CHIEF GENERAL MANAGER
MUTUAL FUNDS DEPARTMENT

MFD/CIR/21/ 25467/2002

December 31, 2002

All Mutual Funds Registered with SEBI
Unit Trust of India
Association of Mutual Funds in India

Dear Sirs,

Guidelines for Participation by Mutual Funds in Trading in Derivative Products

Please refer to SEBI circular no MFD/CIR/011/061/2000 dated February 9, 2000 wherein guidelines were issued for mutual funds to participate in Derivatives trading for the purpose of hedging and portfolio balancing. SEBI Advisory Committee on Derivatives has clarified certain types of transactions with illustrative examples which may be considered as hedging and portfolio balancing.

A copy of the relevant extract of the report is enclosed for your information.

Yours faithfully,

P.K. Nagpal

SEBI Advisory Committee on Derivatives

Report on

Development and Regulation of Derivative Markets in India

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:

• 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:

1. Long call options on 5 million shares at a strike price of Rs 80.
2. Long put options on 2 million shares at a strike price of Rs 90
3. Short call options on 1 million shares at a strike price of Rs 110
4. Long put options on 3 million shares at a strike price of Rs 120
5. Long call options on 4 million shares at a strike price of Rs 130
6. 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.