CFM13020 - Understanding corporate finance: derivatives: what is a derivative?

Definition of a derivative

A dictionary definition of a derivative is

‘a financial instrument whose performance is based on (or derived from) the movement of the price of an underlying asset, which does not have to be bought or sold.’

In the world of accounting, IFRS 9 defines a derivative as follows:

‘A financial instrument or other contract within the scope of this Standard with all three of the following characteristics.

(a) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).

(b) it 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) it is settled at a future date’

CTA09/S576 sets out a statutory definition of a ‘derivative contract’ is for corporation tax purposes. As explained at CFM13010, this meaning of this expression in some ways has a wider and others narrower than that of a ‘derivative’ for accounting purposes.

In the light of the significant differences, the two terms should not be used interchangeably.

Terminology

The word ‘derivative’ has only been in common use since the 1980s, although the idea is not new. Terminology is not standard throughout the derivatives industry. Derivative products, and the terms used to describe them, are constantly evolving. If HMRC staff come across a term that is unfamiliar, they should ask the company to explain it. They should not jump to conclusions about the tax treatment of a derivative contract merely on the basis of how the contract is referred to in the company’s accounts or computations, or in correspondence. They will need to look at the rights and obligations of each party under the contract and ensure they understand what each party pays and receives.

Underlying subject matter

The ‘underlying’ in relation to a derivative, according to IFRS9, is ‘a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. It can be any asset or bundle of assets, tangible or intangible, real or notional, or liability or bundle of liabilities, provided that one can attach a value or a measurement to it. The essence of the meaning is that the underlying subject matter of a derivative is the primary driver of changes in value of the derivative.

It may be something which is - at least in principle - capable of being delivered, such as foreign currency or a commodity. But equally:

• The underlying may be something which does not actually exist, but which can be valued - for example, you can have derivatives based on notional loan relationships. Futures over government bonds typically track the value of a notional bond, with standardised features, regardless of whether or not an identical bond is actually in issue at the time. If holders of the future want to actually take delivery of a bond, they will receive real bonds of an equivalent value.
• It can be something which is not deliverable, but can be measured, such as weather.
• The derivative may be based on an index which tracks the price or behaviour of a whole collection of assets.