CFM62932 - Foreign exchange: matching: derivative contracts used to hedge share transactions: excluded cases

REG 5ZA(7) S.I. 2004/3256

There are four specific exclusions on the type of situation where REG 5ZA can apply.

Derivatives with connected companies (REG 5ZA(7)(a))

The general rule is that for REG 5ZA to apply, the counterparty to the hedging derivative contract must be a person who is not a connected company.

This requirement is relaxed to permit the counterparty to be a connected company (‘A’) where A is party to a derivative contract on equivalent terms, but with an unconnected party. Connected for these purposes is defined in CTA09/S1316.

Company ‘A’ will have offsetting positions on the third party and related party contracts. There can also be multiple internal contracts between connected company ‘A’ and the company with the forecast transaction or firm commitment.

This therefore allows groups to pass a derivative contract from say a group treasury company to the company with the relevant hedging relationship.

Derivatives with large upfront investment (REG 5ZA(7)(b))

There is an exclusion for derivative contracts, which are not accounted for as derivatives but nevertheless pass the accounting condition in CTA09/S579(1)(b). Such instruments might be referred to for regulatory purposes as quasi-derivatives; their value changes in response to changes in the value of the underlying, but they are not accounted for as derivatives. These instruments would be accounted for as derivatives were it not for condition (b) of the accounting definition. Condition (b) is the requirement that a derivative should require no initial net investment, or an initial net investment that is smaller than would typically be required - see CFM50280. It would be very unusual for a company to use such instruments to hedge the currency risk connected with an anticipated share transaction.

This exclusion has the effect that amounts which might be recognised in financial statements in respect of such financial instruments and which may include amounts that are, in effect, funding costs, cannot be disregarded.

Anticipated transactions between connected companies (REG 5ZA(7)(c))

The anticipated transaction must not be with a connected company, see CFM35110.

Example

A Ltd holds 30% of JV Ltd and JV Ltd is planning on acquiring Target SA from Z Ltd for €100m. A Ltd is injecting €30m of equity to help fund the acquisition, in respect of which it takes out a €30m currency forward.

As long as JV Ltd and Z Ltd are not connected companies, then the acquisition of shares in Target SA is eligible to fall within REG 5ZA as an anticipated transaction. A Ltd is therefore able to apply REG 5ZA to its hedging relationship between the derivative contract and the share subscription into JV Ltd.

Hedging relationship as part of a banking trade (REG 5ZA(7)(d))

The hedging relationship must not be part of a trade that consists of or includes dealing in shares or entering into creditor relationships, where a financial trader entered into the derivatives as part of that trade.