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Suppose there is a hedge fund with with USD 50M cash and the balance sheet is below.

Asset: 50M Liability: 0 Partner's Capital: 50M

If the hedge fund executed a USD 100M notional TRS with 25% IA (USD 25M will be the independent amount),

How will it be reflected on the above balance sheet?

Will the 3 times leverage be reflected on the balance sheet as well?

Also will the notional or the MTM of the equity swap be reflected on the balance sheet?

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    $\begingroup$ I suspect the answer differs depending what country's accounting standards are being used and what legislation the hedge fund is setup under. $\endgroup$
    – nbbo2
    Sep 2, 2023 at 5:45
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    $\begingroup$ How about I assume it is under US GAAP $\endgroup$
    – Tom Ho
    Sep 2, 2023 at 5:49

2 Answers 2

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In general derivatives accounting would dictate that the MTM of the swap be on the B/S.

Assuming P1 = P0 shortly after trading, the B/S would show as \$25mm cash asset, \$25mm IA (on the swap counterparty report) also an asset and $50mm liability (capital or AUM).

If P1 > P0, there is VM corresponding to net unrealized P&L (the larger such number as leverage increases) which increases assets and partners equity. And reverse as a decrease if P1 < P0. But the notional of the swap is not a B/S item.

So in a sense, the B/S is not really risk-weighted, because at T0 with P1==P0, the total B/S would be the same irrespective of leverage and cash posted as margin.

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  • $\begingroup$ What is P1 and P0 pls? Otherwise nice answer. $\endgroup$ Sep 5, 2023 at 5:59
  • $\begingroup$ P0 the price at which you acquire the derivative, P1 the market price sometime later. $\endgroup$
    – nbbo2
    Sep 5, 2023 at 10:46
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    $\begingroup$ B/S is quite crude overall and not risk weighted as stated. For banks this is why they require additional filings, such as regulatory capital requirements which mandates holding 4.5% common equity tier 1 capital versus risk weighted assets (RWAs), which is generally a good limiter for long term products such as loans/bonds, and the leverage ratio which says tier 1 capital must be 3% (6% for GSIBs) of the exposure measurement. This second measure is generally a good limiter for short term products such as repos, TRS, short derivatives. $\endgroup$
    – Attack68
    Sep 5, 2023 at 11:43
  • $\begingroup$ Hello all, Thank you and appreciate your answer. If P1<P0, the loss will be reflected on the liability instead and the captial will decrease? Also, if the fund is short TRS instead, if P1<P0, then the gain will be reflected on the asset side as well. Also, may I know how to obtain the AUM and NAV of a hedge fund on the balance sheet? Cause sometimes people say the AUM of the fund is actually the NAV. Sorry for having so many questions. Appreciate your answers. Thank you $\endgroup$
    – Tom Ho
    Sep 6, 2023 at 0:48
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I believe that AUM and NAV is the same thing for hedge funds, although the term AUM is more commonly used. In any case, they represent the "liquidation" value of the firm assuming all assets and liabilities are unwound at the MTM. Obviously, the larger the fund and the more the assumption that market impact (what is now called Liquidity risk) to unwind being zero is false. But otherwise, yes, P&L increases assets either as cash if realized or book entry on the Prime if unrealized, and realized losses reduces equity. As someone commented above, an accounting view of a fund is not really that helpful, but it is also true that the AUM figure combined with the description of the strategy (or strategies if multi-strat) gives a good sense of what the risk might be as ranges of leverage (i.e. GMV/AUM multiple for L/S and LMV/AUM for long only) are usually well-known by strategy types. For banks, RWA, leverage exposure and stress scenarios (CCAR in the US) are the regulators tools to define risk, thence capital requirements, but there are better internal methods that use more advanced risk analytics.

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  • $\begingroup$ Thank you. If the fund entered a short trs positiom and there is a unrealized PNL gain, thr MTM be reflected in the asset as well? Thanks for your help. Also, can I say the asset minus liablity on the balance sheet is the NAV/AUM of the fund? $\endgroup$
    – Tom Ho
    Sep 7, 2023 at 0:50

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