Derivative Exposure

Derivative Exposure means the maximum liability (including costs, fees and
expenses), based upon a liquidation or termination as of the date of the
applicable covenant compliance test, of any Person under any interest rate
swap, collar, cap or other interest rate protection agreements, treasury locks,
foreign currency exchange agreements, commodity purchase or option
agreements or other interest or exchange rate or commodity price hedging
agreements.

Objective of the Derivative Exposure:

The objective to use derivatives is purely to protect the portfolio in case of a
severe market correction. The four major types of derivative contracts are
a. Options
b. Forwards
c. Futures
d. Swaps

Derivatives Exposure Calculations:

a. Identify Derivatives Transactions:
We will find a summary of “derivatives transactions,” all of which may be
included in a Fund’s derivatives exposure. We assume that a Limited
Derivatives User will not elect to treat reverse repurchase agreements as
derivatives transactions because that would increase the Fund’s
derivatives exposure.
b. Quantify the Derivatives Transactions Derivatives transactions cab be
quantified (their “Exposure Amount”) for purposes of calculating a
Fund’s derivatives exposure in below format.

c. Identify Excluded Currency and Interest Rate Hedges:

Qualifying IRDs and currency derivatives transactions do not count
toward derivatives exposure. These include derivatives transactions that
were entered into and maintained in order to hedge currency or interest
rate risks associated with one or more specific equity or fixed-income
investments held by the Fund or the Fund’s borrowings. For these
purposes, a derivatives transaction for foreign currency can only be used
to hedge risks associated with an equity or fixed-income investment that
is denominated in a currency other than U.S. dollars.
To be excluded from the derivatives exposure calculation, the aggregate
Exposure Amounts of these hedging IRDs and currency derivatives may
not exceed the value of the hedged equity investments, the par value of
the hedged fixed-income investments, or the principal amount of any
hedged borrowings by more than 10%.

d. Identify Closed-Out Positions:

A Fund should identify derivatives that directly offset and close-out a
derivatives transaction with the same counterparty. Note that a
derivative that is not a “derivatives transaction” can be used for this
purpose. For example, an option purchased by a Fund (which is not a
 derivatives transaction) can offset an option written by the Fund (which
would be). These offset derivatives transactions do not count toward a
Fund’s derivatives exposure if they do not result in credit or market
exposure to the Fund.

e. Fund’s Derivatives Exposure Calculation:

Sum the Exposure Amounts of the Fund’s derivatives transactions after
excluding the derivatives transactions identified in Steps c and d. The
result is the Fund’s derivatives exposure.

f. Determine Whether the Fund is a Limited Derivatives User

A Fund will be a Limited Derivatives User if its derivatives exposure does
not exceed 10% of its net assets.

Advantages of Derivatives:
Unsurprisingly, derivatives exert a significant impact on modern finance
because they provide numerous advantages to the financial markets:
1. Hedging risk exposure:
Since the value of the derivatives is linked to the value of the underlying
asset, the contracts are primarily used for hedging risks. For example, an
investor may purchase a derivative contract whose value moves in the
opposite direction to the value of an asset the investor owns. In this
way, profits in the derivative contract may offset losses in the underlying
asset.
2. Underlying asset price determination
Derivatives are frequently used to determine the price of the underlying
asset. For example, the spot prices of the futures can serve as an
approximation of a commodity price.
3. Market efficiency
It is considered that derivatives increase the efficiency of financial
markets. By using derivative contracts, one can replicate the payoff of
the assets. Therefore, the prices of the underlying asset and the
 associated derivative tend to be in equilibrium to avoid arbitrage
opportunities.

4. Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable
assets or markets. By employing interest rate swaps, a company may
obtain a more favorable interest rate relative to interest rates available
from direct borrowing.

Disadvantages of Derivatives:
Despite the benefits that derivatives bring to the financial markets, the
financial instruments come with some significant drawbacks. The drawbacks
resulted in disastrous consequences during the Global Financial Crisis of 2007-
2008. The rapid devaluation of mortgage-backed securities and credit-default
swaps led to the collapse of financial institutions and securities around the
world.
1. High risk
The high volatility of derivatives exposes them to potentially huge losses. The
sophisticated design of the contracts makes the valuation extremely
complicated or even impossible. Thus, they bear a high inherent risk.
2. Speculative features
Derivatives are widely regarded as a tool of speculation. Due to the extremely
risky nature of derivatives and their unpredictable behavior, unreasonable
speculation may lead to huge losses.
3. Counter-party risk
Although derivatives traded on the exchanges generally go through a thorough
due diligence process, some of the contracts traded over-the-counter do not
include a benchmark for due diligence. Thus, there is a possibility of counter-
party default.