Guest Contributer: Steve Carrier-Simon, Buy-side Sentinel Product Manager, Fidessa
The implications of UCITS IV are being widely debated. And market watchers will all have their own areas of interest. What will be the tax issues? What will it mean for cross border mergers? How will master feeder structures be affected? Etc…etc
The area that got me thinking and will send the quants’ minds racing can be found in chapter six of the new rules. It covers the calculation for the derivatives commitment ratio.
The new approach will provide a more accurate measure of rate and credit derivatives exposure and will amend techniques, such as synthetic replication, which have failed to provide a true reflection of portfolio risk in the past.
Following the financial crisis, it’s become clear the regulators have understood there is a need for change and secured a place in the new rules for a revolutionary commitment ratio.
Under UCITS IV instead of working out absolute values, different sub-calculations are now to be conducted by derivative type. Each is calculated, pre-compensated and re-netted differently and then aggregated up to the limit of the fund’s net asset value.
All well and good, however the rate instrument derivatives sub-calculation will prove to be extremely complex as it recognises that interest rates with different maturities are linked and so applies modified duration as a factor. CESR has proposed two calculation methods which allow for the netting and hedging of positions. It will now be down to the asset manager to select the most suitable option. That said, to begin with firms will no doubt employ both to determine which gives the most accurate measure of portfolio risk.
The lack of standard market practice for this calculation will require a dialogue between buy-sides to define an appropriate common approach for implementation. It will be interesting to take part in these conversations and to ultimately see how these new measures stand the test of time once put into practice. However, while there is still uncertainty around this, one thing for sure is that the new commitment ratio represents a radical new measurement technique.