Permitted Uses of Derivatives by Mutual Funds

Question 1

applies to mutual funds in Canada and outlines the permitted derivative activities that these funds can undertake

Answer 1

NI 81-102

Question 2

3 sections of Ni 81-102 that apply to the use of derivatives in Mutual funds

Answer 2

• Transactions in Specified Derivatives for Hedging and Non-hedging Purposes
• Transactions in Specified Derivatives for Purposes Other Than Hedging
• Transactions in Specified Derivatives for Hedging Purposes

Question 3

To qualify as a hedge, the derivative that is used must: (3)

Answer 3

• Be intended to offset or reduce a specific risk associated with a position
• Have a value with a high degree of negative correlation to the value of the position being hedged
• Not be expected to offset more than the changes in the value of the position being hedged.

Question 4

positions that have payoffs opposite those of

long positions include the following:

Answer 4

• Short forward, futures and swap contracts
• Long put option contracts
• Short call option contracts

Question 5

What is a currency cross-hedge?

Answer 5

• transaction in which a mutual fund substitutes its exposure to one currency risk for another currency.
• neither currency should be the mutual fund’s NAV

Question 6

The most common use of derivatives for non-hedging purposes?

Answer 6

To gain exposure to a market without having to own the underlying securities.

Question 7

3 uses of derivatives for non-hedging purposes

Answer 7

• The sale of call or put options to earn additional income
• The purchase of options, forwards, futures or swaps to gain exposure.
• The sale of forwards, futures or swaps to reduce exposure.

Question 8

In which 3 instances can a Mutual Fund Manager sell options?

Answer 8

They have:
• An offsetting position in the underlying asset
• The right to buy or sell the underlying asset such as purchased call or put options
• The cash to cover the exercise of the sold options

Question 9

What are fixed income futures and OTC derivatives used for?

Answer 9

Increasing or decreasing a fund’s exposure to interest rate risk

Question 10

two most popular applications of bond futures and fixed income-related OTC derivatives to manage a mutual fund’s duration.

Answer 10

• Buy or short US treasuries

* Buy or short a fixed for floating interest rate swap

Question 11

5 Advantages of using Derivatives

Answer 11

• Risk reduction
• Ease of execution
• Lower costs
• Greater asset selection
• More portfolio income

Question 12

occurs when the execution of a transaction causes subsequent prices to worsen

Answer 12

execution slippage

Question 13

Disadvantages of Derivatives (8)

Answer 13

• Income considerations
• Management of expiration dates
• Portfolio attributes
• Limited gains
• Transparency
• Tax considerations
• Costs
• Credit and counterparty risk

Question 14

How are returns from forward and futures contracts taxed?

Answer 14

as income and therefore does not normally receive any preferential treatment.

Question 15

NI 81-102 includes 3 specific details

Answer 15

• A minimum credit rating for counterparties to over-the-counter (OTC) derivatives
• A 10% of fund’s maximum exposure to individual counterparty
• Calculation of exposure based on mark to market

Question 16

What is a Covered call option?

Answer 16

A call that is sold with the underlying asset already owned in the portfolio. The manager receives the option premium and, in exchange, agrees to sell the underlying security at the strike price if the option is exercised

Question 17

What kind of strategy is writing cash-secured put options?

Answer 17

bullish strategy designed to add income if an underlying asset rallies in value

Question 18

What does cash-secured mean in the context of put options?

Answer 18

Manager needs to have the cash on hand to buy the shares if the option is exercised.