Offsetting positions

A Category III AIF may not take leverage beyond 2 times its net asset value. So how you measure the exposure decides whether the fund is compliant.

Measure it gross and a hedge looks like risk. Buy Rs 100 crore of a share and sell Rs 100 crore of futures on the same share, and the gross exposure is Rs 200 crore — even though the fund has almost no market view at all.

That is why offsetting exists. The two positions cancel, so the fund's exposure counts as nil rather than Rs 200 crore.

But offsetting is not a free choice. It is allowed in accordance with the SEBI norms for hedging and portfolio rebalancing, and one condition is strict.

The long and the short must be in the same stock, index or commodity, and with the same maturity period. Same underlying is not enough. A long March future against a short June future is not an offset.

Two further deductions help the ratio. Idle cash and cash equivalents are excluded from exposure. So is temporary borrowing that is fully covered by capital commitments from investors.

Section 14.11.2 on positions in the commodity and equity derivatives markets, and section 17.10.3 on prudential norms, together give the whole calculation.

The ratio.

Leverage = Total exposure {Long positions + Short positions (after offsetting as permitted)} ÷ Net Asset Value

and the leverage of a Category III AIF shall not exceed 2 times the NAV of the fund. The leverage ratio shall be calculated at the scheme level.

What goes into total exposure.

• Total exposure is calculated as the sum of the market value of the long and short positions of all securities and contracts held by the fund.
• Idle cash and cash equivalents are excluded while calculating exposure.
• Temporary borrowing arrangements which relate to, and are fully covered by, capital commitments from investors are excluded from the calculation of leverage.
• Offsetting of positions shall be allowed for the calculation of leverage in accordance with the SEBI norms for hedging and portfolio rebalancing.
• Category III AIFs investing in units of other AIFs may undertake leverage not exceeding 2 times the NAV, which excludes the value of investment in units of other AIFs.

The offsetting condition. If a Category III AIF has taken a long position as well as a short position in the same stock, index or commodity, with the same maturity period, such positions can be offset with each other to compute the net exposure towards that single stock, index or commodity.

How each exposure is measured before offsetting.

Under Black-Scholes the option premium is calculated from the underlying asset price, the exercise price, the inherent volatility in the asset price, changes in interest rates and the time to expiry. A change in the premium indicates a change in the probability of the option being in-the-money at expiry.

Which side each contract counts on. Total exposure is computed by adding the exposure in all long positions — long futures and call options — and the exposure in short positions — short futures and put options.

Margins are not exposure; they are an asset. Margins deposited with the broker and the central counterparty — SPAN margin, exposure margin, VaR margin, extreme loss margin, initial margin and mark-to-market margin — are taken as an asset for the purpose of computing NAV. A loss on F&O activity results in an additional liability towards the margin; a profit increases the margin balance and so the asset.

What NAV means for this ratio. NAV is the sum of the value of all securities adjusted for mark-to-market gains and losses, including cash and cash equivalents, and the NAV shall exclude any funds borrowed by the AIF. So borrowing cannot flatter the denominator.

And the manager's continuing duty. The investment manager must maintain the leverage limits and ensure that total exposure after offsetting positions does not surpass twice the NAV — including during the mark-to-market process, where an increase or decrease in the price of the underlying can breach the limit with no trade at all.

Narmada Market Neutral Fund, a Category III AIF, has an NAV of Rs 50 crore. Its permitted total exposure after offsetting is therefore Rs 100 crore — the workbook's own illustrative figures.

Gross positions on 31 March:

Gross exposure, adding everything up: 30 + 30 + 22 + 22 + 20 + 4 = Rs 128 crore, which is 2.56 times NAV. On a gross measure the fund is in breach.

Now apply the rules.

Total exposure after offsetting = Rs 68 crore. Leverage = 68 ÷ 50 = 1.36 times NAV — comfortably inside the 2 times cap.

Note what the maturity condition cost the fund. Had the Vindhya short been a 25 April contract instead of a June one, it would have offset the long and exposure would have fallen to Rs 24 crore, or 0.48 times NAV. The same economic hedge, measured two completely different ways, purely on the expiry date.

Then the market moves, with no trade. In April the NIFTY rallies. The long NIFTY future marks up from Rs 20 crore to Rs 34 crore, and the bought calls are repriced under Black-Scholes at Rs 11 crore. The Vindhya positions mark up to Rs 29 crore each.

New exposure = 29 + 29 + 34 + 11 = Rs 103 crore. If NAV has risen only to Rs 51 crore, leverage is 103 ÷ 51 = 2.02 times — a breach, caused entirely by mark-to-market.

The clock then runs, and the workbook's protocol is precise:

About Rs 1 crore of excess exposure has to go. And if the fund had Rs 8 crore of borrowing outstanding, it could not add that to NAV to fix the ratio — NAV excludes any funds borrowed by the AIF.

Chapter 14 (Valuation), section 14.11.2 (Positions in Commodity Derivatives and Equity Derivatives Markets), covers the valuation of derivative positions and the computation of total exposure; Chapter 17, section 17.10.3 (Prudential Norms), states the 2 times NAV cap and the leverage formula, and the breach protocol follows immediately after.

The examinable core is the offsetting condition: a long and a short in the same stock, index or commodity with the same maturity period may be offset. Expect the two exclusions — idle cash and cash equivalents from exposure, and temporary borrowing fully covered by capital commitments from the leverage calculation — and the definition of NAV, which excludes borrowed funds. Expect a calculation question giving gross long and short figures and asking for the leverage ratio; the marks turn on which pairs may be netted. The T-day measurement rules are also asked: futures price times contracts for futures, premium paid for options.

• Same underlying is not enough. The maturity must match too. A long April future against a short June future on the same stock does not offset.
• Offsetting is permitted in accordance with SEBI norms for hedging and portfolio rebalancing. It is not a general netting right the manager may apply as it sees fit.
• Call options count as long exposure and put options as short exposure. Two bought options on the same index do not offset each other just because one is a call and one a put — both are bought, and the workbook puts them on opposite sides of the sum.
• Idle cash is excluded from exposure, but cash and cash equivalents are included in NAV. Two different sides of the ratio, two different treatments.
• NAV excludes borrowed funds. Borrowing cannot be used to inflate the denominator and rescue the ratio.
• The cap is 2 times NAV, measured at the scheme level, not at fund or manager level.
• For a Category III AIF investing in units of other AIFs, the 2 times NAV is computed on a NAV that excludes the value of those units.
• Options are valued at premium paid on T-day and by Black-Scholes thereafter. Using the notional contract value on day one overstates exposure.
• A breach can happen with no trade. Mark-to-market alone can push exposure through the cap, which is why the manager must monitor continuously.