fixed income related derivatives versus equity fund derivative applications?
- equity related futures and OTC derivatives are typically used to either gain or hedge out exposure to entire equity markets generally using equity index related derivatives
- fixed income related futures and OTC derivatives are more focused on increasing or decreasing a funds exposure to interest rate risk
- equity fund managers focus on beta
- fixed income managers focus on duration
The two most popular applications of bond futures and fixed income related OTC derivatives to manager a mutual fund’s duration are:
- buy or short t-bill futures, US treasury futures, and US treasury bond futures
- short selling a longer term fixed for floating interest rate swap or going long on a longer term fixed for floating interest rate swap
The use of derivatives by mutual fund managers benefits investors by offering opportunities to obtain exposure to certain assets and by mitigating certain kinds of risk. The advantages that derivatives provide to mutual fund managers include:
- risk reduction
- ease of execution
- lower costs
- greater asset selection
- more portfolio income
Describe how the use of derivatives in mutual funds helps with ease of execution
- permit a fund manager to purchase a large number of diverse securities in a single transaction
- helps avoid execution slippage (occurs when the execution of a transaction causes subsequent prices to worsen
What are the disadvantages and risks associated with using derivatives in mutual fund management?
- income considerations (sometimes miss out on div and int income)
- management of expiration dates
- portfolio attributes
- limited gains
- transparency
- tax considerations
- costs
- credit and counterparty risk
