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TMI BlogGuidelines for Participation by Mutual Funds in Trading in Derivative ProductsX X X X Extracts X X X X X X X X Extracts X X X X ..... cing. 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 portfoli ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... example, a ₹ 2 billion index put purchased at the money is not an acceptable hedge of a ₹ 1 billion, beta=1.1 fund though the option delta of approximately ₹ 1 billion is less than the underlying exposure of the fund of ₹ 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? ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 appl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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: Price at expiry Options that end up in the money and therefore get exercised by or against the fund Net number of shares (short or long) the fund ends up holding as a result of the option exercises Below 80 b and d 5 million shares short ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 re-balancing : 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X
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