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					 INSURANCE AND SUPERANNUATION
          COMMISSION


        SUPERANNUATION CIRCULAR
                NO. II.D.7


                        DERIVATIVES


                    17 FEBRUARY 1997


(Note:       Following amendments to SIS Regulation 13.15A,
             references to Risk Management Statement in this Circular
             should be read as references to Derivative Risk Statement.
                                                            July 2006)




17 February 1997                                              II.D.7
                                          2


Contents                                                             Page
Summary                                                                      3

Introduction                                                                 5

Investment strategy requirements of SIS                                      6

Other SIS requirements                                                       7

ISC objectives                                                               7

Improper use of derivatives                                                  8

Risk Management and Risk Management Statements (RMS)                        9

     Industry consultation                                                   9

     Specific requirements for risk management statements                   10

     -    Excluded funds                                                    10

     -    Funds whose only investment is through collective
          investment schemes                                                11

Risk considerations                                                         11

     Restrictions on use of derivatives                                     11

     Exposure limits                                                        12

     Treatment of options                                                   12

RMS developed to meet other ISC requirements                                12

Appendix 1 - Guidelines for preparing risk management statements            14

Appendix 2 - Glossary                                                       37




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Summary
The Circular revises and up-dates the November 1995 Circular of the same name
and incorporates the ‘Guidelines for preparing risk management statements’
which were released in April 1996. This Circular also announces a number of
important changes relating to the regulation of derivatives in the superannuation
industry.

The principal change results from a modification of Superannuation Industry
(Supervision) Regulation 13.14. The effect of the modification is to allow a
trustee to create a charge over the assets of a fund where the charge is in relation
to a derivative transaction conducted on a recognised exchange. This change,
however, does not alter the prohibition on borrowing or gearing established
under the SIS Act. A risk management statement must also be completed in
accordance with this Circular for such derivative transaction to be allowed. See
paragraphs 14 -17.

The modification declaration also alters Part 2 of the SIS Regulations to require
a trustee to provide information to members of the fund, and to the
Commissioner, if the derivatives charge ratio of the fund exceeds five percent at
any time during a reporting period. The derivatives charge ratio is the
percentage of the total assets of the fund (by value) that the trustee has
mortgaged or charged as security for derivative investments made by the trustee.
See paragraphs 14 - 17.

This change will enable members to be more informed of the amount of fund
assets that are charged for derivative investments. It will also allow the
Commission to become better aware of any large exposures, and to determine
whether to seek additional information and / or conduct further investigations.
See paragraphs 14 - 17.

The modification also has the result of requiring trustees of excluded funds who
wish to undertake a derivative transaction on an Australian or international
exchange, and in doing so granting a charge over the assets of the fund, to
prepare a RMS in accordance with this Circular. See paragraph 30.

The Circular also seeks to clarify the role and duties of the trustee whose only
derivative investment is through collective investment schemes. In essence, the
ISC believes that the trustee must carefully assess whether the derivative use of
the collective investment scheme is in accordance with the investment strategy
of the fund. The Circular also notes that the ISC will be looking for evidence of


17 February 1997                                                        II.D.7
                                       4


this consideration when undertaking prudential reviews of these funds. See
paragraphs 31 -33.

Other changes include a new section to explain the differing RMS requirements
which apply to general insurance and life insurance companies and that these
requirements should be considered when preparing a RMS. See paragraphs 41 -
 44.

The risk management statement is now required to include a date at which the
trustee or investment manager authorised the particular RMS. See Appendix 1.




17 February 1997                                                   II.D.7
                                          5



Introduction
1.     This Circular revises and up-dates Superannuation Circular II.D.7,
entitled ‘Derivatives’ released in November 1995. It also incorporates the
‘Guidelines for preparing risk management statements’ released by the
Insurance and Superannuation Commission (ISC) in April 1996.

2.    This Circular generally addresses the controls that the ISC considers are
necessary where superannuation funds use derivative instruments. The use of
such investments may be made as part of an investment strategy developed in
accordance with the Superannuation Industry (Supervision) Act 1993 (SIS).

3.     For the purposes of this paper, a derivative is treated as: ‘a financial asset
or liability whose value depends on (or is derived from) other assets, liabilities
or indexes (the “underlying asset”)’.

4.     Derivative transactions are financial contracts and include a wide
assortment of instruments, such as forwards, futures, options, warrants, swaps,
share ratios and other composites.

5.    A brief description of some of the more commonly used derivatives, and
some other technical terms used in this paper, is set out in Appendix 2 -
Glossary.

6.     Superannuation funds, approved deposit funds (ADFs) and pooled
superannuation trusts (PSTs) are referred to collectively as superannuation
entities in SIS. In this Circular, superannuation funds, ADFs and PSTs will be
referred to collectively as funds.

7.     A major thrust of SIS is to ensure that each fund has one responsible
entity. That responsible entity is the fund trustee who has the prime
responsibility for ensuring prudent management of the fund.

8.     Trustees’ fiduciary duties have been established through common law.
SIS codifies some of the most important duties in formal covenants. For trustees,
SIS means their basic duties are clearly spelt out. For members, SIS establishes
statutory rights to civil action for loss or damage due to breach of the covenants.




17 February 1997                                                        II.D.7
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Investment strategy requirements of SIS
9.     Section 52 of SIS provides that certain covenants are to be included, or
taken to be included, in the governing rules of funds. One of these covenants,
contained in SIS paragraph 52(2)(c), requires trustees to exercise their duties and
powers in the best interests of beneficiaries.

10. The covenant contained in SIS paragraph 52(2)(f) relates to investment
strategy.

11. The investment strategy covenant requires trustees to formulate and give
effect to an investment strategy which has regard to the whole of the
circumstances of the fund including, but not limited to, the following:

• the risk involved in making, holding and realising, and the likely return from
  the fund’s investments having regard to its objectives and its expected cash
  flow requirements;

• the composition of the fund’s investments as a whole including the extent to
  which the investments are diverse or involve the fund in being exposed to risk
  from inadequate diversification;

• the liquidity of the fund’s investments having regard to its expected cash flow
  requirements; and

• the ability of the fund to discharge its existing and prospective liabilities.

12.   In summary, trustees are responsible for:

• determining an investment strategy/strategies following consideration of
  relevant factors including those outlined in paragraph 10 of this Circular;

• selecting investments for inclusion in each strategy consistent with the fund’s
  objectives;

• monitoring on an ongoing basis whether investments remain consistent with
  investment strategies;




17 February 1997                                                         II.D.7
                                          7


• monitoring on an ongoing basis whether the investment strategies remain
  appropriate for the fund; and

• periodically informing members of investment strategies and objectives.

13. Any investment in derivatives must be seen in the context of the fund’s
overall investment strategy.


Other SIS requirements
14.    The Commissioner has modified the SIS Regulations to allow a trustee to
create a charge over the assets of a fund where the charge is in relation to a
derivatives transaction conducted by the trustee, or someone on their behalf
(such as an investment manager), on an Australian or international exchange.
The charge must be in relation to the derivatives contract and for the purpose of
securing the trustee’s obligations to the exchange.

15. Additionally, for the transaction to be allowed, the trustee must have
prepared a RMS in accordance with this Circular.

16. In addition, trustees must now to report to members at the end of a
reporting period if, at any time during the reporting period, the derivative charge
ratio of the fund exceeded 5 percent. The derivative charge ratio must be
expressed as a percentage and is determined by the following formula:

      (the value of the assets of the fund that are subject to a charge in relation
      to a derivatives contract) ÷ (the value of all the assets of the fund)

17. The trustee must also give this information to the Commissioner as soon as
practicable, but in any event within 6 months, after the end of the reporting period
to which the information relates.


ISC objectives
18. Trustees of funds which use derivatives should have in place appropriate
policies for the use of derivatives, adequate controls on the use of derivatives,
and adequate checks on compliance with those controls. These policies and
controls should prevent any improper use of derivatives.



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                                         8


19. Derivatives should not be considered in isolation but as part of the
investment strategy of the fund as a whole, having regard to the risk/return
characteristics of all assets in the investment portfolio.

20. In particular, derivative exposure combined with physical exposure
should not result in a net exposure which is inconsistent with the fund’s
investment strategy. For instance, if trustees have set a strategy, part of which
sets a minimum exposure to Australian equities of 25% of the fund’s assets and
a maximum exposure of 50% then the net exposure taking account of both the
physical and derivative exposure should remain within these limits.

21. As part of its fund review process the ISC will also be reviewing the RMS
and looking for evidence that the trustee has properly considered risk and risk
management in relation to its investments. This applies not only to derivatives
but also to other investments.


Improper use of derivatives
22. Derivatives should not be used for ‘speculation’. As ‘speculation’ can
mean different things to different people it is defined for the purposes of this
Circular to mean investment activity which results in one or more of the
following:

• the net exposure of the fund to an asset class (e.g. Australian equities) being
  outside the limits set out in the fund’s investment strategy. (Net exposure is
  exposure taking account of both physical and derivative exposure);

• the risk involved for the whole portfolio being outside that which the trustees
  considered appropriate when they developed and approved the fund’s
  investment strategy;

• the fund holding uncovered derivatives (see definition of covered in
  Appendix 2);

• the fund’s total portfolio being ‘geared up’ through derivatives to circumvent
  the limitations imposed by Sections 67, 95 and 97 of the SIS Act on
  borrowings.




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Risk Management and Risk Management
Statements (RMS)
23. Whether funds are invested in derivatives directly, through collective
investment schemes or through external investment managers, trustees
should regularly review their investment strategy policies and risk
management policies in relation to derivative investments in order to ensure
that the covenants contained in SIS paragraphs 52(2)(c) and 52(2)(f)
continue to be met at all times.

24. In particular, trustees of funds investing in derivatives (other than only
through one or more collective investment schemes where paragraphs 31 - 33
applies) should:

• have satisfactory risk management practices for derivatives evidenced by a
  Risk Management Statement (RMS). The RMS should include exposure to
  physical assets as well as derivatives. In particular, the risk management
  practices should effectively exclude the improper use of derivatives (see
  paragraph 22);

• make specific comment, where they use derivatives, on the Annual Return for
  1996-97 and subsequent years lodged with the ISC that they have approved
  the RMS, that they understand its content and that they have monitored the
  operation of the RMS and have received regular reports;

• implement satisfactory internal and external audit procedures; and

• require their external auditors to report on whether a RMS is in place and, if
  so, the extent of compliance with the RMS.

Industry consultation

25. The detail of the Risk Management Statement was developed in close
consultation with the superannuation industry. In March 1995 the ISC issued a
discussion paper ‘Derivatives in Superannuation’. This led to the formation of
an industry taskforce, made up of industry representatives and ISC officers,
which discussed and considered the most appropriate format for a Risk
Management Statement to be used by superannuation fund trustees.

26. There was a clear view by the taskforce that, instead of direct regulation
by legislation, it would be preferable to require increased disclosure of controls

17 February 1997                                                       II.D.7
                                        10


through Risk Management Statements. This would ensure that trustees had
properly met their duties to consider the risks associated with derivative
investments in relation to the fund as required by the investment strategy
provisions of the SIS Act.


Specific requirements for risk management statements

27. Appendix 1 sets out the guidelines which have been prepared to provide
trustees with assistance in ensuring that an appropriate RMS is in place when
derivatives are used in the investment of superannuation funds. If trustees
properly consider, prepare and adhere to an RMS in accordance with the
guidelines this will provide evidence to the ISC that trustees have given proper
consideration to ensuring that the covenants contained in SIS paragraphs
S52(2)(c) and 52(2)(f) have been met. It is, however, the responsibility of the
trustee to give full and proper consideration of the circumstances of each fund
and any appropriate changes to the structure as set out in the guidelines should
be made before an RMS is adopted.

28. The use of the guidelines cannot be taken to guarantee that the fund
complies with all legislative requirements nor that there will be no risk
associated with the use of derivatives.

29. The trustee should ensure that its investment strategies and objectives in
using derivatives and its reporting requirements are adequately reflected in
contracts with any investment managers. Compliance with investment
management contracts must be monitored by the trustee on an ongoing basis.


Excluded funds

30. Generally an excluded fund (i.e. a fund with fewer than five members)
does not require a formal RMS for derivatives although trustees of such funds
may choose to introduce one as an aid to formulating and formalising their
control processes. However, if an excluded fund wishes to undertake a
derivatives transaction on an Australian or international exchange, and in doing
so a charge is created over the assets of the fund (eg to meet the obligations of
the exchange for collateral), then the fund must prepare a RMS in accordance
with Appendix 1 (see also paragraphs 14 - 17).


Funds whose only investment is through collective investment schemes


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                                         11


31. A fund whose only exposure to derivatives is through a collective
investment such as a PST, unit trust or life insurance policy will not require a
RMS. However, before investing in a collective investment and during any
subsequent review process, the trustee should consider the return likely to be
achieved from the collective investment and the risks involved. The risks
include those from the use of derivatives.

32. The ISC believes that the trustee must carefully assess whether the
derivative use of the collective investment schemes (both individually and in the
aggregate) is in accordance with the investment strategy of the fund. The ISC
will be looking for evidence of the trustee’s consideration of these risks, as well
as the manner in which the overall investments of the schemes relate to the
investment strategy of the fund, when undertaking prudential reviews.

33. Trustees should also carefully consider the information under the heading
‘Investment in collective schemes’ contained in Appendix 1.


Risk considerations
34. When looking at investment strategy policies and risk management
policies in relation to derivative investments trustees should consider the
following paragraphs.


Restrictions on use of derivatives

35. The variation in derivative products is enormous. The trustee should
consider whether it is appropriate for the fund to be involved in some types of
derivatives. The trustee should properly consider the use, for each fund, of the
following derivatives. It may be appropriate to rule out or restrict their use
where:

• the potential exposure cannot be reliably measured;

• closing out of a derivative is difficult considering the illiquidity of the market;

• the derivative is not readily marketable (e.g. over-the-counter rather than
  exchange traded derivatives); or

• the counterparty is not suitably creditworthy.


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Exposure limits

36. Derivative exposure should be considered in the context of the fund’s
overall investment strategy. In particular, derivative exposure combined
with physical exposure should not result in a net exposure which is
inconsistent with the fund’s investment strategy.

37. Trustees should consider setting exposure limits for derivatives taking
account of the uncertainty caused by all types of risks such as credit, market,
liquidity, counterparty, operations and legal risk. Serious consideration should
be given to having quantitative limits for the exposure to any one counterparty
(taking account of the credit risk of the counterparty) particularly in relation to
‘over-the-counter’ transactions.

38. To determine the level of those exposure limits the trustee should address
the types of risks involved in their investment portfolio and adjust these limits
accordingly. For example, the level of uncertainty caused by credit, legal and
operations risk (e.g. incorrect calculation of exposure) is significantly less for
exchange traded as opposed to over-the-counter (OTC) derivatives. Therefore, a
portfolio trading predominantly in exchange traded derivatives may allow for
higher exposure limits than if the portfolio invested predominantly in OTCs.


Treatment of options

39. The ISC considers that in calculating the effective exposure of options the
‘delta’ equivalent should be used. The ‘delta’ of an option is the expected
increase or decrease in the option premium given a small change in the value of
the underlying security. For example, if the option premium is expected to
increase or decrease by 1 cent for every 2 cents price movement in the
underlying security the delta is 1 ÷ 2 = 0.5. So in this case the delta equivalent
exposure in shares to the option is 0.5 shares per option.

40. As the ‘delta’ equivalent approach is only appropriate for small changes
in the price of the underlying security, where large option positions are held
worst case scenario analysis should be carried out as a matter of course.



RMS developed to meet other ISC requirements


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                                      13


41. Appendix 1 provides guidelines for trustees of superannuation funds to
prepare an RMS. It is important to note that different requirements apply to
general and life insurance companies. These requirements are set out in:

• General Insurance Circular No G 3/95; and
• Life Insurance Circular No C.I.1.

42. Directors of life insurance companies should consider the requirements
detailed in these Circulars before preparing an RMS they propose to make
available to superannuation fund trustees who invest in their life insurance
policies.

43. Circular C.I.1 requires more detailed explanation of various aspects of
derivative controls so will generally include more information than an RMS
prepared in accordance with Part B of the Appendix. The Commission generally
considers that an RMS produced to meet the requirements set out in Circular
C.I.1 would be sufficient to meet the requirements for a Part B RMS albeit in a
different format. However, directors of life companies may consider that the
different purposes underlying a RMS developed under C.I.1 results in it
containing commercially sensitive information. They may therefore wish to
prepare an abridged version of that C.I.1 RMS which meets the Part B
requirements for provision to superannuation trustees.

44. It is important to note however that the core requirements for all
RMS are the same regardless of whether they have been prepared for
general insurance companies, life insurance companies or for
superannuation trustees.




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Appendix 1 - Guidelines for preparing risk
management statements

Contents                                                 Page
Preface                                                         17

Document structure:                                             18

     1. Direct investment                                       20

     2. Investment in collective schemes                        20

     -    PSTs and life products                                21

     -    Other collective investments                          21

     3. Employment of an external investment manager            22

Reporting to the ISC                                            22

Part A - Fund Reference Risk Management Statement               24

Superannuation funds                                            24

     1. Name of superannuation fund                             24

     2. Objective of this statement                             24

     3. Fund overall investment strategy                        24

     4. Strategy delegated to investment manager                25

     5. Identification of investment manager RMS                25

     6. Trustee authorisation of use of derivatives             25

     7. Date of authorisation by trustee                        26

Collective investments                                          26

17 February 1997                                       II.D.7
                                        15



     1. Name of collective investment                              26

     2. Objective of this statement                                26

     3. Overall investment strategy                                26

     4. Strategy delegated to investment manager                   26

     5. Identification of investment manager RMS                   27

     6. Authorisation of use of derivatives                        27

     7. Date of authorisation by manager / trustee                 27

Part B - Detailed Risk Management Statement                        28

     1. Responsible party name                                     28

     2. Objective of RMS                                           28

     3. Definition of derivatives                                  28

     4. Relationship to investment strategy of the fund            29

     5. Purpose of the use of derivatives                          29

     6. Restrictions on the use of derivatives                     30

     7. Risk analysis                                              30

     -    7(a) Market risk                                         30

     -    7(b) Liquidity risk                                      32

     -    7(c) Counterparty (Credit) risk                          32

     -    7(d) Operations risk                                     33

8. Currency                                                        33

9. Personnel management                                            34


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                                     16


10. Assessment of controls                                                34

11. External audit                                                        35

12. Reporting to trustees                                                 35

    Direct                                                                35

    External investment management (including collective investments)     35

13. Date of approval of Part B RMS                                        36




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Preface
The Insurance and Superannuation Commission (ISC) is concerned to ensure
that portfolio risk assumed by superannuation entities properly reflects the
investment strategy of the fund that has been developed and adopted by the
trustees. In particular, the ISC wishes trustees to be aware of, and to focus on,
the impact derivatives can have on the investment profile of a fund. The ISC
believes that this can best be achieved by way of formal Risk Management
Statements (RMS).

It is envisaged that these guidelines will cover most circumstances but there may
be situations where the guidelines are not directly applicable. In such cases the
trustees should satisfy themselves that appropriate risk management controls are
in place and are consistent with the principles of these guidelines.

Funds may use derivatives in three broad ways:

1. trustees invest directly in derivatives (i.e. using their own staff and systems);

2. trustees invest in a collective investment scheme or schemes;

3. trustees have employed an external investment manager to manage all or part
   of their investments as an individually managed portfolio, and the manager
   uses derivatives in managing assets of the fund. Where a separate legal entity
   to the trustee is responsible for investment management, that entity is an
   external investment manager for the purposes of these guidelines even if the
   trustee and that entity are related companies.

In each case there will be practical differences in how the principles of an RMS
should be implemented. For ease of reference the ISC has developed one form
of RMS that is applied in different manner for each of the above cases.

If a fund uses derivatives in more than one fashion, there should be an overall
RMS that draws together each separate portion - i.e. one or more of direct,
collective and external investment management.

These guidelines have been prepared to provide trustees and investment
managers with assistance in ensuring that appropriate Risk Management
Statements are in place when derivatives are used in the investment of
superannuation funds. It is the responsibility of the trustee to give full and
proper consideration of the circumstances of each fund and any



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                                         18


appropriate changes to the structure as set out in these guidelines should be
made before an RMS is adopted.

The use of these guidelines cannot be taken to guarantee that the fund
complies with all legislative requirements nor that there will be no risk
associated with the use of derivatives.

Where a fund uses derivatives in circumstances outside these guidelines the
trustees should be satisfied that their risk controls are adequate, and be able to
demonstrate this if necessary.


Document structure:
The approach taken in this document is divided into two parts:

A.   Part A is a ‘Fund Reference RMS’ which sets the framework for derivative
     investment and links it to the fund’s investment strategy.

B.   Part B is a detailed RMS which covers all detailed aspects of derivatives
     use and control by the party responsible for implementation of derivative
     investment decisions.

Part B requirements should be in place from 1 July 1996 whenever derivatives
are used. Part A requirements should be in place from 1 July 1997.

It is expected that the Fund Reference RMS would refer to other documentation
that relates to establishing the investment profile of the fund. This could include
documents such as investment management agreements and investment
mandates in the case of external managers, delegations to staff in the case of
direct investments or trust deeds in the case of collective investments.

Part B does not seek to prescribe in detail day to day decision making or
administration issues such as verifying stock registration, assessing market
liquidity or identifying credit limits to particular counterparties of investment
managers. These details will be left to the professional expertise of the parties
concerned who have a fiduciary duty and defined standards of care to make
detailed decisions on a commercial and prudent basis.

The Part B RMS should be structured in a way that makes the appropriate
standards visible and apparent and capable of external review or audit. As part
of its fund review process the ISC will also be reviewing the RMS.


17 February 1997                                                        II.D.7
                                        19



The general principle that should be followed is that the organisation or person
responsible for actually investing money should have appropriate risk controls.
In addition there should be a ‘chain’ of RMS statements, or equivalent
information, between the responsible entity and the entity actually doing the
investments. Disclosure of the ‘chain’ need not be automatically provided to
every investor but it must be able to be sighted (eg by external auditors and the
ISC) and be available on request.

The structure by which Parts A and B should be applied will vary in each of the
three ways in which derivatives can be used (and which are outlined above).
This is summarised in the following table. Note that in relation to collective
investment schemes the responsibility will vary depending on whether the
scheme is regulated under SIS or under the Corporations Law (CL). For a SIS
scheme the trustee is responsible, and for a Corporations Law scheme (CL) the
manager is responsible for preparing a Part B statement.


Part    Party               Party responsible for              Party responsible
        responsible for     completion for                     for completion for
        completion for
        direct              collective investment              external
        investment                                             investment
                                                               management
A       Fund trustee        Trustee (SIS) /manager (CL) of     Fund trustee
                            collective investment
B       Fund trustee        Direct           Via external      Investment
                            investment       investment        Manager
                                             manager
                                             External
                            Trustee (SIS) manager
                            /manager (CL)
                            of collective
                            investment




17 February 1997                                                      II.D.7
                                         20



1.    Direct investment

The extent and detail of the RMS will depend on the degree to which the fund is
engaged in derivative investments. However, the trustee is expected to develop
an RMS that fully covers all matters raised in both Parts A and Part B of the
attachment.


2.    Investment in collective schemes

For the purpose of these guidelines, collective investments may be divided into
two groups - SIS collective investments (i.e. PSTs and life company products)
which are subject to the RMS requirements imposed by the ISC, and other
collective investments (e.g. overseas unit trusts, or unit trusts regulated under the
Corporations Law).

While listed trusts are not considered to be collective investments, for the
purposes of these requirements if a trustee does invest in a listed trust which
uses derivatives then the trustee should consider the possible derivative exposure
when preparing their Part A RMS.

Capital guaranteed life insurance policies, while they may be considered as
collective investments, may generally be disregarded for RMS purposes.
Trustees investing in capital guaranteed policies may consider it relevant to
request the life company to provide information on their internal risk control
processes.

A Part A RMS is not required to be prepared by the trustee where a trustee’s
sole derivative exposure is through a collective investment scheme. The trustee
should, however, obtain and consider the minimum level of disclosure set out
below from the collective investment scheme.

These guidelines set out a minimum level of disclosure which should be
expected from collective investment schemes which use derivatives. If a trustee
of a superannuation fund is unable to obtain disclosure which meets these
minimum standards then the trustee should consider whether it would be prudent
to invest in the particular collective investment scheme.

Collective investment schemes which meet the minimum level of disclosure set
out below cannot be guaranteed to have disclosed all relevant facts about
derivatives activity. Nor can it be guaranteed that there will be no risk


17 February 1997                                                        II.D.7
                                        21


associated with the use of derivatives by the collective investment. Trustees
may in general or in specific cases want to obtain more information about the
use of derivatives and risk management practices (such as a Part B RMS) in
order to make a more fully informed decision on an investment in a collective
investment scheme.

Trustees should always obtain sufficient information (not limited to information
on derivative activities) on a collective investment to allow them to make an
informed decision about investing in that scheme and whether such an
investment is appropriate in terms of the investment strategy of the fund.

Where a trustee does obtain an RMS from a collective investment scheme, the
trustee must properly consider the RMS. The trustee is responsible for the
decision to invest assets of the fund in the collective investment scheme(s) and
an assessment of the RMS is an integral part of the trustees’ decision making
process.

The ISC will be looking for evidence of such consideration when undertaking
prudential reviews of funds.


PSTs and life products

For SIS collective investments, the trustee of the superannuation fund should
obtain a copy of the RMS for the life company or PST, and be informed of any
changes to that RMS. If the PST trustee or life company uses external
investment managers to implement investment decisions (as opposed to their
simply providing advice), the trustee of the superannuation fund should obtain at
least a copy of Part A of the PST’s or life company’s total RMS. The PST
trustee or life company should make Part B of the total RMS available to
investors on request. In respect of investments by the superannuation fund in a
capital guaranteed life insurance policy the life company is not required to
provide an RMS in respect of this investment.

There must be regular and comprehensive reporting by the PST or life company
on asset exposures to the trustees of the fund. In particular, the trustee must
ensure that they are regularly informed of the aggregate portfolio exposure,
including the impact of derivatives.


Other collective investments




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                                         22


As other collective investments are not subject to the same prudential
supervision as PSTs and life products, the trustee needs to be fully satisfied as to
the risks involved. The trustee of the superannuation fund should get full
information at least to the extent as would be obtained from a corresponding
PST, and in particular should obtain sufficient information for the trustee to be
satisfied on all issues raised below in Parts A and B.

As with SIS collective investments, there must be regular and comprehensive
reporting by the manager of the collective scheme on asset exposures to the
trustees of the fund. In particular, the trustee must ensure that they are regularly
informed of the aggregate portfolio exposure, including the impact of
derivatives.


3.    Employment of an external investment manager

Where trustees have employed the services of an external investment manager
the approach to be taken is for the trustee to prepare Part A and the investment
manager to prepare an Investment Manager RMS (IMRMS) which meets Part B.
It is anticipated that each manager will prepare a generic Part B for all portfolios
where risk management practices for derivatives are uniform throughout the
investment management organisation.

The objective of the IMRMS will be to clearly identify the investment
manager’s credentials and resources in the area of derivative management. It is
expected that investment managers are professionally equipped to manage
financial assets, and derivatives in particular. However, the IMRMS will seek to
clearly spell out the resources such as staff functions, investment tools and
reporting systems that each manager has available and to show how these
resources are used to ensure that derivatives are appropriately managed.

The trustee must make reasonable checks on the sufficiency and adequacy of the
risk control processes set out in the IMRMS.


Reporting to the ISC
Trustees will be required in their annual fund return to the ISC to report on their
use of derivatives and their risk management practices. The questions set out
below are expected to be introduced in the 1996/97 return. Prior year returns
seek somewhat different information.



17 February 1997                                                        II.D.7
                                       23


1.    Does the fund invest in derivatives:

      •      directly; or
      •      via a collective investment (ie PST or unit trust); or
      •      via a mandate set out in an agreement with an investment manager

2.    Does the trustee have a specific risk management statement (RMS) in
      place covering use of derivatives?

3.    Does this RMS comprise both Parts A and B as set out in Superannuation
      Circular No II.D.7?

4.    Is there a monitoring program in place to ensure that the risk management
      statement has been adhered to?

5.    Has the trustee Board received regular reports during the year on the
      derivatives position of the entity?




17 February 1997                                                     II.D.7
                                        24



Part A - Fund Reference Risk Management
Statement
Two versions of Part A are given - one relating to superannuation funds, and the
other to collective investments


Superannuation funds

This document is to be prepared by Fund Trustees for each superannuation
entity for which derivative investments are made whether such investments are
made by the trustee directly or by external investment managers who in turn use
derivatives.


1.    Name of superannuation fund


2.    Objective of this statement

Part A identifies all cases where derivatives are used by the fund itself, whether
directly by the trustees or by external investment managers acting under a
mandate from the trustees. It also identifies all collective investments used by
the fund where the collective investment uses derivatives. It confirms whether
all these derivative investments are made under appropriate controls - ie Part B
of an RMS has been prepared by the trustee if the trustee uses derivatives
directly, and all external investment managers / collective investment schemes
who are authorised to use derivatives have completed an appropriate Investment
Manager RMS.

It also confirms that the trustees have communicated to each such manager the
component of the fund’s overall investment strategy which is to be implemented
by the manager and to be subject to risk management in accordance with the
Investment Manager RMS. In respect of collective investments, it confirms that
the trustee has received copies of Part A of an RMS prepared by the
trustee/manager of each collective investment which uses derivatives.


3.    Fund overall investment strategy




17 February 1997                                                      II.D.7
                                        25


This section should identify where the fund’s overall investment strategy is
recorded (e.g. “in the document entitled Statement of Investment Objectives and
Policies dated DD/MM/YY”).


4.    Strategy delegated to investment manager

This section should identify each of the collective investment schemes and
external and internal investment managers used and the area of investment
strategy contractually delegated to each manager. It should also
specify/summarise the required documentation and timing of communication by
the Trustees to each manager of instructions in relation to assets managed for the
fund. Where a separate legal entity to the trustee is responsible for investment
management, that entity is an external investment manager for the purposes of
these guidelines even if the trustee and that entity are related companies.


5.    Identification of investment manager RMS

This section should include the effective date of the latest Investment Manager
RMS (both internal and external) and make reference to the investment
manager’s confirmation to the trustees that the RMS is subject to external audit
and that it applies to the assets managed for the fund for the delegated strategy.


6.    Trustee authorisation of use of derivatives

The trustee must recognise that they are responsible for the investment strategy
of the fund as implemented by the manager including the use of derivatives.

The trustee must determine that the use of derivatives is permitted by the
governing rules of the fund. The trustee must also be satisfied that the purposes
of the use of derivatives as stated by each manager in their IMRMS is consistent
with the investment strategy of the fund and also the implementation of that
strategy as agreed between the trustee and each manager. An appropriate
statement indicating that that the trustee has considered these matters and is
satisfied that the use of derivatives meets these requirements should be included
in the RMS.

Where more than one manager is used there must be an assessment of the overall
use of derivatives against the objectives and investment strategy for the whole
fund. An appropriate statement covering this aspect should be included in the
RMS.

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                                       26




7.    Date of authorisation by trustee

The RMS should include a date as at which the trustee authorised the particular
RMS.


Collective investments

This document is to be prepared by the party responsible for the collective
investment (ie the trustee for a PST, the manager or trustee for a Corporations
Law unit trust (as may be appropriate in each case), and the life company for a
life product) and a copy obtained by the superannuation fund trustee.


1.    Name of collective investment


2.    Objective of this statement

Part A identifies the cases in which derivatives are used by the collective
investment. It confirms whether all these derivative investments are made under
appropriate controls - ie Part B of an RMS has been prepared in respect of all
derivative uses. If the collective investment uses external investment managers
then it also confirms that each investment manager has been told the component
of the overall investment strategy which is to be implemented by that manager
and which is to be subject to risk management in accordance with the
Investment Manager RMS.


3.    Overall investment strategy

This section should identify where the overall investment strategy of the
collective investment is recorded (e.g. “in the document entitled Statement of
Investment Objectives and Policies dated DD/MM/YY”).


4.    Strategy delegated to investment manager

This section should identify each of the external investment managers and
internal resources used and the area of investment strategy contractually
delegated to each manager. It should also specify/summarise the required


17 February 1997                                                     II.D.7
                                        27


documentation and timing of communication by the trustees to each investment
manager of instructions in relation to assets managed for the collective
investment.


5.    Identification of investment manager RMS

This section should include the effective date of the latest Investment Manager
RMS (both internal and external) and make reference to the investment
manager’s confirmation to the trustees that the RMS is subject to external audit
and that it applies to the assets managed for the Fund for the delegated strategy.


6.    Authorisation of use of derivatives

The responsible party must determine that the use of derivatives is permitted by
the governing rules of the collective investment, and must also be satisfied that
the purposes of the use of derivatives are consistent with the overall investment
strategy and a statement to this effect should be made in the RMS.

Where more than one manager is used there must be an assessment of the use of
derivatives against the objectives and investment strategy for the whole
portfolio. An appropriate statement covering this aspect should be included in
the RMS.


7.    Date of authorisation by manager / trustee

The RMS should include a date as at which the RMS was authorised for release
to its investors in the collective investment.




17 February 1997                                                       II.D.7
                                         28



Part B - Detailed Risk Management Statement
This document is to be prepared for each superannuation entity for which
derivative investments are made whether such investments are made by the
trustee directly (internal investment manager) or by external investment
managers who in turn use derivatives. If investments are made directly by the
trustee (internal investment management) this document must be prepared by the
trustee itself. If investments are made by an external investment manager then
the external investment manager must prepare this document. If more than one
investment manager is used then a statement in this form must be prepared by
each investment manager that is employed by trustees of superannuation entities
where that investment manager uses derivatives.

Where the superannuation entity’s exposure to derivatives is through a collective
investment a copy of the collective investment’s RMS should be obtained. For
reference below the party responsible for preparing the document is called the
‘responsible party’.


1.    Responsible party name

The responsible party who has prepared this statement must be identified. eg
trustee, external investment manager, collective investment.


2.    Objective of RMS

The RMS summarises the policies in place covering the use of derivatives,
controls on their use, and the processes for assessing compliance with those
controls. These policies and controls are intended to ensure proper use of
derivatives. Derivatives are not to be considered in isolation, but as part of the
investment operations of the responsible party as a whole and the investment
strategy being implemented. The RMS is expected to be reviewed by
management regularly.

The RMS must be read and understood by all persons responsible for managing,
monitoring or implementing the investment processes of the responsible party.


3.    Definition of derivatives



17 February 1997                                                       II.D.7
                                        29


A derivative is defined as: ‘a financial contract whose value depends on, or is
derived from, assets, liabilities or indices (the “underlying asset”). Derivative
transactions include a wide assortment of instruments, such as forwards, futures,
options, share ratios, warrants, swaps and other composites’.

A number of other composite derivatives exist that may not fit the normal
structure and control processes for derivatives (eg delta weighting). Where there
is an element of uncertainty as to whether something should be included or not,
it should be included.

There are a number of instruments that are, or appear like, derivatives which
may arise incidentally from other investment activity (eg company issued
options). As long as they are only incidental and will not have a substantial
impact on the overall investments of the fund they need not be explicitly covered
by an RMS prepared in accordance with these guidelines.


4.    Relationship to investment strategy of the fund

This section should tie in the investment management of assets covered by Part
B with the portion of the overall investment strategy of the Fund for which the
investment manager is responsible. It should be read in conjunction with the
relevant trust deeds, management agreements or investment mandates in place
for the superannuation fund. The use of derivatives must be subordinate to the
investment strategy and be consistent with the objectives of the strategy. (Thus,
for example, the use of derivatives to obtain exposure substantially different to
that which could be obtained through physical securities would generally be
inappropriate). A statement covering these aspects needs to be included here.


5.    Purpose of the use of derivatives

The RMS must state the purpose of the use of derivatives as part of investment
operations to ensure that derivatives are a properly considered part of the
investment process. The purpose could include the following (which are not
exclusive):

• hedging: to protect an asset of the fund, or the portfolio, against, or minimise
  liability from, a fluctuation in market values;
• achieving transactional efficiency;
• to reduce the transaction cost of achieving required exposure;
• to obtain prices that may not be available in the cash market;


17 February 1997                                                       II.D.7
                                        30


• to control the impact on portfolio valuations of market movements caused by
  significant transactions;
• to assist in the achievement of the best execution of security transactions;
• reducing volatility;
• adjustment to asset exposures within the parameters set in the strategy;
• to adjust the duration of a fixed interest portfolio;
• foreign currency hedging.


6.    Restrictions on the use of derivatives

The RMS should state what policies and processes the responsible party has in
place to ensure that any derivative transactions do not breach any legal or
contractual obligations including, but not limited to, trust deed limitations,
investment management agreements and specifications in investment mandates
such as asset class investment operating ranges. It should also state what the
legal or contractual obligations are or refer to the documents which cover those
obligations.


7.    Risk analysis

There are various types of risks associated with the use of derivatives. Those
that follow as examples should not be seen as ‘exclusive’ - others may be
relevant.

The RMS should seek to detail the process by which a responsible party
assesses, monitors and controls these risks. In particular it should show that
there are systems controlling derivatives that are integrated and consistent with
other systems of the responsible party and that there are procedures in place for
derivative transactions, which are followed and reviewed. It should include
showing that there is proper separation of dealing and management of
derivatives from administration and settlement functions.


7(a) Market risk

Market risk is the primary area of concern in managing the risk of derivative
positions in a portfolio. It is also one of the most quantifiable, and specific
controls can be put in place to guard against undue risk being adopted by a fund.




17 February 1997                                                      II.D.7
                                        31


Market risk represents the risk of adverse movements in markets (including asset
prices, volatility, changes in yield curve, implied option volatility or other
market variables) for the derivatives or the underlying asset, reference rate or
index to which the derivative relates. Such risk is created by holding any
security, physical or derivative, which creates exposure to movements in prices
of a security or market.

Ideally, the market risk associated with the use of derivatives is best assessed in
the context of the total portfolio being managed, where derivatives are included
on a fully paid up exposure basis. Where option or option related derivatives are
involved, exposure is determined on a delta weighted basis.

A related form of market risk that is relevant to derivative management is basis
risk. This is the risk that a derivative position will not move in line with a
physical position. Some examples of where consideration should be given to
basis risk are:

• a portfolio of Australian equities may not move in line with the Share Price
  Index future which is based on the All Ordinaries Index, because of the
  different weighting of various shares;
• a portfolio of 3 year bonds is not likely to move in line with movements in 10
  year bond futures.

It is expected that portfolio risk management techniques used by the responsible
party will include the market impact of derivatives under different market
scenarios. In the case of derivative transactions that may have a significant
impact on portfolio value, suitable periodic stress testing is expected. Periodic
stress testing should be designed to ensure that the restrictions below are
complied with even in adverse circumstances. For example, if the responsible
party is selling options stress testing should at least include consideration of a
movement in the market that would result in the option being exercised.

Methods of limiting market risk should include the following restrictions:

• ensuring that a fund’s total portfolio is not being leveraged (or ‘geared’). A
  portfolio would be geared if the level of market exposure exceeds the market
  value of the fund. Derivatives cannot be used to circumvent the borrowing
  limitations imposed by Sections 67, 95 and 97 of SIS;
• ensuring that the net exposure of a fund to an asset class, including the delta
  weighted exposure of derivative investments, does not go outside that set out
  in a fund’s investment strategy;



17 February 1997                                                       II.D.7
                                          32


• ensuring that a fund does not hold uncovered derivatives, where cover is
  defined as follows:

    i. In the case of derivative positions to achieve exposure - cover consists of
      assets that in the responsible party’s professional judgment are equivalent
      to cash and can be converted to cash within the settlement period. They
      must be sufficient to meet all potential obligations arising from the
      underlying asset exposure represented by the derivative position. Short
      dated fixed interest securities may well be equivalent to cash but equities
      are not. Synthetic cash (e.g. derived by selling 10 year bond futures
      against the physical bonds) is also acceptable. Net derivative positions
      can be considered where relevant.

    ii. In the case of derivative positions to remove exposure - cover consists of
        assets for which in the responsible party’s professional judgment the
        derivative(s) are considered a reasonable hedge. Net derivative positions
        can be considered where relevant.

Breaching the restrictions set out above for the fund overall would be seen as
speculation which is not allowed.


7(b) Liquidity risk

Two types of liquidity risk are faced in derivatives activities. The first is the risk
that a responsible party may not be able to, or cannot easily, unwind or offset a
particular position at or near the previous market price, because of inadequate
market depth or because of disruptions in the market place. The second is the
risk that the responsible party will not be able to meet its future financial
obligations resulting from its derivative activities such as meeting margin calls
on futures contracts.

The responsible party should show that the liquidity of derivative positions is
taken into consideration in the investment process and that the fund has
sufficient capacity to meet any obligations resulting from derivative positions.


7(c) Counterparty (Credit) risk

Counterparty risk is the risk that a counterparty (the other party with whom a
derivatives contract is made) will fail to perform contractual obligations (ie.



17 February 1997                                                         II.D.7
                                          33


default in either whole or part) under a contract. This is also sometimes referred
to as ‘credit risk’.

The responsible party should show that they have processes in place that address
the following issues in a credible way:

•    assessing creditworthiness and approval of counterparties;
•    establishing limits for approved counterparties;
•    monitoring total exposure to counterparties against limits;
•    legal power of counterparty to enter into the contract;
•    sufficient or enforceable legal documentation;
•    compliance with regulatory requirements;
•    safe storage of documentation.


7(d) Operations risk

Operations risk is the risk that deficiencies in the effectiveness and accuracy of
the information systems or internal controls will result in a material loss. This
risk is associated with human error, system failures and inadequate procedures
and internal management controls. This might include the risk that the valuation
system incorrectly calculates a price for a derivative or its equivalent exposure.
This risk can be exacerbated in the case of certain derivatives because of the
complex nature of their payment structures and calculation of their values.

The valuation standard for derivatives should be consistent with current industry
market practice (ie. derivatives should be valued at market value and exposures
stated on a delta adjusted basis). The responsible party will need to show that the
sources of valuations are appropriately independent, including those for OTCs
and thinly traded derivatives.

The RMS should show that there is proper separation of dealing and
management functions on the one hand and administration and settlement
functions on the other.


8.      Currency

Foreign currency exposure will naturally arise from investment in overseas
assets and this creates another dimension of portfolio risk management. Similar
principles for currency exposure should be applied as are detailed elsewhere in
this document and in the investment strategy for the fund.


17 February 1997                                                      II.D.7
                                           34



In particular, the use of derivatives in a fund's international portfolio should be
consistent with the fund's acceptable level of currency risk. Reports to trustees
should monitor open currency positions, both on a net basis and, because of the
possible counterparty risk involved, on a gross basis.

9.       Personnel management

The RMS should show that the responsible party has considered the expertise of
staff in determining what derivative transactions should be carried out. It should
also show the procedures that are in place to ensure staff are only authorised to
carry out duties within their designated expertise. Staff should have a program
of continuing education to maintain standards and to recognise changes in the
investment environment and the nature of derivatives that are used by the
responsible party.

Importantly, the RMS will be made readily available to all relevant staff and
there will be a regular program of training and re-enforcement for these staff of
the RMS requirements and on the obligations that they face in order to ensure
that these requirements are met.

Other matters for consideration could include:

•    supervision;
•    appropriate segregation of staff reporting lines;
•    signoff requirements for transactions;
•    required qualifications (e.g. SFE registration);
•    appropriate remuneration strategies.


10. Assessment of controls

In addition to showing that as outlined in the above sections the responsible
party has appropriate policies and procedures in place in relation to derivatives,
the RMS should also show how they will be independently assessed in an
ongoing way. This should include outlining responsibility for either internal or
external assessment arrangements performed by groups such as management,
compliance, internal audit or consultants.

The monitoring process should include control systems that would report to
senior management any material problems and ensure that any problems that do
occur are subject to prompt corrective action. Senior management or for an


17 February 1997                                                        II.D.7
                                        35


external investment manager the Board of Directors should approve the RMS,
attest to its sufficiency, monitor ongoing compliance and ensure its continued
adequacy.


11.    External audit

The external auditor will sign off on an annual basis that an RMS exists, that the
major procedures laid down in the RMS have been followed and that any
changes have been approved. The external audit will be completed in
accordance with Australian Auditing Standards and referenced as appropriate in
letters of comfort. The ISC expects to issue, after discussion with the industry,
further guidance on this area.


12. Reporting to trustees

This will vary a little between a direct investment situation and an external
investment management situation:


Direct:

There must be regular and comprehensive reporting on both exposures and
adequacy of systems to the trustee and senior investment management
personnel. There must also be processes that ensure that trustees are notified of
any breaches in internal controls. In particular the Board must ensure it is
regularly informed by investment management of derivative exposures, in
particular, the aggregate exposure (both derivatives in isolation and combined
with physical exposure).


External investment management (including collective investments):

The investment manager must ensure that the RMS is provided to the Board of
the trustee company both initially and when there are any subsequent changes.

There must be regular and comprehensive reporting on asset exposures to the
trustees of the fund. In particular, the investment manager must ensure that they
can regularly inform trustees of the aggregate portfolio exposure, including the
impact of derivatives. The manager will also report to the trustee when in the
professional judgment of the investment manager there is a significant
occurrence in relation to the use of derivatives by the manager.

17 February 1997                                                       II.D.7
                                        36



It should be noted that delta weighted exposure disclosure may not always be
fully appropriate and careful consideration needs to be given to other disclosure
that may be necessary.


13. Date of approval of Part B RMS

The date of approval of the Part B RMS by the responsible entity should be
included within the RMS.




17 February 1997                                                      II.D.7
                                        37



Appendix 2 - Glossary
(This Glossary does not aim to provide prescriptive definitions of these terms,
rather it has been provided to assist in the understanding of this Circular.)

Asset class exposure:
       The proportion of an entity’s investment portfolio that is invested in a
       particular asset class (for example, Australian equities or property).

Basis risk:
       The risk that a derivative position will not move in line with a physical
       position. For example, a portfolio of Australian equities may not move
       in line with the Share Price Index (SPI) future which is based on the All
       Ordinaries Index because of the different weighting of various shares.

Collective investment:
       A class of investments where investors’ subscriptions are typically
       pooled and managed by an investment manager. Examples would
       include unit trusts, PSTs, and life insurance company pooled funds.

Counterparty:
       The other party with whom a derivatives contract is made.

Counterparty risk:
       The risk that a counterparty will fail to perform contractual obligations
       (i.e. default) under a contract. This is also sometimes referred to as
       ‘credit risk’.

Cover:
    i. In the case of derivative positions to achieve exposure - cover consists of
       assets that in the responsible party’s professional judgment are equivalent
       to cash and can be converted to cash within the settlement period. They
       must be sufficient to meet all potential obligations arising from the
       underlying asset exposure represented by the derivative position. Short
       dated fixed interest securities may well be equivalent to cash but equities
       are not. Synthetic cash (e.g. derived by selling 10 year bond futures
       against the physical bonds) is also acceptable. Net derivative positions
       can be considered where relevant.




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                                         38


    ii. In the case of derivative positions to remove exposure - cover consists of
      assets for which in the responsible party’s professional judgment the
      derivative(s) are considered a reasonable hedge. Net derivative positions
      can be considered where relevant.

Delta:
         The expected expansion or contraction in an option premium given a
         change in the value of the underlying security.

Derivative exposure:
         The effective proportion of an entity’s investment portfolio that is
         invested in derivatives. For example, with a futures contract, the
         exposure is not the amount of margin calls (or deposits) paid but the full
         value of the contract.

Discretionary individual portfolio:
         A portfolio over which an investor gives a manager or broker authority
         to effect transactions without prior reference to or approval from that
         client.

Exchange traded derivatives:
         Exchange traded derivatives are usually traded on organised exchanges -
         principally the Sydney Futures Exchange and the Australian Options
         Market in Australia. They are typically standardised as to expiry,
         contract size and delivery terms.

Excluded funds:
         Are defined in the Superannuation Industry (Supervision) Act 1993 as
         superannuation funds with fewer than 5 members.

Exotics:
         Are defined broadly as complex variations of standard derivatives.

Forwards:
         Are legally binding agreements to buy or sell a commodity, currency or
         security at a fixed time in the future at a price agreed upon today.

Futures:
         Are legally binding agreements to buy or sell a commodity or security at
         a fixed time in the future at a price agreed upon today (i.e. the same as a
         forward contract). For example, on the Sydney Futures Exchange the
         delivery period, quantity and quality of a futures contract is standardised

17 February 1997                                                        II.D.7
                                        39


       and specified, while the price is set at the time the contract is opened and
       negotiated by competitive outcry between buyers and sellers on the
       trading floor or on the Exchange’s computerised overnight market. At
       the opening of a position an initial margin or deposit is required (usually
       less than 5% of the value of the contract). In addition margins are
       required to be paid (or received) daily reflecting the profit or loss each
       day.

Legal risk:
       The risk that an entity may not have the legal power to enter into a
       derivatives contract (and is therefore not bound to perform the
       contractual obligations).

Liquidity risk:
       An entity faces two types of liquidity risk in its derivatives activities:
       one related to specific products or markets and the other to the general
       funding of the entity’s derivatives activities. The former is the risk that
       an entity may not be able to, or cannot easily, unwind or offset a
       particular position at or near the previous market price because of
       inadequate market depth or because of disruptions in the market place.
       The latter is the risk that the entity will not be able to finance its
       derivatives activities (for example, meeting margin calls on futures
       contracts).

Margins:
       ‘Security’ deposits required for exchange traded derivatives to ensure
       that if the market moves against the derivatives holder during the day,
       extra backing is provided against potential losses.

Market risk:
       The risk to an institution’s financial condition resulting from adverse
       movements in (stock, bond, currency, etc.) market prices.

Net exposure:
       The total of physical exposure and derivative exposure, as defined
       above.




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                                        40


Operations risk:
       The risk that deficiencies in information systems or internal controls will
       result in unexpected loss. This risk is associated with human error,
       system failures and inadequate procedures and controls. This risk can be
       exacerbated in the case of certain derivatives because of the complex
       nature of their payment structures and calculation of their values.

Options:
       Provide investors with the right but not the obligation to buy or sell a
       commodity, currency, security or futures contract. Buying options
       provides a means of obtaining insurance against risk in the underlying
       markets while still providing the investor the option of benefiting from
       favourable price movements. The fee for this flexibility or ‘option’ is a
       premium (likened to a once only insurance premium). Apart from their
       flexibility, the primary advantage of purchasing options is that they
       allow investors to take advantage of many different market scenarios and
       implement strategies whereby any potential losses are limited and are
       clearly defined at the outset.

       Call option:
            Gives the holder the right but not the obligation to buy a specified
            commodity, currency, security or futures contract at a designated
            price on or before a specified date in the future.

       Put option:
            Gives the holder the right but not the obligation to sell a specified
            commodity, currency, security or futures contract at a designated
            price, on or before a specified date in the future.

Over-the-counter (OTC) derivatives:
       Are derivatives not listed on any security exchange. OTC contracts
       (e.g. between banks and corporations) are custom tailored to an
       institution’s needs and often specify commodities, instruments and/or
       maturities that are not offered on any exchange. Main OTC derivatives
       include swaps, forwards and options, which are based upon interest rates,
       currencies, equities or commodities.

Physical exposure:
       Is the proportion of an entity’s investment portfolio which is invested in
       ‘physical’ or actual securities, as distinct from derivative securities. For
       example, equities would be regarded as physical exposure whereas
       equity derivatives would be regarded as derivative exposure.


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                                        41



Sensitivity analysis:
       Is the financial modelling technique of determining how changes in
       selected variables impact on overall results. For example, sensitivity
       analysis may be used to estimate the impact of falls in the $A compared
       to the $US on a portfolio’s investment returns. Stress testing is the
       related modelling technique which shows the entity’s capacity to cope
       with a series of hypothetical adverse scenarios.

Share ratio futures:
       Are futures contracts based on the relative movements between the price
       of a specified share (e.g. BHP) and the All Ordinaries Index.

Swaps:
       Are agreements between two parties to exchange (swap) their respective
       obligations (loan repayments or interest payments) so that they can
       manage their cash flows more effectively. In Australia, there are two
       main categories of swaps - interest rate swaps and currency swaps.
       Interest rate swaps are the largest of the two categories and there is no
       exchange of principal but rather only the stream of periodic interest
       payments are ‘swapped’ and settlement is the net difference between the
       two interest rate costs. Traditionally, interest rate swaps involve an
       exchange of fixed interest payments for floating rate payments and vice
       versa.

Synthetic exposure:
       An arrangement whereby a derivative is aggregated with cash to arrive at
       an equivalent exposure to the physical situation (for example, combining
       a ten year bond future with cash, giving equivalent exposure to holding a
       ten year bond).

Underlying asset:
       The asset on which the derivative contract is based. For example a BHP
       call option is based on BHP shares.

Valuation risk:
       The risk that the valuation system incorrectly calculates a price for a
       derivative or its equivalent exposure.

Warrants:
          Are the same as call options (see options) but tend to be long dated.


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