UCITS Investment In Financial Derivative Instruments

Author:Mr Andrew Bates
Profession:Dillon Eustace

UCITS may invest in financial derivative instruments for investment purposes subject to a variety of conditions as outlined below relating to the nature of the exposures taken, the leverage generated through such positions, the process employed by the UCITS to manage the risks arising from derivatives investment as well as rules relating to OTC counterparty exposure and to the valuation of derivatives positions.

The Central Bank has prescribed in detail through its UCITS Notices and Guidance Notes the risk management conditions that must be met by Irish UCITS investing in derivatives.

UCITS are permitted to invest in exchange traded or over-the-counter derivative instruments for investment purposes, subject to certain conditions, in particular, those set down in:

UCITS Notice 9 – which sets out investment restrictions applicable to UCITS including limits on counterparties and certain counterparty criteria; UCITS Notice 10 – which sets out high level derivatives rules including summary of permitted derivatives, cover requirements and risk management requirements; and Guidance Note 3/03 – which contains detailed provisions for the use of derivatives by UCITS. Conditions for the use of derivatives by UCITS As outlined in UCITS Notice 10, UCITS may invest in any type of exchange traded or OTC derivative for investment purposes, subject to the following conditions: the underlying asset relates to UCITS eligible assets (i.e. transferable securities, money market instruments, CIS, deposits), financial instruments having one or several characteristics of these assets, financial indices, interest rates, foreign exchange rates or currencies; the counterparties to OTC derivative transactions are institutions subject to prudential supervision and belong to categories approved by the Central Bank (qualifying credit institutions, MIFID authorised investment firms or an entity subject to regulation as a Consolidated Supervised Entity by the US Securities and Exchange Commission) with a minimum credit rating (in the case of counterparties which are not credit institutions) of A2 or equivalent, or an implied rating of A2 or guaranteed by an entity with a rating of A2; the OTC derivatives are subject to reliable and verifiable valuation on a daily basis and can be sold, liquidated or closed by an offsetting transaction at any time at their fair value at the initiative of the UCITS. Positions may create long or short exposure to the underlying asset and may result in leverage to the portfolio. UCITS that use derivatives for investment (or for EPM) purposes must prepare a Risk Management Process and file it for approval with the Central Bank. In addition, adequate disclosure of derivative investments must be made in the UCITS' prospectus. Specific provisions in this regard are outlined in Guidance Note 3/03. Guidance Note 3/03 Guidance Note 3/03 was produced by the Central Bank to outline clearly the parameters for the use of derivatives by UCITS and to provide guidance on what the Central Bank expects in relation to the measurement and control of derivatives associated risk by UCITS. It was updated as part of UCITS IV in order to reflect the ESMA Guidelines on Risk Measurement and the calculation of Global Exposure and Counterparty Risk for UCITS dated July 28, 2010. Guidance Note 3/03 contains detailed requirements in relation to (i) measuring and controlling global exposure (by the use of the commitment approach or VaR); (ii) the use of OTC derivatives including counterparty risk and issuer concentration; (iii) the use of techniques and instruments (including repurchase and reverse repurchase agreements and stock lending) for the purpose of efficient portfolio management; (iv) cover, reporting, the UCITS annual Financial Derivative Instruments report and prospectus disclosure; and (v) the format and content of the Risk Management Process. Risk Management Process In order to monitor, measure and manage the risk profile of a UCITS, its investment...

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