Off-Balance Sheet Exposure
Exposure a fund takes through leverage and derivative contracts to assets that are not its direct obligation — only margin and premium show in the books, but the fund bears the full risk and return.
In plain language
If a fund buys Rs 20 crore of shares, Rs 20 crore of shares appears in its statement of assets. If it buys gold futures with a notional value of Rs 20 crore, what appears is only the margin it deposited with the broker. The exposure to Rs 20 crore of gold is real, but it sits off the balance sheet.
The workbook defines off-balance sheet exposure as investing in assets which do not represent a direct obligation on the fund, through leverage strategies and derivative contracts, although the risks and returns associated with such assets are indirectly borne by the fund.
That gap between what the books show and what the fund is exposed to is exactly why SEBI measures a Category III AIF's leverage on total exposure, not on margin.
How it works
Measuring the exposure. For leverage, total exposure is the sum of the market value of long and short positions, after permitted offsetting:
Leverage = Total exposure (long + short, after offsetting) ÷ NAV ≤ 2
- Futures: on the trade date, the futures price × number of contracts; afterwards, marked to market.
- Options: on the trade date, the premium paid; afterwards, Black-Scholes and mark-to-market.
- Offsetting is allowed between long and short positions in the same stock, index or commodity with the same maturity.
- Idle cash is excluded from exposure, as are temporary borrowings fully covered by investors' capital commitments.
What happens to NAV. Margin deposited with brokers is treated as an asset. When the fund opens positions, the margin and premium are taken from the F&O margin account; daily mark-to-market profits are added back to it and losses create additional liability towards margin.
A worked example
The workbook's Fund INC, 5,00,000 units. NAV on 15 May 2023 is Rs 1,125.40, with Rs 11 crore in its F&O margin account.
16 May, 9:15 am — positions opened:
| Position | Notional exposure |
|---|---|
| Nifty 9000 PE, 300 lots × 75 × Rs 380 | Rs 85,50,000 |
| Nifty 9700 CE, 600 lots × 75 × Rs 110 | Rs 49,50,000 |
| LMN futures, 300 lots × 250 × Rs 2,275 | Rs 17,06,25,000 |
| Gold futures, 50 lots × 100 × Rs 47,550 | Rs 23,77,50,000 |
Nifty options after offsetting = 85,50,000 − 49,50,000 = Rs 36,00,000
Total exposure = 36,00,000 + 17,06,25,000 + 23,77,50,000 = Rs 41,19,75,000
Margin account at 9:20 am:
Rs 11,00,00,000 − 1,57,78,800 (gold margin) − 5,49,15,900 (LMN margin)
− 1,35,00,000 (option premium) = Rs 2,58,05,300
Net assets fall to Rs 47,85,05,300, NAV to Rs 957.0106:
Leverage = Rs 41,19,75,000 ÷ Rs 47,85,05,300 = 0.86 (limit 2.00)
4:00 pm. Futures prices fall to Rs 2,150 and Rs 46,760, giving mark-to-market profit of Rs 93,75,000 + Rs 39,50,000 = Rs 1,33,25,000, credited to the margin account. With other prices updated, NAV closes at Rs 1,014.9706. The workbook's note: NAV is not back at its opening level because the fund took off-balance sheet exposure in derivatives, which reduced the margin account balance.
Rs 41 crore of exposure against Rs 48 crore of net assets — and almost none of it visible as a line in the asset list.
Why NISM asks about it
Chapter 8 (Valuation), section 8.2.2 Positions in Commodity Derivatives and Equity Derivatives Markets defines the term in a footnote to Examples 4 and 5, which carry the Fund INC numbers above. The leverage ratio it relies on is the one from Chapter 5 (section 5.6.3). Expect questions on how exposure is measured for futures and options, which positions may be offset, what is excluded from exposure, and why NAV moves when derivative positions are opened.
Common exam traps
- Off-balance sheet does not mean off-risk. The fund bears the risks and returns in full.
- Leverage uses notional exposure, not margin. Margin is what shows in the books; exposure is what counts against the 2× NAV limit.
- Offsetting needs the same underlying and the same maturity. The workbook's own example offsets a bought Nifty call against a bought Nifty put with the same expiry but different strikes.
- Idle cash is excluded from exposure, and so are temporary borrowings fully covered by capital commitments.
- The workbook's example labels are inconsistent. The futures table is headed "Short Positions" and the mark-to-market profit is computed as a short's profit when prices fall, but the exposure table calls the same contracts "Long Futures", and the text calls the bought put "a short position". For computation, follow the arithmetic: the futures were short, and both options were bought.
Check yourself
1.Fund INC's NAV fell from Rs 1,125.40 to Rs 957.0106 within five minutes of executing derivative trades. The reason is:
- a)Immediate mark-to-market losses on the new positions
- b)Payment of margin for the futures contracts and option premium on the NIFTY50 options, which reduces the F&O margin account balance — an off-balance sheet exposure
- c)A write-down of the fund's unlisted equity holdings
- d)An error, since taking derivative positions cannot change NAV
Show the answer
Answer: (b) Payment of margin for the futures contracts and option premium on the NIFTY50 options, which reduces the F&O margin account balance — an off-balance sheet exposure
A significant drop in the NAV is observed, primarily on account of payment of margin for the futures contracts and the option premium on NIFTY50 Options. The margin account fell from Rs 11,00,00,000 to Rs 2,58,05,300 — Rs 1,57,78,800 to gold margin, Rs 5,49,15,900 to LMN margin and Rs 1,35,00,000 to premium. The workbook explains that NAV is not at the same level as on opening hours because the Investment Manager has taken an off-balance sheet exposure in derivative contracts, which reduces the balance maintained in the F&O Margin Account. No loss had yet occurred.
Where this is taught
- Series XIX-B · Chapter 8: Valuationintroduced here
- Series XIX-E · Chapter 12: Valuationintroduced here
Related terms
- Category III AIFThe AIF category for funds running diverse or complex trading strategies with leverage — hedge funds and their kin — and the only category denied tax pass-through status.
- Net Asset ValueThe net assets of a mutual fund scheme divided by the number of units outstanding — what one unit of the scheme is worth on a given day, after every liability except the unitholders' own.
- DerivativeA contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
- LeverageControl of a large contract value for a small upfront outlay — premium for an option buyer, margin for a futures position — which multiplies percentage gains and percentage losses by the same factor.
- Mark to MarketThe daily settlement of a futures position at that day's closing price, so gains and losses are paid in cash every evening instead of accumulating until expiry.
- Option premiumThe price an option buyer pays the seller for the right the contract carries — non-refundable, and made up of intrinsic value plus time value.
- MarginThe money a buyer or seller must deposit before a trade is allowed to stand, so that the clearing corporation is covered if they fail to bring in funds or to deliver securities.
- Initial marginThe deposit both the buyer and the seller of a futures contract must place before the position is accepted, sized to cover a 99% worst-case one-day loss on that position.