Sri Lankan Income Tax - New Income Tax Act 2017

Derivatives Lesson 01 : Introduction to Derivatives

Definition

Derivatives are specific types of instruments that derive their value over time from the performance of an underlying asset: eg equities, bonds, commodities.

A derivative is traded between two parties – who are referred to as the counterparties. These counterparties are subject to a pre-agreed set of terms and conditions that determine their rights and obligations.

Derivatives can be traded on or off an exchange and are known as:

• Exchange-Traded Derivatives (ETDs): Standardised contracts traded on a recognised exchange, with the counterparties being the holder and the exchange. The contract terms are non-negotiable and their prices are publicly available.

• Over-the-Counter Derivatives (OTCs): Bespoke contracts traded off-exchange with specific terms and conditions determined and agreed by the buyer and seller (counterparties). As a result OTC derivatives are more illiquid, eg forward contracts and swaps.

Pension schemes were freed by the Finance Act of 1990 to use derivatives without concern about the tax implications. The Act clarified the tax for derivative use. At the time of writing this guide, OTC assets are not explicitly included as valid assets for Local Government Pension Schemes and relevant pension fund trustees should consider obtaining legal advice as to their admissibility.

Commonly used derivatives and their uses

The most common types of derivatives are options, futures, forwards, swaps and swaptions.

• Options:Exchange-traded options are standardised contracts whereby one party has a right to purchase something at a pre-agreed strike price at some point in the future. The right, however, is not an obligation as the buyer can allow the contract to expire and walk away. The cost of buying an option is the seller’s premium which the buyer must pay to obtain the option right. There are two types of option contracts that can be either bought or sold:

• Call – A buyer of a call option has the right but not the obligation to buy the asset at the strike price (price paid) at a future date. A seller has the obligation to sell the asset at the strike price if the buyer exercises the option.

• Put – A buyer of a put option has the right, but not the obligation, to sell the asset at the strike price at a future date. A seller has the obligation to repurchase the asset at the strike price if the buyer exercises the option.

• Futures: Futures are exchange-traded standard contracts for a pre-determined asset to be delivered at a pre-agreed point in the future at a price agreed today. The buyer makes margin payments reflecting the value of the transaction. The buyer is said to have gone long and the seller to have gone short. Counter-parties can exit a commitment by taking an equal but offsetting position with the exchange, so that the net position is nil and the only delivery will be a cash flow for profit or loss. Futures coverage includes currencies, bonds, agricultural and other commodities such as gold. An example would be to buy 10 EUR/USD December contracts each with a nominal of EUR 125,000 to gain future delivery of EUR 1.25 million at a pre-agreed exchange rate.

• Forwards: Forwards are non-standardised contracts between two parties to buy or sell an asset at a specified future time at a price agreed today. For example, pension funds commonly use foreign exchange forwards to reduce FX risk when overseas currency positions are required at known future dates. As the contracts are bespoke they can be for non-standardised amounts and dates, eg delivery of EUR 23,967 against payment of USD 32,372 on 16 January 2014.

• Swaps: Swaps are agreements to exchange one series of future cash flows for another. Although the underlying reference assets can be different, eg equity or interest rate, the value of the underlying asset will characteristically be taken from a publicly available price source. For example, under an equity swap the amount that is paid or received will be the difference between the equity price at the start and end date of the contract.

Swaptions: These are non-standard contracts giving the owner the right but not the obligation to enter into an underlying swap. The most common swaptions traded are those dependent on interest rates which allow funds to create bespoke protection. Contracts can be preconfigured to provide both upside and downside protection if an event occurs. For example, a party can purchase a swaption to protect itself from the 10-year interest rate swap rate going below 1% in 3 months’ time.