Introduction to Derivatives

Derivatives as contracts

Derivatives are contracts and must therefore conform with the general principles of the law of contract. A “contract” is an agreement between two parties, entered into after an offer has been made by one party – the offeror - and accepted by the other party – the offeree. An “offer” is a statement of willingness to contract on the terms specified in the offer, and it is made with the intention that it will become binding on acceptance by the offeree. The “acceptance” by the offeree signifies his unconditional agreement to be bound by the terms and conditions proposed by the offeror in the offer. When the offer has been accepted and the contract comes into existence, it is said to have been concluded, and the conclusion of the contract brings into being both rights and obligations for each of the parties. The carrying out by a party of a contractual obligation is referred to as “performance”, or more frequently in the context of derivative contracts, “settlement”. If the contract provides for a length of time to elapse before one of the parties is required to render performance, that time is referred to as the “period” of the contract, and in the context of derivatives, the last date on which a party is required to perform is referred to as the date on which the contract “matures”, or the “maturity date” of the contract.

In the context of derivatives, FRS 13 Derivatives and other financial instruments: disclosures defines a “contract” as an agreement between two or more parties that has clear economic consequences and which the parties have little, if any, discretion to avoid, usually because the agreement is enforceable in law. “Contractual rights” and “contractual obligations” are defined as rights and obligations that arise out of a contract, and include rights and obligations that are contingent on the happening of a future event. FRS 13 notes that most contracts give rise to a variety or rights and obligations, and that the rights and obligations arising from a contract often change or are supplemented as the contract is performed. It adds that contracts may take on different forms, and need not be in writing. Inland Revenue takes the view, based on Ingram v IRC [2000] AC 293 (HL), where it was held that the term “property” did not refer to a physical asset, but to a specific interest which could co-exist with other interests in a single physical asset, that the rights of a party to a derivative contract constitute property in the hands of that party.

Meaning of “derivative contract”

A “derivative contract” is an agreement between two parties, in terms of which one or both parties undertake to render performance by delivering an asset to the other party, with the amount or value of the asset to be delivered left to be determined at a future date by reference to the value of another asset, called the “underlying asset”, “underlying item” or “underlying subject matter”. FRS 13 defines the term “derivative financial instrument” as “a financial instrument that derives its value from the price or rate of some underlying item. Underlying items include equities, bonds, commodities, interest rates, exchange rates and stock market and other indices”. The Statement of Recommended Practice on Derivatives of the British Bankers’ Association defines the term “derivative” as &dlquo;a financial instrument that derives its value from an underlying rate or price, such as interest rates, exchange rates, equity prices, credit data or commodity prices&drquo;. The SORP describes “derivatives” as a range of financial instruments deriving their value from an underlying rate or price, and falling within three basic structures – futures and forwards, swaps and options – which provide a means of transferring and spreading risk and accommodating risk management more effectively and economically than conventional financial instruments.

For tax purposes, the labelling of a contract in a particular way in a company’s accounts is not, however, conclusive of the nature of the contract, and the tax consequences of a contract are determined by the contractual rights and obligations of the parties, as well as the cash flow movements to and from each party.

The “underlying asset” concept

The features that distinguishes the derivative contract from other contracts is the fact that the performance due by one or both parties under a derivative contract is left to be quantified at a future date, by reference to the value or measurement of another asset, called the “underlying asset”, “underlying item” or “underlying subject matter”. This feature is referred to as measurement of contractual performance by reference.

The underlying asset of a derivative contract may be any single asset or group of assets, whether tangible - such as a physical asset that is capable of delivery, like currency or a commodity - or intangible, such as another financial instrument or a share index. The underlying asset may be in existence when the derivative contract is concluded – such as a quantity of a commodity, or it may be notional, in the sense that it does not exist when the contract is concluded but can be conceived of at that date - such as a notional loan relationship - to which a notional value can be attributed based on the values of similar assets.

The minimum requirement for an asset to be an “underlying asset” of a derivative contract is that it must be capable of having a value attributed to it, whether that value be a price - such as the price of an index or the market value of a group of assets - or whether that value is merely capable of being measured in some way - such as weather conditions.

Common underlying assets of derivative contracts are -

The market in the underlying assets of derivative contracts is referred to as the “cash market” in those assets, while the market in the derivative contracts whose underlying assets constitute those cash market assets, is called the “derivatives market”.

Performance under derivative contracts

A derivative contract is entered into with the intention that there will be performance by one or both of the parties, and that once a party to a derivative contract has performed as required in the terms of the contract, he will be discharged from his obligations under the contract. Performance also entitles one party to demand that the other party also performs his contractual obligations. Performance under a derivative contract is also referred to as “settlement”.

Performance of a party’s obligations under a derivative contract can be effected in one of two ways: by delivery of the underlying asset, or by the making of a cash payment. Thus, although a derivative contract may have an underlying asset that is capable of physical delivery, where the contract so provides, performance of contractual obligations may be made by the payment of cash instead of by the delivery of the underlying asset, in which case the contact is said to be “cash settled”. FRS 13 thus defines the term “cash-settled commodity contract” as a “a commodity contract (including a contract for the delivery of gold) which, though having contract terms that require settlement by physical delivery, is of a type that is normally extinguished other than by physical delivery in accordance with general market practice”.

For some derivative contracts, performance by the delivery of the underlying asset may indeed be impossible, for example, where the underlying asset is a securities index, or weather conditions; performance under these contracts may only be by way of cash settlement. Even if it is possible to perform contractual obligations by delivering the underlying asset, the contract may grant the contract creditor in respect of the performance of an obligation the right to elect to receive the contact debtor’s performance either in the form of a cash payment or by way of the delivery of the underlying asset. Or the contract may provide that the contract debtor has an obligation to make both a cash payment in addition to delivering the underlying asset, particularly where he is obliged in terms of the contract to make good deficiencies in the quality or time of delivery of the underlying asset. Where both parties to the contract have an obligation to make a cash payment to the other party, they may agree that only a single net payment be made, with the result that their respective obligations are settled by what is referred to as “netting”.

The classification of derivative contracts

Derivative contracts may be categorised in one of two ways, either by the type of contract, or according to the manner in which the contract is entered into.

FRS 13 includes within the scope of the term “derivative financial instruments” - futures, options, forward contracts, interest rate and currency swaps, interest rate caps, collars and floors, forward interest rate agreements, commitments to purchase shares or bonds, note issuance facilities and letters of credit. FA 2002 Schedule 26 identifies the following types of derivative contracts – “options”, “futures” and “contracts for differences”.

Derivative contracts categorised according to the manner in which they are entered into are divided into two categories – “exchange-traded” contracts, or “over-the-counter” contracts.

Exchange-traded contracts are concluded or bought and sold on organised public exchanges, such as the London International Financial Futures Exchange. Such exchanges are officially recognised markets in which securities or interests in securities are traded. The exchanges also regulate the type of issuer whose securities may be listed, disclosure requirements, and the conduct of exchange members, with a view to achieving a fair, transparent and orderly market, and avoiding market abuse. Exchange-traded contracts are standard form contracts, that identify the underlying asset and state where, when and how performance is to be effected and how much cash one or both parties to the contract will receive or pay as the price or value of the underlying asset changes; and specify the obligations of each party on the maturity or termination of the contract. Performance under exchange-traded contracts is usually required to be made on specific dates according to a fixed sequence of months, for example, three monthly. The use of standard-form contracts reduces the contracting parties’ costs, because the contractual terms are familiar to them so that negotiating time is reduced and legal expenses are avoided. The parties to exchange-traded contracts do not contract directly with one another, but with the exchange itself in its role as a clearing house, so that counterparty creditworthiness and default risk is eliminated for both parties because it is borne by the exchange. The exchange protects itself against default risk by requiring all parties to deposit cash collateral with it on the date on which they enter into any derivative contract with it. This deposit is called “initial margin”, and it is re-evaluated daily to take into account movements in the price or value of the underlying asset, with the parties being paid or being required to pay in additional cash amounts called “variation margin”, equal to the daily movement in the price or value of the underlying asset. Because of the role played by the exchange, a party to an exchange-traded derivative contract is effectively able to terminate its rights and obligations under the contract before the contract’s maturity date arrives, by entering into a derivative contract with rights and obligations that are equal in value to those under the original derivative contract, but which provide for rights and obligations that are opposite to those under the original contract; this process of effective termination of contractual rights and obligations is referred to as the "ldquo;closing out” of a “position”.

An “over the counter” or “OTC” derivative contract may be either a standard-form derivative contract that is entered into outside a public derivative exchange, or a non-standard-form derivative contract the terms of which are negotiated directly between the parties. The standard form of over-the-counter contract may be based on a model agreement, such as the model agreements issued by the International Swaps and Derivatives Association, or the British Bankers Association. A non-standard-form contract is a customised agreement drafted specifically for the transaction in question. An over-the-counter contract is entered into when an exchange-traded contract is not flexible enough for the needs of one or both parties, or where the underlying asset is not dealt in on any exchange. The contract need not be entered into by way of face to face negotiations, but may be entered into telephonically or electronically on the basis of electronically displayed information; once the terms of the contract have been negotiated verbally on the telephone and have been unequivocally accepted by both parties, the contract is effectively concluded. The terms of the contact may then be confirmed in writing, for both parties to sign, after which a written contract is exchanged. Where the parties contract with one another on a regular basis, and they habitually rely on the terms of a model agreement, they may execute a single agreement based on the form of a model agreement, and agree that the same terms will apply to all subsequent transactions entered into between them. The holder of an over-the-counter contract is usually obliged to remain a party to the contract right up to its maturity, and is not normally permitted to assign his rights and obligations or sell the contract to a third party.

Derivate contracts as “financial instruments”

The derivative contract is a category of a broader group of contracts referred to as “financial instruments”. FRS 13 defines the term “financial instrument” as “any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include both primary financial instruments – such as bonds, debtors, creditors and shares – and derivative financial instruments.” FRS 13 defines “financial asset” as cash, a contractual right to receive cash or another financial asset from another entity, a contractual right to exchange financial instruments with anther entity under conditions that are potentially favourable, or an equity instrument of another entity. Similarly, the term “financial liability” is defined by FRS 13 as a contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial instruments with another entity under conditions that are potentially unfavourable. “Equity instrument” is defined as an instrument that evidences an ownership interest in an entity, that is, a residual interest in the assets of the entity after deducting all of its liabilities, including some non-equity shares, as well as warrants and options to subscribe for or purchase equity shares. A document that evidences a “financial claim” is a “financial instrument”, and a “financial claim” is a claim to receive payment of an amount of money at a future date. The creditor in relation to a financial claim is said by FRS 13 to hold a “financial asset”, and the debtor to have incurred a “financial liability”. Commodity contracts that require settlement by the delivery of non-financial assets, says FSR 13, are not “financial instruments”. But because it is common for standard-form commodity contracts to be traded on exchanges whose rules permit such contracts to be “closed out” by settlement in cash or by the contracting of other financial instruments, rather than by taking physical delivery of the underlying commodity, such contracts are similar to “financial instruments”. They are often used for the same purposes – hedging or speculation – and are regarded as being interchangeable with financial instruments, and are managed in a similar way to them. These types of commodity contracts – called “cash-settled commodity contacts” – are accordingly treated for accounting purposes in the same way as “financial instruments”.

A “financial instrument” has a number of identifying characteristics: risk, liquidity, real value certainty, expected return, term to maturity, currency denomination, and divisibility.

FRS 13 identifies a number of forms of risk arising from “financial instruments”:

Uses of derivative contracts

Derivative contracts are used to earn income, firstly, through speculation and trading by way of dealing in such contracts; secondly, through arbitrage; and thirdly, through the preservation of income and financial assets through the hedging of risks. A trading company may enter into derivative transactions in order to manage risks arising from its operations and sources of finance. The British Bankers’ Association’s SORP on Derivatives gives three reasons why banks enter into derivative contracts: firstly, customer facilitation, where a bank enters into a transaction for the purpose of accommodating a customer; secondly, proprietary purposes, where a bank deals for its own account as principal, and thirdly, hedging, where the bank enters into derivative transactions as part of its risk management strategy, either in relation to other transactions entered into for trading or proprietary purposes, or in relation to the bank’s own business activities. Inland Revenue assumes that large groups of companies are more likely to use derivative contracts, and that it will be more likely to examine such companies, that small and medium-sized companies rarely use derivatives, and that banks and other financial institutions carry on the business of selling derivative products.

Hedging is the process of purchasing and holding a financial instrument in order to insure against a possible reduction in wealth caused by unforeseen economic fluctuations. The British Bankers’ Association’s SORP on Derivatives defines “hedging transactions” as “transactions entered into with the purpose of matching or eliminating the risk of loss or reduction in profit as a result of movement in interest rates, exchange rates, equity prices, credit quality or commodity prices”. For example, a commodity producer may be concerned about a possible fall in the future price of the commodity that he produces. In order to hedge against this risk, he would locate a person who wished to hedge against a rise in the price of the commodity, such as a manufacturer who used the commodity in his manufacturing process. The parties would agree on a price for the future delivery of the commodity, thereby removing the risk for both parties of an adverse movement in the price of the commodity. By hedging in this way, the parties achieve certainty, although they do not gain any income or profit.

The most common forms of risk against which derivative contracts are used for hedging purposes, are interest rate risk and exchange rate risk.

Interest rate risk is the risk that an increase in interest rates may lead to increased finance charges for a borrower, and an increased interest return for a lender. This results in difficulties for traders, particularly when loans are subject to floating interest rates. Interest rate risk may assume several forms:

Exchange rate risk arises when changes in exchange rates alter the sterling equivalent of foreign currency, with the result that the sterling costs of imported inputs might increase for a UK manufacturer or trader. Like interest rate risk, exchange rate risk assumes several different forms:

Exchange rate risk can be managed either by taking a positive decision to take no action at all, or by hedging through specific measures designed to reduce the risk. A decision to take no action implies accepting the spot exchange rate on the date on which payment is made or received. If a company does nothing to manage exchange risk, it has no protection at all against exchange rate movements, but it also avoids the costs of hedging. Apart from hedging, it could implement passive exchange rate management measures, such as monitoring exchange rate movements, or defensive management measures such as contracting with foreign customers and suppliers in sterling only, and maintaining foreign currency reserves to meet future foreign commitments. If it decides to hedge against exchange risk, it will obtain some protection against exchange rate movements, but such protection will have a cost. A company can also manage exchange risk internally by attempting to forecast the future movement of spot rates, and then accelerating or delaying payments or receipts in foreign currency as and when movements in rates are anticipated; or it can require supplier invoices to be denominated in sterling, thereby shifting the exchange risk to his suppliers; or it can operate foreign currency accounts, and keep a float of foreign currency available to meet foreign exchange commitments, although this gives rise to translation risk in relation to the currency which it holds. A company can also use external methods to manage exchange risk, such as the use of currency forward contracts, which provide certainty regarding the local currency equivalent of foreign currency receipts or payments. By paying a premium to the provider of a forward exchange contract for assuming the exchange risk, the company thereby gains certainty about the future exchange rate.