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18.98. Swaps Risk

Swaps are types of derivatives. Swap agreements involve the risk that the party with which the Investment Compartment has entered into the swap will default on its obligation to pay the Investment Compartment and the risk that the Investment Compartment will not be able to meet its obligations to pay the other party to the agreement. In order to seek to hedge the value of the Investment Compartment’s portfolio, to hedge against increases in the Investment Compartment’s cost associated with interest payments on any outstanding borrowings or to seek to increase the Investment Compartment’s return, the Investment Compartment may enter into swaps, including interest rate swap, total return swap or credit default swap transactions. In interest rate swap transactions, there is a risk that yields will move in the direction opposite of the direction anticipated by the Investment Compartment, which would cause the Investment Compartment to make payments to its counterparty in the transaction that could adversely affect Investment Compartment performance. In addition to the risks applicable to swaps generally (including counterparty risk, high volatility, liquidity risk and credit risk), credit default swap transactions involve special risks because they are difficult to value, are highly susceptible to liquidity and credit risk, and generally pay a return to the party that has paid the premium only in the event of an actual default by the issuer of the underlying obligation (as opposed to a credit downgrade or other indication of financial difficulty).

Historically, swap transactions have been individually negotiated non-standardized transactions entered into in OTC markets and have not been subject to the same type of government regulation as exchange-traded instruments. However, the OTC derivatives markets have recently become subject to comprehensive statutes and regulations. In particular, in the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), signed into law by President Obama on July 21, 2010, requires that certain derivatives with U.S. persons must be executed on a regulated market and a substantial portion of OTC derivatives must be submitted for clearing to regulated clearinghouses. As a result, swap transactions entered into by the Investment Compartment may become subject to various requirements applicable to swaps under the Dodd-Frank Act, including clearing, exchange-execution, reporting and recordkeeping requirements, which may make it more difficult and costly for the Investment Compartment to enter into swap transactions and may also render certain strategies in which the Investment Compartment might otherwise engage impossible or so costly that they will no longer be economical to implement. Furthermore, the number of counterparties that may be willing to enter into swap transactions with the Investment Compartment may also be limited if the swap transactions with the Investment Compartment are subject to the swap regulation under the Dodd-Frank Act.

Credit default and total return swap agreements may effectively add leverage to the Investment Compartment’s portfolio because, in addition to its Managed Assets, the Investment Compartment would be subject to investment exposure on the notional amount of the swap. Total return swap agreements are subject to the risk that a counterparty will default on its payment obligations to the Investment Compartment thereunder. The Investment Compartment is not required to enter into swap transactions for hedging purposes or to enhance income or gain and may choose not to do so. In addition, the swaps market is subject to a changing regulatory environment. It is possible that regulatory or other developments in the swaps market could adversely affect the Investment Compartment’s ability to successfully use swaps.