part i of Financial Derivatives Additions to the fifth edition (1993) of the Balance Of Payments Manual
- International Monetary Fund. Statistics Dept.
- Published Date:
- May 2000
XXV. Financial Derivatives
Concept and Coverage
FD 1. A financial derivative contract is a financial instrument that is linked to another specific financial instrument or indicator or commodity and through which specific financial risks (such as interest rate risk, foreign exchange risk, equity and commodity price risks, credit risk, etc.) can, in their own right, be traded in financial markets. Transactions in financial derivatives are treated as separate transactions rather than as integral parts of the values of the underlying transactions to which they are linked. The value of a financial derivative derives from the price of an underlying item such as an asset or index. No principal amount that must be repaid is advanced, and no investment income accrues. Financial derivatives are used for a number of purposes—risk management, hedging, arbitrage between markets, and speculation, for example.
FD 2. Financial derivatives enable parties to trade specific financial risks to other entities that are more willing, or better suited, to take or manage these risks and that typically, but not always, do so without trading in primary assets or commodities. The risk embodied in a derivative contract can be traded either by trading the contract itself, as with options, or by creating a new contract embodying risk characteristics that match, in a countervailing manner, those of the existing contract. The latter practice, which is termed offsetability1, occurs in forward markets. Offsetability means that it is often possible to eliminate the risk associated with a derivative by creating a new but “reverse” contract having characteristics that countervail the risk of the first derivative. Buying the new derivative is the functional equivalent of selling the first derivative because the result is the elimination of risk. The ability to countervail the risk in the market is therefore considered the equivalent of tradability in demonstrating value. The outlay that would be required to replace the existing derivative contract represents its value; actual offsetting is not required to demonstrate value.
FD 3. There are two broad types of financial derivatives. In a forward contract, which is unconditional, two counterparties agree to exchange a specified quantity of an underlying item (real or financial) at an agreed-upon price (the strike price) on a specified date. In an option contract, the purchaser acquires from the seller a right to buy or sell, (depending on whether the option is a call or a put) a specified underlying item at a strike price on or before a specified date. Unlike debt instruments, financial derivatives do not accrue investment income; nor are principal amounts advanced that must be repaid.
FD 4. The value of a financial derivative derives from the price of the underlying item (the reference price). Because a future reference price is not known beforehand, the value of a financial derivative at maturity can only be anticipated or estimated. A reference price may be related to a commodity, a financial instrument, an interest rate, an exchange rate, another derivative, a spread between two prices, or an index or basket of prices. An observable reference price for the underlying item is essential for calculating the value of any financial derivative. If there is no observable prevailing market price for the underlying item, it cannot be regarded as a financial asset. Transactions in financial derivatives are treated as separate transactions rather than as integral parts of the values of the underlying transactions to which they are linked. Embedded derivatives, however, are not identified and valued separately from primary instruments. (See paragraph FD 6.)
FD 5. Financial derivative contracts are usually settled by net payments of cash. Exchange-traded contracts, such as commodity futures, are often settled before maturity. Cash settlement is a logical consequence of the use of financial derivatives to trade risks independently of the ownership of underlying items. However, some financial derivative contracts, particularly those involving foreign currency, are settled by deliveries of the underlying items.
FD 6. For balance of payments purposes, the following types of financial instruments are not financial derivatives.
A fixed price contract for goods and services is not a financial derivative unless the contract is standardized so that the market risk therein can be traded in financial markets in its own right.
insurance is not a financial derivative. Insurance contracts provide individual institutional units with financial protection against the consequences of the occurrence of specified events. (In many instances, the value of this financial protection cannot be expressed in terms of market prices.) Insurance is a form of financial intermediation through which funds are collected from policyholders and invested in financial or other assets. These assets are held as technical reserves to meet future claims arising from the occurrence of events specified in insurance policies. That is, insurance is used to manage event risk primarily by the pooling, not the trading, of risk.
contingencies, such as guarantees and letters of credit, are not financial derivatives. The principal characteristic of a contingency is that one or more conditions must be fulfilled before a financial transaction takes place. Contingencies are typically not instruments that facilitate the trading of specific financial risks.
An embedded derivative (a derivative feature that is inserted in a standard financial instrument and is inseparable from the instrument) is not considered a financial derivative for balance of payments purposes. If a primary instrument such as a security or loan contains an embedded derivative, the instrument is valued and classified according to its primary characteristics—even though the value of that security or loan may well differ from the values of comparable securities and loans because of the embedded derivative. Examples are bonds that are convertible into shares and securities with options for repayment of principal in currencies that differ from those in which the securities were issued.
FD 7. In addition, timing delays that arise in the normal course of business and may entail exposure to price movements do not, for balance of payments purposes, give rise to transactions and positions in financial derivatives. Timing delays include normal settlement periods for spot transactions in financial markets.
FD 8. Financial derivatives that can be valued separately from the underlying items to which they are linked are included—whether or not they are traded on an exchange—in the financial account of the balance of payments and in the international investment position.
FD 9. In a forward contract, the counterparties agree to exchange, on a specified date, a specified quantity of an underlying item (real or financial) at an agreed-upon contract price (the strike price). This class of financial derivatives includes futures and swaps. Futures are forward contracts traded on organized exchanges. Futures and other forward contracts are typically, but not always, settled by payments of cash or provision of other financial instruments rather than by actual deliveries of underlying items. Futures are valued and traded separately from underlying items. If a forward contract is a swap contract, the counterparties exchange, in accordance with pre-arranged terms, cash flows based on the reference prices of the underlying items. Forward rate agreements and forward foreign exchange contracts are common types of forward contracts. Interest-rate and cross currency interest-rate swaps are common types of swap contracts. (See paragraphs FD 27 and FD 28 for further discussion.)
FD 10. At the inception of a forward contract, risk exposures of equal market value are exchanged. Both parties are potential debtors, but a debtor/creditor relationship can be established only after the contract goes into effect. Thus, at inception, a contract normally has zero value. However, as the price of the underlying item changes during the life of the forward contract, the market value of each party’s risk exposure will differ from the market value of zero at the inception of the contract. When a change in the price of the underlying item occurs, an asset (creditor) position is created for one party, and a liability(debtor) position is created for the other. The debtor/creditor relationship may change, in both magnitude and direction, during the life of a forward contract.
FD 11. The purchaser of an option contractpays a premium to the writer of the option. In return, the buyer acquires the right but not the obligation to buy (call option) or sell (put option) a specified underlying item (real or financial) at an agreed-upon contract price (the strike price) on or before a specified date. A major difference between forward and option contracts is that either party to a forward contract is a potential debtor, whereas the buyer of an option acquires an asset, and the option writer incurs a liability. However, an option may expire without worth; it is exercised only if settling the contract is advantageous to the buyer. The option buyer may make gains of unlimited size, and the option writer may experience losses of unlimited size.
FD 12. Options are written on a wide variety of underlying items—such as equities, commodities, currencies, and interest rates (including caps, collars, and floors).2 Options are also written on futures, swaps (known as swaptions), caps (known as captions), and other instruments.
FD 13. In organized markets, option contracts are usually settled in cash, but some types of option contracts are normally settled by purchases of underlying assets. For instance, a warrant is a financial contract that gives the holder the right to buy, under specified terms, a certain number or amount of the underlying asset (such as equity shares). If a warrant is exercised, the underlying asset is usually delivered. Warrants can be traded separately from the underlying assets to which they are linked.
Recording of Financial Derivative Transactions and Positions
FD 14. The statistical treatment of financial derivatives for the balance of payments and the international investment position requires compilers and statisticians to
recognize the exchange of claims and obligations at the inception of a derivative contract as a true financial transaction creating asset and liability positions that normally have, at inception, zero value if the instrument is a forward and value equal to the premium if the instrument is an option
treat any changes in the values of derivatives as holding gains or losses
record secondary market transactions in marketable derivatives, such as options, as financial transactions
record any payments made at settlements as transactions in financial derivative assets or liabilities (That is, no income arises from settlements of financial derivatives.)3
record, in the international investment position, outstanding values of financial derivatives at market prices.
Valuation of positions
FD 15. A key characteristic of most derivative contracts is that the counterparties make commitments to transact, in the future and at agreed-upon prices, in underlying items. The present value (or market price) of a financial derivative is derived from the difference between the agreed-upon contract price of an underlying item and the prevailing market price (or the market price expected to prevail), appropriately discounted, of that item. For options, whether they are traded on an exchange or not, the prices are directly observable because option purchasers acquire assets (the rights to buy or sell specified underlying items) and the prices of those assets must be established. The price of an option depends on the potential price volatility of the underlying instrument, the time to maturity, interest rates, and the difference between the strike price and the market price of the underlying item. The value of a swap contract based on a notional principal amount is derived from the difference, appropriately discounted, between expected gross receipts and gross payments.
FD 16. Financial derivatives are valued at market prices prevailing on balance sheet recording dates. Price changes occurring between recording dates are classified as revaluation gains or losses. If market price data are unavailable, other fair value methods (such as option models or discounted present values) may be used to value derivatives.
Payments at inception
FD 17. The purchaser of an option pays a premium to the seller. The full price of the premium is recorded, by the buyer, as the acquisition of a financial asset and, by the seller, as the incurrence of a liability. Sometimes a premium is paid after the inception of a derivative contract. Then the value of the premium payment is recorded by the option purchaser as an asset that was financed by a loan from the option writer at the time the derivative was purchased.
FD 18. The creation of a forward contract does not normally require the recording of a transaction in a financial derivative because risk exposures of equal value are usually being exchanged. That is, there is zero exposure and zero value for both sides.
FD 19. Commissions and fees paid—at inception or during the lives of derivatives—to banks, brokers, and dealers are classified as payments for services. These payments are rendered for services provided within current periods and are independent of asset and liability relationships created by the derivatives.
Sales of derivatives in secondary markets
FD 20. Sales of derivatives in secondary markets—whether the markets are exchanges or over-the-counter—are valued at market prices and recorded in the financial account as transactions in financial derivatives.
FD 21. Net settlement payments are financial transactions that are similar to transactions at the maturities of other financial instruments. At settlement, either a cash payment is made, or an underlying item is delivered.
When a financial derivative is settled in cash, a transaction equal to the cash value of the settlement is recorded for the derivative. No transaction in the underlying item is recorded. In most instances, when a cash settlement payment is received, a reduction in a financial derivative asset (a credit) is recorded. When a cash settlement payment is made, a reduction of a financial derivative liability (a debit) is recorded. However, in some circumstances, this practice does not hold. When a contract (such as an interest rate swap) calls for ongoing settlement and a cash settlement is received, there is an increase in a financial derivative liability (a credit) if, at the time of the settlement payment, the contract is in a liability position. The reverse also applies; that is, when a contract calls for ongoing settlement, a cash payment is recorded as an increase in an asset (a debit) if, at the time of the settlement, the contract is in an asset position. If compilers are unable to implement this approach because of market practice, it is recommended that all cash settlement receipts be recorded as reductions in financial assets and all cash settlement payments be recorded as decreases in liabilities.
When an underlying instrument is delivered, two transactions occur and both are recorded. The transaction in the underlying item is recorded at the market price prevailing on the day of the transaction. The transaction in the derivative is recorded as the difference, multiplied by the quantity, between the prevailing market price for the underlying item and the strike price specified in the derivative contract.
When more than one contract is settled—in cash, at the same time, and with the same counterparty—some of the contracts being settled are in asset positions and some are in liability positions. In this situation, it is recommended that the transactions be recorded on a gross basis ; that is, the transactions in assets are recorded separately from those in liabilities and are thereby recorded as separate credit and debit flows. Recording the transactions on a gross basis is preferred to recording them on a net basis; that is, after the sum of the liability flows is subtracted from the sum of the asset flows, the resulting debit or credit is recorded as a single amount.4 However, for practical reasons, there may be no alternative to net recording.
FD 22. Margins are payments of cash or deposits of collateral that cover actual or potential obligations incurred through financial derivatives—especially futures or exchange-traded options. The required provision of margin reflects market concern over counterparty risk and is standard in financial derivative markets
FD 23. Repayablemargin consists of cash or other collateral deposited to protect a counterparty against default risk. Ownership of the margin remains with the unit that deposited it. Although its use may be restricted, a margin is classified as repayable if the depositor retains the risks and rewards of ownership—such as the receipt of income or exposure to holding gains and losses. At settlement, a repayable margin (or the amount of repayable margin in excess of any liability owed on the derivative) is returned to the depositor. In organized markets, repayable margin is sometimes known as initial margin.
FD 24. Repayable margin payments of cash are transactions in deposits, not transactions in financial derivatives. A depositor has a claim on an exchange, brokerage, or other institution holding the deposit. Some countries may prefer to classify repayable margin deposits within other accounts receivable/payable in order to reserve the term deposits for monetary aggregates. When a repayable margin deposit is made in a non-cash asset (such as securities), no transaction is recorded because no change in ownership has occurred. The entity (the issuer of the security) on which the depositor has a claim is unchanged.
FD 25. The payment of nonrepayable margin is a transaction in a derivative; the payment is made to reduce a financial liability created through a derivative. In organized exchanges, nonrepayable margin (sometimes known as variation margin) is paid daily to meet liabilities recorded as a consequence of the daily marking of derivatives to market value. The entity that pays nonrepayable margin no longer retains ownership of the margin or has the right to the risks and rewards of ownership. A payment of nonrepayable margin is recorded as a reduction in financial derivative liability (a debit); the contra-entry is a reduction (probably in currency and deposits) in a financial asset (a credit). The receipt of nonrepayable margin is recorded as a reduction in a financial derivative asset (a credit); the contra-entry is an increase (probably in currency and deposits) in a financial asset (a debit).
FD 26. Arrangements for margining can be complex, and procedures differ among countries. In some countries, repayable and nonrepayable margins are recorded in a single account, and it may be difficult to distinguish between the two types. The actual institutional arrangements (such as the identities of units making payments and types of instrument used) must be reviewed. The key test is whether the margin is repayable or whether payment of the margin represents an effective transfer of ownership between counterparties to the financial derivative contract.
Treatment of Selected Financial Derivatives
Specific interest-rate contracts
FD 27. An interest-rate swap contract consists of a contract to exchange, in one currency and during a specified period of time, cash flows related to interest payments or receipts on a notional amount of principal that is never exchanged. Such swaps are often settled through net cash payments from one of the counterparties to another. A forward rate agreement (FRA) is a contract in which the counterparties agree on an interest rate to be paid, at a specified settlement date, on a notional amount of principal that is never exchanged. FRAs are settled by net cash payments; that is, the difference between the rate agreed upon and the prevailing market rate at the time of settlement is recorded as a transaction in the balance of payments. The buyer of an FRA receives payment from the seller if the prevailing rate exceeds the rate agreed upon. The seller receives payment from the buyer if the prevailing rate is lower than the rate agreed upon. The existence of active financial markets in these contracts results in holding gains and losses. The creation of interest rate swaps and FRA contracts normally requires no entries in the financial account because there are no exchanges of value at the inception of these contracts. Net cash settlement payments for interest-rate swaps and FRAs are classified in the financial account as transactions in financial derivatives. Interest-rate swaps usually involve ongoing settlements during the lives of the contracts; FRAs are usually settled at contract maturity.
Specific foreign currency contracts
FD 28. A foreign exchange swap contract consists of a spot sale/purchase of currencies and a simultaneous commitment to a forward purchase/sale of the same currencies. A forward foreign exchange contract consists of a commitment to transact, at a designated future date and agreed-upon exchange rate, in a specified amount of specified foreign currencies. A cross currency interest-rate swap contract (also known as a currency swap) consists of an exchange of cash flows related to interest payments and, at the end of the contract, an exchange of principal amounts in specified currencies at a specified exchange rate. There may also be an exchange of principal at the beginning of the contract. In that case, subsequent repayments that comprise both interest and amortization of principal may be made over time and according to pre-arranged terms. Streams of interest payments resulting from swap arrangements are recorded in the financial account as transactions in financial derivatives, and repayments of principal are recorded in relation to relevant instruments.
FD 29. For foreign currency financial derivative contracts, it is necessary to distinguish between a transaction in a derivative contract and the requirement to deliver and receive underlying principal associated with the contract.
In contrast to the creation of other forward contracts, the creation of a foreign currency financial derivative contract does not normally lead to the recording, in the financial account, of a transaction in financial derivatives. Any initial sale or purchase of currency is a transaction that is recorded, at the exchange rate agreed upon by the counterparties, in the other investment category of the financial account.
The exchange rate for the forward sale or purchase of currencies through a foreign currency derivative contract is agreed upon by the counterparties when the terms of the contract are established. The derivative contract acquires value as the prevailing market exchange rate differs from the exchange rate agreed upon in the contract.
• At the time of settlement, the difference between the values (which are measured in the unit of account and at the prevailing exchange rate) of the currencies exchanged are allocated to a transaction in a financial derivative. In other words, if the value of the currency received exceeds that of the currency paid, a reduction in a financial derivative asset (a credit) is recorded. The contra-debit entry is an increase in another asset (probably other investment—assets, currency and deposits) classified in the financial account. When the value of the currency received is less than that of the currency paid, the opposite applies. That is, a reduction in a financial derivative liability (a debit) is recorded. The contra-credit entry is a reduction in another item (probably other investment—assets, currency and deposits) classified in the financial account.
FD 30. The financial derivatives described in previous sections are related to market risk, which pertains to changes in the market prices of securities and commodities and to changes in interest and exchange rates. Other types of financial derivatives are used primarily to trade credit risk. These credit derivatives, which are designed for trading in loan and security default risk, can be either forward or option contracts. Like other financial derivatives, credit derivative contracts are frequently drawn up according to standard legal agreements that specify procedures for the provision of margin, which serves as a basis for market valuation.
FD 31. There are a number of common types of credit derivatives. A total return swap consists of swapping of cash flows and capital gains and losses related to the liability of a lower-rated creditor for cash flows related to a guaranteed interest rate, such as an interbank rate, plus a margin. A spread option is a contract with value derived from an interest rate spread between higher quality credit and lower quality credit. For example, if the spread narrows sufficiently, the option holder benefits from exercising the option. A credit default swap consists of swapping, usually on an ongoing basis, the risk premium inherent in an interest rate on a bond or a loan in return for a cash payment that is made in the event of default by the debtor. Some credit default swap contracts require that one party make only a single payment to the other in order to be financially protected against the risk of a catastrophe befalling the creditor. Reference prices for these single-premium contracts, which are more properly classified as forms of insurance rather than financial derivatives, may not be readily available.
Selected Supplementary Information
FD 32. Because financial derivatives are risk-transferring instruments, there may be interest—from analytical and policymaking points of view—in presenting transactions and positions in financial derivatives by type (option and forward) and by category of risk (foreign exchange, interest-rate, and other).
Offsetability should not be confused with an offset, which is the legal right of a debtor to net its claims against the same counterparty. It is recommended that positions be recorded on a gross basis whenever possible.
A cap imposes an upper limit; a floor sets a lower limit; and a collar maintains upper and lower bounds on floating-rate interest payments or receipts.
Financial derivative transactions may take place directly between two parties or through intermediaries. In the latter case, there may be implicit or explicit service charges. Distinguishing an implicit service change is not usually possible. Therefore, it is recommended that net settlement payments for derivative contracts be recorded as financial transactions. When possible, service charges should be recorded separately.
However, the net basis is recommended for transactions in financial derivatives classified as reserve assets.