SEBI announces new MF norms for derivatives investment and disclosure

The market regulator SEBI issued new norms for MFs to invest in derivatives. What are they?

Mumbai: New regulations restrict the cumulative gross exposure through equity, debt and derivative positions to 100 per cent and also limit option premium exposure to 20 per cent of the net asset value of a scheme. This cap would restrict the extent of hedging positions a mutual fund takes.

The regulator, Securities and Exchange Board of India (SEBI), has banned MFs from selling options and purchasing instruments with embedded options. This move is intended to limit the exposure as the option writer undertakes unlimited loss as compared to an option buyer whose loss is limited to the option premium paid.

SEBI allows MFs to enter into plain vanilla interest rate swaps for hedging purpose but now SEBI has specified that the counter party to such a transaction has to be a RBI recognised market-maker. Also, exposure to single counterparty cannot now exceed 10 per cent of the net asset of the scheme.

Each position taken in derivatives shall have an associated exposure as given in the table. Exposure is the maximum possible loss that may occur on a position. However, certain derivative positions may theoretically have unlimited possible loss.

The Impact: Mutual funds are no longer exposed to the unlimited risk that trading in options entails. Apart from the ban on selling options, limits have been imposed on exposure to other derivatives positions, effectively capping risks to fund portfolios. The regulatory move was prompted by sudden spurt derivatives trading volumes of mutual funds in June 2010.