CFM50340 - Derivative contracts: relevant contracts: options
CTA09/S580
What is an option?
Beyond making it clear that ‘option’ includes a warrant, S580 does not define option, and the word must be understood in its normal market meaning.
Under an option, one of the parties to the contract must be able to exercise a choice. In the case of a call option the option holder has the choice to purchase an asset from the counterparty. In the case of a put option the holder has the choice whether or not to sell the asset to the counterparty. The holder will only exercise the option if it is financially advantageous to do so. Otherwise the holder would let the option lapse, incurring the maximum possible loss, being the cost of the option.
An option may not necessarily run to marurity; it may be assigned for consideration at some earlier time, or cash-settled either on or before maturity. It is the nature of the contract which determines if it is an option.
S580(1) provides that the term ‘option’ includes a warrant. A ‘warrant’ is defined in CTA09/S710 as an instrument entitling the holder to subscribe for shares in a company or assets representing a loan relationship of a company. S710 makes it clear that the statutory definition includes covered warrants, whose underlying subject matter is shares or bonds that already exist, and warrants which give the holder a right to subscribe to as yet un-issued shares or bonds.
Although an option typically requires the holder to take some action to exercise his rights, some options, are automatically exercised. The holder then reaps any benefits of the contract without needing to give notice of exercising the option. Such contracts are still options for the purposes of Part 7 CTA09.
Physical delivery of the underlying asset
To be an option under CTA09/PT4, the contract must be capable of delivery of the underlying asset. Where delivery is not possible, S580(2) specifically excludes it from being treated as an option under CTA/PT7. It typically will be a contract for differences, see CFM50380.
It is possible to create other contracts whose value and market pricing behave in exactly the same way in response to the value of the underlying and the passage of time but where delivery of the underlying asset is not possible. This would be the case where the contract provided for cash settlement to always apply. Such a contract might also be regarded by the markets as an option, but only in a mathematical sense. It would not be an option within S580.
For example, a contract that provides for an option to enter into a derivative contract will itself be a contract for differences instead of an option, for example in the case of a swaption (CFM50360), as entry into a contract would not constitute delivery.
As an exception to the general rule, a currency option which is settled by one or both parties paying an amount of foreign currency is not debarred from being an ‘option’ for the purposes of CTA09/PT7. The currency is in this case the property that is delivered.
Examples
There are examples at CFM50350.
Further guidance
A cash-settled option can, however, still an ‘option’ for the purposes of particular pieces of legislation: