Mutual funds can use IRF to hedge risks, says Sebi

Providing more leeway, Sebi today allowed mutual funds to use interest rate futures contracts to hedge risks from volatility in interest rates.
An IRF provides for future delivery of an interest- bearing security such as government bonds and such contracts provide an avenue to hedge against risks arising from fluctuations in interest rates.
"To reduce interest rate risk in a debt portfolio, mutual funds may hedge the portfolio or part of the portfolio (including one or more securities) on weighted average modified duration basis by using IRFs," Sebi said in a circular.
Besides, mutual funds will have to disclose about the hedging positions through IRF in respective debt portfolios, details of IRFs used for hedging along with debt and money market securities transacted on its website, and investments made in interest rate derivatives in the monthly portfolio disclosure.

In case the IRF (interest rate future) used for hedging the interest rate risk has different underlying security than the existing position being hedged, Sebi said that it would result in imperfect hedging.
Imperfect hedging will be exempted from the gross exposure, up to maximum of 20 per cent of the net assets of the scheme, provided 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 permitted to resort to imperfect hedging, without it being considered under the gross exposure limits, in case the correlation between the portfolio and the IRF is at least 0.9 at the time of initiation of hedge.

In case of any subsequent deviation from the correlation criteria, the same should be rebalanced within five working days and if not rebalanced within the timeline, the derivative positions created for hedging will be considered under the gross exposure.
According to Securities and Exchange Board of India (Sebi), basic characteristics of the mutual fund scheme should not be affected by hedging the portfolio or part of the portfolio.
Prior to commencement of imperfect hedging, all unit holders of an existing scheme should be given a time period of at least 30 days to exercise the option to exit at prevailing net asset value without charging of exit load.

Sebi said that risks associated with imperfect hedging will have to be disclosed and explained by suitable numerical examples in the offer documents. Besides, it should be communicated to investors through public notice or any other form of correspondence.