There are many ways to trade stocks today, with leverage being one of the popular options. Leverage allows a trader to gain exposure to the underlying asset with minimal capital invested, thereby increasing their profitability or losses. Leverage can be measured, and it’s a simple tool that has been used for many years as a risk metric for funds across the world.
Leverage can be used in several ways, including debt or as a type of derivatives. In India, when it comes to alternative investment funds (AIF), the Securities and Exchange Board of India (SEBI) allows the use of leverage. Still, some vital requirements should be followed. This piece will examine how to calculate leverage ratio, how AIFs use leverage, and some of the challenges these funds face regarding the subject.
According to SEBI regulations, a category III AIF can use as much leverage as the institution has set for the industry. According to a leverage circular released back in 2013, SEBI issues a few guidelines for calculating leverage. According to the document, the leverage allowed to category III AIFs is limited to two times the net asset value (NAV). To get the leverage ratio, you have to divide the total exposure of Category III AIF by its NAV. The leverage circular also states that the fund’s total exposure when it comes to calculation of the leverage ratio usually should be the sum of the market value of all the securities or contracts held by the fund. However, it doesn’t include cash or other cash equivalents.
Additionally, the total exposure will be the sum of the spot market exposure and the derivative market exposure at any given time. In this case, the NAV will be the sum value of all securities after they are adjusted for the mark to market gains/losses, and this includes cash and cash equivalents but shall exclude any funds that have been borrowed by the AIF.
The circular also has guidelines for offsetting of positions when calculating the leverage ratio. Offsetting is only allowed for transactions entered into when hedging or rebalancing the portfolio.
Hedging represents the derivative market positions taken to offset any potential losses that may arise from existing cash market positions. When dealing with futures contracts, hedging is allowed if you are dealing with the same script or handling a diversified equity portfolio by taking a position in the sectoral index.
Hedging is also allowed when operating in the same script, and this applies for both derivatives and cash equity; however, a hedge transaction shouldn’t result in a naked short position. Simply put, the net position shouldn’t be a short position in the security.
The circular stipulates that you have to ensure the short position is not on the narrow sectoral index when hedging a diversified equity portfolio with a short position in the sectoral index. Additionally, the short position should be taken in a manner that doesn’t create a naked short position in the sectoral index futures.
When it comes to hedging option contracts, the notional value of the hedge, which is the value represented by the option contract, should not be more than the underlying position in the script. Covered call writing is allowed as long as the call’s notional value doesn’t exceed the underlying position.
As for portfolio rebalancing, which involves adjusting a strategy to achieve the desired portfolio position more efficiently or through lower cost by using derivatives rather than cash market transactions, the fund is allowed to use derivatives just like it would have done directly. But, the fund’s derivative position when it comes to underlying security coupled with any cash equity position it may have in such security should range within the allowed investments limits.
As things stand, India’s current regulatory regime does lack clarity when it comes to offsetting mechanisms, which as a fund manager, you can use to calculate the total exposure for your fund when calculating the leverage ratio.
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