Guidance

Overview of derivative contracts

Published 27 March 2015

Basic tax definition

A derivative contract is a relevant contract which is treated for accounting purposes as a derivative financial instrument. In broad terms this means it:

a) has a value that changes in response to a change in an underlying variable - provided in the case of a non-financial variable that the variable is not specific to a party to the contract

b) requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors

c) is settled at a future date

A relevant contract is:

• an option
• a future
• a contract for differences

A relevant contract will still be treated as a derivative if it is only condition (b) that prevents the above conditions from being met. Additional rules prescribed that certain relevant contracts are included or excluded depending on the underlying subject matter of the contract.

Options

An option gives the holder the right (but not the obligation) to buy or sell a specified underlying asset on or before a particular date at an agreed price. This will often involve the paying of a premium.

There are 2 types of option:

• call option - confers the right to buy the underlying asset

• put option - confers the right to sell the underlying asset

For example, a company buys a call option on a particular publicly-quoted company’s share which states the price that would have to be paid and the date on which the option can be exercised. If, on the specified date, the actual share price is higher than the option price, the company is likely to exercise the option. If the actual price is lower, the company is unlikely to exercise the option.

The tax definition of an option includes all warrants and other contracts which entitle the holder to subscribe for shares or loans in a company.

Forward contracts and futures

A forward is an agreement to buy or sell a quantity of a particular asset at a specified future date at a pre-agreed price. This protects both buyer and seller from the risks of movement in prices. The most common use is in the currency and interest rate markets.

A future is similar to a forward contract in that it commits the holder to take or make delivery of a standard amount of a specified commodity or financial instrument on a future date at an agreed price. Futures differ from forwards in that they tend to be standardised (exchange-traded) rather than bespoke (over-the-counter).

Futures also differ from forward contracts in that futures are not normally held to maturity. The holder of the contract can normally terminate their commitment by entering into an equal but opposite transaction at a date of their choosing. Futures also differ in that the current profit or loss on the contract is calculated on a daily basis, a process that is called being marked to market. The buyer (or seller) has to be able to provide sufficient funds to the institution to cover any losses which are calculated on this basis.

Both forward contracts and futures fall within the tax definition of a ‘future’.

For example, a financial trading company buys a futures contract which obliges it to buy 150 tons of tuna at $700 per metric ton on 31 January 20X9. The trader does not intend to acquire the tuna, but seeks, instead, to make a profit out of the expected movement of the price of fish due to dwindling supplies. To close its position and secure a profit, the company subsequently sells a futures contract which obliges it to sell 150 tons of tuna at $800 per metric ton on the same date. The contracts have effectively cancelled each other and the trader has made a profit of $15,000.

Swaps

A swap is an agreement to exchange a series of cashflows based on the value of, or return from, one property with a series of cashflows based on a second property. The most common derivative contracts are what are known as interest-rate swaps, and currency swaps. Swaps would normally fall within the tax definition of a contract for difference.

Interest-rate swap

A company may enter into an interest-rate swap to effectively exchange a variable (usually described as floating) rate of interest for a fixed rate, or exchange a fixed rate for a variable rate.

For example, a company has taken out a loan with a floating rate of interest. Due to potential changes in interest rates, it takes out an interest rate swap, so that it makes fixed payments (rather than variable ones). The net effect is the same as if it had borrowed at a fixed rate of interest. Note that, in this example, if it ends up paying less interest than it receives under the swap the contract is said to be in-the-money. The company will need to account for any profit it makes under this derivative contract as a credit.

Cross currency swap

Historically, cross currency swaps were the first type of swap to be developed, but it is probably easiest to think of them as a special type of interest-rate swap. Under a cross currency swap, the parties exchange interest payments on an amount denominated in one currency for interest on an amount denominated in a second currency. Unlike interest rate swaps, however, the principal amounts are generally exchanged at the end of the swap period, at an exchange rate agreed in the contract.

A cross currency swap is similar to an interest-rate swap, in that the parties exchange interest obligations for an agreed period. But it has extra complications because two different currencies are involved. A company would normally enter into a cross currency swap to protect itself from the adverse consequences that a rise or fall in the value of either UK sterling or a relevant foreign currency might have upon its business.

For example, a UK trading company has a liability in the form of a €100 million sterling loan from European investors. It enters into a cross currency swap with a bank to hedge its currency risk. It will then pay the bank amounts that are equivalent to the rate of GBP interest (on the GBP equivalent of €100 million, say £80 million) while the bank will pay the company amounts equivalent to the euro interest on €100 million. At the end of the loan, the company will pay the bank the £80 million and receives €100 million. As a result the company has the certainty that it will pay a fixed amount in GBP and is therefore isolated from currency fluctuations.

The company will need to judge carefully the financial risks and costs involved.

Further guidance

There is further guidance in the Corporate Finance Manual at CFM13010 onwards.