Explanation of an omnibus fund’s use of derivatives and reserve management

If it stopped at that point, the omnibus fund would probably attract few investors. It would offer the aggregate return and risk of the publicity-traded corporate sector as if it had never borrowed or issued debt. Aggregate means average. No one is exactly average. Some like me and my father happen to be more risk-tolerant, and opt for the higher returns that tend to come from higher risk. Some prefer the opposite. How can the omnibus fund attract both? The answer is derivatives. Derivatives are obligations whose benefits depend on outcomes imperfectly foreseen. I said in the forward that I’m all in favor of them so long as we respect and manage the risks. Equities themselves are the classical example. Mortgage-backed securities give another. Common forms include futures and swaps. The idea is about the same. Each typically picks an index, often the S&P 500. One party, the “short leg”, bets so much money, the “notional amount”, that the S&P 500 index will go down tomorrow. Another party, the “long leg”, bets it will go up. The short leg gets so much, say Libor plus 20 basis points (hundredths of a percent) of the notional amount, in any outcome. The long leg gets the index change, whether up or down, times the same notional amount. No one actually invests the notional amount. It is called “notional” for good reason. Rather each side (leg) commits a cash reserve, held by the firm managing the swap or future, in this case the omnibus fund itself, of 20% of the notional amount. The reserve is drawn down to meet payments required when market swings are averse, and replenished when favorable. When it falls to 10% of the notional amount, it is considered unsafe and the swap or future ends prematurely. Parties are warned, and new reserves can be committed in time. Monitoring of the reserve is continuous during market hours. Whenever the reserve falls to 10%, even in the middle of the day, the account is closed immediately. This discipline keeps the other party safe. Chapter 8 Banks, Money and Macroeconomics 2/8/16 4 HOUSE_OVERSIGHT_011093