Guidelines for Participation by Mutual Funds in Trading in Derivative Products

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....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....

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.... 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 usin....

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.... 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 R....

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.... 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 80-90 a, b and d nil 90-110 a and d 2 million shares long 110-120 a, c and d 1 million shares long 120-130 a and c 4 million shares long 130-140 a, c and e 8 million shares long above 140 a, c, e and f 5 million shares long The worst case short exposure arises when the share price a....