Chapter 14 - Mutual Funds (Done)

Question 1

What is an alternative mutual fund?

Answer 1

An investment fund that, compared to
a conventional mutual fund, has more
freedom with respect to the use of
derivatives, short selling and leverage,
as prescribed in National Instrument
81-102 Investment Funds.

Question 2

What are the Canadian Securities Administrators?

Answer 2

A forum for the 13 securities regulators
of Canada’s provinces and territories to
coordinate and harmonize regulation
of the Canadian capital markets.

Question 3

What are closed-end funds?

Answer 3

A fund with a fixed number of shares
outstanding. The shares are bought
and sold on a stock exchange instead
of being issued and redeemed the way
a typical mutual fund does.

Question 4

What is a conventional mutual fund?

Answer 4

An investment fund that is subject
to the most conservative set of
investment activities with respect to
the use of derivatives, short selling
and leverage, as prescribed in National
Instrument 81-102 Investment Funds.

Question 5

What is a hedge fund?

Answer 5

A term commonly used to describe
lightly regulated pools of capital that
have great flexibility in their choice of
investment strategies.

Question 6

What are national instruments?

Answer 6

A set of rules and regulations
established by the Canadian Securities
Administrators that is legally binding in
all jurisdictions in Canada.

Question 7

What is NI 81-102?

Answer 7

A set of rules and regulations that
must be complied with by publicly
offered investment funds.

Question 8

What are non-redeemable investment funds?

Answer 8

See Closed-end Fund.

Question 9

What is an offering memorandum fund?

Answer 9

An investment fund not subject
to any of the investment rules and
restrictions in National Instrument 81-
102 Investment Funds, including those
on the use of derivatives, short selling
and leverage.

Question 10

What are structured products?

Answer 10

Investment instruments that combine
at least one derivative with traditional
assets such as equity and fixed-
income securities. The value of the
derivative(s) depend on one or more
underlying assets.

Question 11

Describe the regulatory framework for Canadian investment funds.

Answer 11

From a regulatory perspective, investment funds in Canada fall into two broad categories: those issued with a
prospectus and those issued without a prospectus.
* Investment funds issued with a prospectus include conventional mutual funds (also referred to simply as
“mutual funds”), alternative mutual funds and non-redeemable investment funds (more commonly known as
closed-end funds).
* Investment funds issued without a prospectus include a broad set of funds, including hedge funds, targeted
primarily to institutional investors and high-net-worth individuals. These funds are sometimes referred to as
offering memorandum funds.

Question 12

Describe the specific guidelines under regulation that permit mutual funds to use derivatives for hedging
purposes.

Answer 12

Mutual funds have a wide latitude to use derivatives for hedging purposes. To qualify as a hedge, the derivative
that is used must:
* be intended to offset or reduce a specific risk associated with all or part of a position or positions in the fund;
* have a value with a high degree of negative correlation to the value of the position being hedged; and
* not be expected to offset more than changes in the value of the position being hedged.

Question 13

Demonstrate the ways in which mutual funds use derivatives to hedge.

Answer 13

Mutual funds will mostly use derivatives to hedge long positions in an underlying asset with:
* short forward, futures, and swap contracts;
* long put option contracts; and
* short call option contracts.

Question 14

Describe the specific guidelines under regulation that permit mutual funds to use derivatives for non-
hedging purposes.

Answer 14

Mutual funds may use derivatives for non-hedging purposes within the following guidelines:
* The purchase value of long options (including futures options) must be no more than 10% of the fund’s net
asset value.
* Long forwards and futures must be accompanied by cash, or a combination of cash and certain short-term
marketable securities, equal to or greater than the value of the fund’s obligations under the derivatives
(known as cash cover).
* Short put options (but not futures put options) must be accompanied by cash cover or a right to sell the
underlying interest (for example, a long put option).
* Short forwards, short futures, and short call options (but not futures call options) must be accompanied by
a long position in the underlying interest or a right to acquire the underlying asset (for example, a long call
option).
* Swaps must be accompanied by cash cover or a right to acquire the underlying asset, depending on the
direction of the cash payment.
The requirement for mutual funds to hold cash cover or a position or right to acquire a position in the
underlying interest effectively eliminates the leverage available from these positions.

Question 15

Demonstrate the non-hedging ways in which mutual funds use derivatives.

Answer 15

Mutual funds typically use derivatives for non-hedging to gain investment exposure quickly, effectively and in
a cost-efficient manner. In some cases, derivatives may also be used to provide additional portfolio income
(by selling covered calls) or to provide the opportunity to buy the underlying asset at a lower price than it is
currently trading.

Question 16

Describe the potential disadvantages or risks associated with the use of derivatives by mutual funds.

Answer 16

Some of the risks associated with the use of derivatives include:
1. Basis risk, which arises whenever one kind of risk exposure is hedged with an instrument that behaves in
a similar, but not necessarily identical, manner.
2. The burden of additional monitoring, especially for firms less familiar with monitoring derivatives positions.
The increased effort can, in some cases, impose considerable costs.
3. Potentially limited returns from a strategy such as covered call writing.
4. The cost of hedging, which is either the foregone opportunity to generate windfall gains (as with the
locked-in prices associated when hedging with forwards and futures) or cash losses (outlays for the purchase
of option premiums).

Question 17

Which of the following statements about the use of derivatives to hedge in a mutual fund is not true?
a. The derivative must be intended to offset a specific risk of a position in the fund.
b. The value of the derivative position must be strongly negatively correlated with the value of the position
being hedged.
c. The derivative must not be expected to offset more than changes in the value of the position being hedged.
d. The derivative must be offset before the position that is being hedged is offset.

Answer 17

d. The derivative must be offset before the position that is being hedged is offset.
While a mutual fund cannot maintain a derivatives position for hedging purposes if the position that it is
supposed to be hedging is offset, it can offset the derivative at about the same time that the underlying
position is offset.

Question 18

A mutual fund has $100 million in net assets. What is the maximum value of long options it can hold for
non-hedging purposes?

Answer 18

The fund may hold up to 10% of its net asset value of the fund in long options for non-hedging purposes. In
this case that is $10 million.

Question 19

Describe four potential risks associated with the use of derivatives by mutual funds.

Answer 19

Four potential risks are as follows:
i. Basis risk, which arises whenever one kind of risk exposure is hedged with an instrument that behaves in a
similar, but not necessarily identical, manner.
ii. The burden of additional monitoring, especially for firms less familiar with monitoring derivatives positions.
The increased effort can, in some cases, impose considerable costs.
iii. Potentially limited returns from a strategy such as covered call writing.
iv. The cost of hedging, which is either the foregone opportunity to generate windfall gains (as with the
locked-in prices associated when hedging with forwards and futures) or cash losses (outlays for the
purchase of option premiums).