By Stephen A. Keen and Andrew P. Cross

Our last post examined examples of currency hedges that we believe Rule 18f‑4(c)(4)(i)(B) should allow a fund seeking to comply with the Limited Derivatives User requirements to exclude from its derivatives exposure. This post struggles with examples of interest-rate hedges that may, or may not, be excluded.

A Paradigmatic Bond Hedge

As originally proposed, Rule 18f-4 would have excluded only currency hedges. The final rule added the exclusion of interest-rate hedges based on commenters who:

routinely enter into fixed-to-floating interest rate swaps (or vice versa) and [match] these transactions … to the notional amount and maturity of a specific security in the fund’s portfolio.”

As the SEC added the exclusion of interest-rate hedges to accommodate these commenters, it is reasonable to conclude that such a fixed-to-floating rate swap could be excluded from a fund’s derivatives exposure. We are less sure about the “vice versa,” as a floating-to-fixed rate swap would increase, rather than mitigate, a fund’s interest-rate risk. We do not believe the SEC would view using derivatives to increase duration as a “hedging purpose.”

Continue to the full post at Asset Management ADVocate.