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The Securities and exchange Board of India has provided even more flexibility as the board has now permitted the mutual funds to use the IRF or the interest rate futures contracts to hedge risks from volatility in the interest rates, as per the Indian legal news.
The interest rate futures provide for future delivery of an interest- bearing security like the government bonds etc. Such contracts offer the benefit of an avenue which is used to hedge against the risks that is always associated with the ups and downs in the interest rates.
As the SEBI mentions in its circular, in order to diminish the risk of the interest rate in a debt portfolio, the mutual funds are now allowed to hedge the portfolio or become the part of the portfolio. And it may include one or more securities as well on weighted average modified duration basis by using interest rate futures.
Along with this, the mutual funds are now expected to reveal their hedging positions through the IRF in a particular debt portfolio, the details of the IRFs which are used for hedging, debt and money market securities transacted online, and the investments that are made in the interest rate derivatives in the monthly portfolio disclosure.
Sebi has also said that if the interest rate future which is used for hedging the interest rate risk has different underlying security than the current position it is being hedged, then it will be concluded as the imperfect hedging which will be exempted from the gross exposure, up to maximum of 20% of the net assets of the scheme, on a condition that the exposure to IRFs is created only for hedging the instrument based on the weighted average modified duration of the bond portfolio or part of the portfolio.
Mutual Funds are allowed to do the imperfect hedging, and will not be treated in the gross exposure limits, if the correlation between the portfolio and the IRF is at least 0.9 at the time of initiation of hedge. If there is any difference from the correlation criteria, the same must be re-balanced within five working days. If the same is not rebalanced within the five working days, the derivative positions created for hedging will be treated under the gross exposure.
As the SEBI says, the genuine nature of the mutual fund scheme must not change by hedging the portfolio or being the part of the portfolio. It is also important that before the start of the imperfect hedging, all the unit holders of the current scheme must be given a timeline of minimum a month or 30 days to exit at prevailing net asset value (NAV) without charging of exit load.
The board also added that the risks associated with imperfect hedging will have to be unveiled and also discussed by apt examples in the offer documents and must also be told to the investors through any way of correspondence.