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Derivatives
The use of derivatives and their sale to
customers as risk management products
is an integral part of the Group’s trading
activities. These instruments are also
used to manage the Group’s own
exposure to fluctuations in interest and
exchange rates as part of its asset and
liability management activities.
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Derivative instruments are contracts whose value is derived
from one or more underlying financial instruments or indices
defined in the contract. They include swaps, forward rate
agreements, futures, options and combinations of these
instruments and primarily affect the Group’s net interest
income, dealing profits, commissions received and other
assets and liabilities. Notional amounts of the contracts are
not recorded on the balance sheet.
The Group participates both in exchange traded and ‘over
the counter’ (OTC) derivatives markets.
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Exchange traded derivatives |
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The Group buys and sells exchange traded financial
instruments, primarily financial futures and options on
financial futures. Holders of exchange traded instruments
provide margin daily with cash or other security at the
exchange, to which the holders look for ultimate settlement.
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OTC traded derivatives |
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The Group buys and sells financial instruments that are traded
over the counter, rather than on a recognised exchange. In
general, the terms and conditions of these transactions are
tailored to the requirements of the Group’s customers,
although the majority conform to normal market practice.
In many cases, industry standard documentation is used, most
commonly in the form of a master agreement, with individual
transaction confirmations. The existence of a signed master
agreement is intended to give the Group protection in
situations where a counterparty is in default, including the
ability to net outstanding balances where the rules of offset
are legally enforceable. For further explanation of the Group’s
policies on netting, see Accounting policies.
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Foreign exchange derivatives |
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The Group’s principal exchange rate related contracts are
forward foreign exchange contracts, currency swaps and
currency options. Forward foreign exchange contracts are
agreements to buy or sell a specified quantity of foreign
currency usually on a specified future date at an agreed rate.
A currency swap generally involves the exchange, or notional
exchange, of equivalent amounts of two currencies and a
commitment to exchange interest periodically until the
principal amounts are re-exchanged on a future date.
Currency options provide the buyer with the right, but not
the obligation, either to purchase or sell a fixed amount of
a currency at a specified exchange rate on or before a future
date. As compensation for assuming the option risk, the
option writer generally receives a premium at the start of
the option period.
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Interest rate derivatives |
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The Group’s principal interest rate related contracts are
interest rate swaps, forward rate agreements, caps, floors,
collars, swaptions and bond options.
An interest rate swap is an agreement between two parties
to exchange fixed rate and floating rate interest by means of
periodic payments based upon a notional principal amount
and the interest rates defined in the contract. Certain
agreements combine interest rate and foreign currency swap
transactions, which may or may not include the exchange of
principal amounts. A basis swap is a form of interest rate swap,
in which both parties exchange interest payments based on
floating rates, where the floating rates are based upon
different underlying reference rates.
In a forward rate agreement, two parties agree a future
settlement of the difference between an agreed rate and a
future interest rate, applied to a notional principal amount.
The settlement, which generally occurs at the start of the
contract period, is the discounted present value of the payment
that would otherwise be made at the end of that period.
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Equity derivatives |
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The Group’s principal equity related contracts are equity and
stock index swaps and options (including warrants, which are
options listed on an exchange).
An equity swap is an agreement between two parties to
exchange periodic payments, based upon a notional principal
amount, with one side paying fixed or floating interest and the
other side paying based on the actual return of the stock or
stock index. No principal amounts are exchanged.
An equity option provides the buyer with the right, but not the
obligation, either to purchase or sell a specified stock or stock
index at a specified price or level on or before a specified date.
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Commodity derivatives |
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The Group’s commodity related contracts are mainly swaps
and options on commodities such as oil price indices and
precious and base metals price indices.
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Property forwards |
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Property index forwards are OTC contracts for differences
between the contract price and the settlement price on a
given date in the future of a specified property index.
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Credit derivatives |
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Credit derivatives are financial instruments that enable banks
to manage credit risk without changing their underlying loan
portfolios. The effect of a credit derivative is to transfer credit
risk from one party, the protection buyer, to another party,
the protection seller, who receives premium or interest related
payments in return for contracting to make payments to the
protection buyer. The payments are linked to the standing
of a reference asset, which may be a security, a loan or an
obligation on other derivative instruments. The term credit
derivative may also be applied to cash instruments where
repayment is linked to the credit standing of a reference asset.
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