Guidelines for Participation by Mutual Funds in Derivatives Trading - SEBI - SEBI/ IMD/CIR No. 4/2627/ 2004

GENERAL MANAGER INVESTMENT MANAGEMENT DEPARTMENT SEBI/ IMD/CIR No. 4/2627/ 2004 February 6, 2004 All Mutual Funds Registered with SEBI Association of Mutual Funds in India Dear Sirs, Guidelines for Participation by Mutual Funds in Derivatives Trading Please refer to SEBI circular no MFD/CIR/011/061/2000 dated February 1, 2000 wherein guidelines were issued for mutual funds to participate in derivative trading for the purpose of hedging and portfolio balancing. Subsequently, vide circular no. MFD/CIR/21/25467/2002 dated December 31, 2002 based on recommendations of SEBI Advisory Committee on Derivatives, certain types of transactions were explained with illustrative examples which may be considered as hedging and portfolio balancing. Association of Mutual Funds in India (AMFI) has made a representation for some more clarifications for hedging and portfolio balancing. After examining the matter, further clarifications are being issued, which are enclosed. These clarifications are being issued in accordance with the provisions of Regulation 77 of the SEBI (Mutual Funds) Regulations, 1996. Yours faithfully, SURESH GUPTA Guidelines for Participation by Mutual Funds in Derivatives Trading The mutual funds shall be required to adhere to the following guidelines for trading in derivatives: These guidelines apply to equity oriented schemes. The guiding principle while initiating any derivatives position shall clearly be hedging or portfolio balancing . At no point in time the derivative position shall result, even for a few moments on an intra-day basis, in actual or potential leverage or short sale / short position on any underlying security. Derivatives Positions and Limits: Some sample cases of basic derivative positions of hedging and portfolio balancing are given in Table 1. All derivatives positions shall be backed by cash or stock as the case may be. i.e. all current or potential long positions shall be backed by cash and equivalents at the time of exposure and all current or potential short positions will be fully backed by stock (stocks portfolio for index derivatives). Definition of the word Cash shall include cash, money market instruments, deposits with scheduled commercial banks (public sector, private sector and foreign banks) and net current assets. Limits: Each mutual fund shall have a maximum derivatives net position of 50% of the portfolio (i.e. net assets including cash). Each fund shall decide in advance with formal approval of Board of Trustees the maximum net derivatives exposure in terms of percentage of portfolio value it would allow. Within the overall limits of a maximum derivatives net position of 50% of the portfolio (i.e. net assets including cash), the limits per scrip/ Instrument shall be specified by the Board of Trustees. Thus, the Board of Trustees shall determine the overall exposure limit to derivatives, as well as the derivative limits on individual stocks. Trustees should satisfy themselves that the risk containment measures are in place. All the exposure limits in Table 1 (to be specified by the Board of Trustees) are in terms of notional value of the derivative position. The notional value of the derivative position for each specific instrument held is defined as: Options: Number of Contracts held (multiplied by) Number of underlying shares (multiplied by) strike price / (divided by) index per contract Futures: Number of Contracts held (multiplied by) Number of underlying shares / (divided by) index per contract (multiplied by) current or closing market price The gross position (as defined below) of the underlying securities and derivatives shall be considered for the purpose of applying and monitoring stock exposure limits as per Clause 2 of Seventh Schedule of SEBI (Mutual Funds) Regulations, 1996. The gross position per stock is defined as the sum total of the fund s exposure (notional value) in a particular underlying and its derivatives that represent a current or potential long / short position on the underlying. This does not include investments in index derivatives. Thus, for an individual scrip to calculate scrip exposure limits, Gross Long position shall be the total of scrip held (cash position) + long futures on the scrip + long calls on the scrip + short puts on the scrip Gross Short position shall be the sum of short scrip futures + short calls on the scrip + long puts Note: Reversal of positions shall not be considered in calculating gross positions e.g. if call has been written, then purchase of the same instrument will not be considered in gross addition. For calculating overall derivatives exposure, the total of all positions on individual stocks plus position on indices shall be considered. In instances where the fund has long/potential long and short/potential short positions (as defined above in point e ) in derivatives with the same underlying, with the net of the gross long and gross short positions falling within limits, the gross position on both the long and the short side should still not exceed 150% of the permissible SEBI exposure limit position on either side. In addition to the above limits, the fund shall do a worst case scenario exposure on the total positions on any given underlying. The worst-case scenario exposure to the underlying shall not exceed the SEBI exposure norms. The procedure for performing the worst-case analysis shall be similar to the one described in the SEBI letter dated 31st December 2002. 2. Positions Involving Multiple Derivatives: Positions involving multiple derivatives positions on the same underlying shall be allowed. The exposure limits for the same shall be fixed as above. 3. Disclosure and Accounting Norms: Each mutual fund shall disclose the maximum net derivatives exposure in terms of percentage of portfolio value, the limits of derivatives exposure per scrip/instrument and derivatives positions and limits in Table 1 in the offer documents/addendum of the respective schemes to the investors. The data of actual exposures shall be disclosed in the half yearly portfolio statements. When calculating the industry exposure for disclosure on monthly basis, the total exposure per scrip including derivatives exposure shall be considered. Gap reporting / Calendar spread analysis of all derivative positions shall be reported internally on a weekly basis to a committee which should be appointed by the Board of Trustees All the details shall also be reported to the Board of Trustees in the immediate next meeting after such positions are initiated. Table I. Common Derivative Positions and Limits Limits to be decided by Board of Trustees SR NO. DERIVATIVE ACTION DESCRIPTION LIMIT 1 Index futures Buy Buy futures against cash to protect against rising market To the extent of cash / equivalents in the portfolio. Max. limit (_%) of portfolio 2 Index futures Sell Hedging of portfolio against expected market downturn Up to (_%) of equity portion of the fund 3 Index Options - Call Buy Buy index calls against cash (existing /expected) to protect against rising market To the extent of cash / equivalents in the portfolio. Max. limit (_%) of portfolio 4 Index Options - Call Sell Covered Call Sale- against existing portfolio Up to (_%) of equity portion of the fund 5 Index Options - Put Buy Buy index puts to hedge existing portfolio Up to (_%) of equity portion of the fund 6 Index Options - Put Sell Covered Put Sale- Possible top sell index puts against existing / expected cash To the extent of cash / equivalents in the portfolio. Max. limit (_%) of portfolio 7 Stock futures Buy Buy against cash to protect against rising share prices To the extent of cash / equivalents in the portfolio. Max. limit (_%) of portfolio; per scrip limit (__%)