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HMRC internal manual

Corporate Finance Manual

Accounting for corporate finance: derivative contracts: examples of derivatives

This guidance applies for IFRS, New UK GAAP and FRS 26 under Old UK GAAP.

Examples of derivatives

Example 1

A company buys an option, the underlying subject matter of which is 10 ounces of gold. The strike price is £260/ounce, and the option is exercisable in three months’ time. It can only be cash settled. The company pays a premium of £200 for the option.

Because the option can be settled net in cash, it is within the scope of the relevant financial instrument standard, and - since there is no possibility of gold being delivered - it is unnecessary to consider whether the company wants gold for its normal trade purposes (see CFM21508). The value of the option changes as gold prices changed, and it is settled at a future date. (This will be the case even if the option is out of the money, and expires without being exercised - this is a form of settlement).

The company must make an initial net investment of £200 in order to acquire the option. However, this is less than would have to be paid for a contract that responded similarly to changes in gold price, such as a contract to physically acquire 10 ounces of gold. The option therefore passes all three tests to be a derivative.

Example 2

X Ltd makes a 5-year fixed rate loan of £10 million to Y Ltd. Y Ltd makes a £10 million loan for 5 years to X Ltd, at a variable rate of interest.

This arrangement functions in the same way as an interest rate swap. The value of the arrangement depends on interest rates, and there is settlement at future dates, when each exchange of interest payments is made. There is no initial net investment, since the loans are self-cancelling.

This arrangement would be treated as a derivative under the relevant financial instrument standard. Non-derivative transactions may be aggregated and considered together where they are entered into at the same time and in contemplation of each other, have the same counterparty and relate to the same risk, and there is no apparent business purpose to having separate transactions.

Example 3

A company enters into a £50 million 2-year interest rate swap, under which it receives fixed rate payments and pays variable rate payments. However, it prepays its obligation under the swap by making, at the inception of the contract, a lump sum payment representing the value of the stream of variable rate payments at current market rates. It continues to receive the fixed rate payments over the life of the contract.

Although this may be described as a swap, it is not treated as a derivative. The company has, in essence, paid a capital sum for a fixed annuity. The amount it would have to pay for such an annuity contract varies with interest rates; but the company has made an initial investment equal to the full price. The swap therefore fails the second of the three tests given in CFM24200.