CFM50350 - Derivative contracts: relevant contracts: options: examples

Examples explaining the definition of ‘option’

Example 1

A company buys an over the counter (OTC) oil cap. This is an option product, whose underlying subject matter is crude oil. The contract gives the company the right, but not the obligation, to fix the price of a notional cargo of crude oil at a specified price (the strike price) for a specified period. If the average oil price over the period goes above the strike price, the company will exercise the option. The writer of the option will then make a payment to the company based on the difference between the strike price and the market price of the oil. The crude oil cargo, which forms the underlying subject matter, is purely notional and there is no provision in the contract for any oil to be delivered.

The contract meets the conditions in CTA09/S580(2), so for the purposes of Part 7 CTA09 the contract is classed as a contract for differences (CFD) rather than an option.

Example 2

A company buys an OTC currency option, giving it the right, but not the obligation, to purchase US$1m for £600,000 on a specified future date. At the exercise date, US$1m can be bought for £550,000 in the spot market, so the company does not exercise the option. The contract provides for the delivery of property - the dollars being property for this purpose - so it does not meet the CTA09/S580(2) conditions. It is classified as an option for Part 7 purposes. This would still be the case if, as an alternative to the option writer delivering the dollars, the contract provided for a cash settlement in sterling. It would only be debarred from being an option if gross settlement (i.e. an exchange of dollars for sterling) was not offered at all.

Example 3

This example illustrates a case where S580(2) is overridden by other legislation.

Company X issues a security of £100 nominal value, with the following terms: on maturity, the holder of the security is entitled to receive £100 or, if greater, the value of 10 £1 shares in X. The holder has no right to subscribe for, or receive, shares in X as an alternative.

Company X accounts for the security as a host contract (treated as a debtor loan relationship) plus an embedded derivative. For the purposes of CTA09/S652, this embedded derivative is characterised as an option, even though it can only be settled in cash. This is because, for the issuer of the security, CTA09/S652(7) construes ‘option’ as though the restriction in CTA09/S580(2) was omitted.

This means that the statutory provisions (S654 and S655) relevant to options embedded in debtor loan relationships apply in this case, just as they do to a more conventional convertible security where company X may be obliged to transfer or issue shares (see CFM55400+ for more about these rules).

Note, however, that there is no such extension of the meaning of ‘option’ for CTA09/S645, the section dealing with creditor relationships containing embedded options (CFM55220). So the security in this example will not, from the holder’s perspective, come within the special rules for convertible securities.