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18.96. Strategic Transactions and Derivatives Risk

The Investment Compartment may engage in various Strategic Transactions for duration management and other risk management purposes, including to attempt to protect against possible changes in the market value of the Investment Compartment’s portfolio resulting from trends in the securities markets and changes in interest rates or to protect the Investment Compartment’s  unrealized gains in the value of its portfolio securities, to facilitate the sale of portfolio securities for investment purposes or to establish a position in the securities markets as a temporary substitute for purchasing particular securities or to enhance income or gain. Derivatives are financial contracts or instruments whose value depends on, or is derived from, the value of an underlying asset, reference rate or index (or relationship between two indices). The Investment Compartment also may use derivatives to add leverage to the portfolio and/or to hedge against increases in the Investment Compartment’s costs associated with any leverage strategy that it may employ. The use of Strategic Transactions to enhance current income may be particularly speculative.

Strategic Transactions involve risks. The risks associated with Strategic Transactions include (I) the imperfect correlation between the value of such instruments and the underlying assets, (ii) the possible default of the counterparty to the transaction, (iii) illiquidity of the derivative instruments, and (iv) high volatility losses caused by unanticipated market movements, which are potentially unlimited. Although both OTC and exchange-traded derivatives markets may experience the lack of liquidity, OTC non-standardized derivative transactions are generally less liquid than exchange-traded instruments. The illiquidity of the derivatives markets may be due to various factors, including congestion, disorderly markets, limitations on deliverable supplies, the participation of speculators, government regulation and intervention, and technical and operational or system failures. In addition, daily limits on price fluctuations and speculative position limits on exchanges on which the Investment Compartment may conduct its transactions in derivative instruments may prevent prompt liquidation of positions, subjecting the Investment Compartment to the potential of greater losses. Furthermore, the Investment Compartment’s ability to successfully use Strategic Transactions depends on the Manager’s ability to predict pertinent securities prices, interest rates, currency exchange rates and other economic factors, which cannot be assured. The use of Strategic Transactions may result in losses greater than if they had not been used, may require the Investment Compartment to sell or purchase portfolio securities at inopportune times or for prices other than current market values, may limit the amount of appreciation the Investment Compartment can realize on an investment or may cause the Investment Compartment to hold a security that it might otherwise sell. Additionally, segregated or earmarked liquid assets, amounts paid by the Investment Compartment as premiums and cash or other assets held in margin accounts with respect to Strategic Transactions are not otherwise available to the Investment Compartment for investment purposes. Please see the Investment Compartment’s SAI for a more detailed description of Strategic Transactions and the various derivative instruments the Investment Compartment may use and the various risks associated with them.

Many OTC derivatives are valued on the basis of dealers’ pricing of these instruments. However, the price at which dealers value a particular derivative and the price which the same dealers would actually be willing to pay for such derivative should the Investment Compartment wish or be forced to sell such position may be materially different. Such differences can result in an overstatement of the Investment Compartment’s NAV and may materially adversely affect the Investment Compartment in situations in which the Investment Compartment is required to sell derivative instruments. Exchange-traded derivatives and OTC derivative transactions submitted for clearing through a central counterparty have become subject to minimum initial and variation margin requirements set by the relevant clearinghouse, as well as possible SEC- or CFTC- mandated margin requirements. These regulators also have broad discretion to impose margin requirements on non-cleared over-the-counter derivatives. These margin requirements will increase the overall costs for the Investment Compartment.

While hedging can reduce or eliminate losses, it can also reduce or eliminate gains. Hedges are sometimes subject to imperfect matching between the derivative and the underlying security, and there can be no assurance that the Investment Compartment’s hedging transactions will be effective.

Derivatives may give rise to a form of leverage and may expose the Investment Compartment to greater risk and increase its costs. Recent legislation calls for new regulation of the derivatives markets. The extent and impact of the regulation is not yet known and may not be known for some time. New regulation may make derivatives more costly, may limit the availability of derivatives, or may otherwise adversely affect the value or performance of derivatives.