Derivatives Exposure under Rule 18f-4: Notional Apples and Oranges
Having provided two "big pictures" of the calculation of a fund's "derivatives exposure," we resume with an in-depth examination. We begin by considering how to determine the "gross notional amount" of a derivatives transaction. This post may contain our only categorical conclusion regarding derivatives exposure: gross notional amounts must be absolute values expressed in U.S. dollars.
Absolute Values
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:a fund's derivatives exposure must include the sum of the absolute values of the notional amounts of the fund's derivatives transactions, rather than a figure based on calculations that net long and short positions."This means that none of the numbers on the right side of the derivatives exposure equation will be negative.
Middle School Math
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.What Is the Problem?
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.