The Securities and Exchange Board of India has put out detailed guidelines with examples to clear all doubts raised by mutual funds with respect to trading in derivatives.
Starting out with the definition of hedging the regulator has also cited examples of how hedging is achieved. First, an income fund has a large portfolio of bonds.
This portfolio stands to make losses when interest rates go up. Hence, the fund may choose to short an interest rate futures product in order to offset this loss.
Second, an income fund has a large portfolio of corporate bonds. This portfolio stands to make losses when credit spreads of these bonds degrade or when defaults take place.
Hence, the fund may choose to buy credit derivatives which pay when these events happen, or every equity portfolio has exposure to the market index.
Hence, the fund may choose to sell index futures, or buy index put options, in order to reduce the losses that would take place in the event that the market index drops.
According to the regulator it is concerned with the effectiveness of the hedge and its size.
Since funds had raised concerns regarding the thin dividing line between hedging and speculation the regulator has taken pains to clarify this.
According to Sebi, hedging a Rs 1 billion equity portfolio with an average beta of 1.1 with a Rs 1.3 billion short position in index futures is not an acceptable hedge because the over hedged position is equivalent to a naked short position in the future of Rs 0.2 billion.
Similarly, hedging a diversified equity portfolio with an equal short position in a narrow sectoral index would not be acceptable because of the concern on effectiveness.
"A hedge of only that part of the portfolio that is invested in stocks belonging to the same sector of the sectoral index by an equal short position in the sectoral index futures would be acceptable."
Arguing on the same lines, hedging an investment in a stock with a short position in another stocks' futures is not an acceptable hedge because of effectiveness concerns.
This would be true even for merger arbitrage where long and short positions in two merging companies are combined to benefit from deviations of market prices from the swap ratio, Sebi has said.
Hedging with options would be regarded as over-hedging if the notional value of the hedge exceeds the underlying position of the fund even if the option delta is less than the underlying position.
Covered call writing is hedging if the effectiveness and size conditions are met. But here again the size of the hedge in terms of notional value and not option delta must not exceed the underlying portfolio.
With respect to portfolio rebalancing the regulator has said that a fund's position in a stock -underlying and derivatives taken together - should be within the fund's maximum permissible limit in the stock.
For this purpose, stock option long calls should be counted as notional value. Funds have been advocated to take the worst case exposure for complex options positions for both hedging and portfolio rebalancing.
To justify the strategy in a 'hedging and portfolio rebalancing' framework, it is necessary to show that the worst case short position resulting from the strategy is an acceptable hedging activity and that the worst case long position resulting from it is an acceptable portfolio rebalancing activity, Sebi said.
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