This paper is the product of work arising from the Informal Group on Financial Derivatives that met at the IMF in April 1996, various meetings of the IMF Committee on Balance of Payments Statistics, and the Expert Group meeting held in November 1996 in conjunction with the preparation of the IMF’s Manual on Monetary and Financial Statistics. An earlier draft was sent to statisticians in IMF member countries, and many commented. The author wishes to thank all those experts who contributed to the project and the production of the paper. He also extends his thanks to Mr. Russell Krueger of the Fund’s Statistics Department who made substantial contributions in the form of ideas and comments and prepared Appendix III, and to Mr. Christopher Wright of the Bank of England, who made important contributions on several issues including the question of offsetability on the market and whose paper on this issue is included as Appendix II.
Written by Mr. Christopher Wright of the Bank of England.
The use of financial derivatives can reduce transactions costs, and/or aid price discovery.
For a definition of “offsetable on the market” see the entry for “offsetability on the market” in the glossary of terms at the end of this paper.
In this paper, the term reference price is the price of the underlying item(s) from which the financial derivative contract acquires value. The strike price is the agreed price of the contract at which the counterparties will transact if the financial derivative is exercised. Where the value of a forward contract is based on the difference between two reference prices, such as in an equity swap, there is no agreed strike price as such.
See paragraph 6.135 of the 1993 SNA for a description of the characteristics of insurance.
Forwards, swaps and options are also described in paragraphs 11.37 to 11.43 of the 1993 SNA, and paragraphs 401 to 408 of BPM5.
financial derivatives are instruments over which ownership rights can be enforced. Also, financial derivatives can bring economic benefits. For instance, a financial derivative may allow end users to smooth cash flow over time by accepting a known future market price for a financial instrument or commodity rather than facing the, as yet, unknown market price at the moment they want/need to transact. Among the economic benefits deriving from a smoother cash flow are a possible reduction in tax bills, the ensuring of sufficient cash to finance planned investment programs, and a reduction in the possibility of getting into financial difficulty because of sudden adverse movements in market prices.
Of course, there is the risk, however remote, that the clearinghouse could default.
The exchange, through its margining practices, may revalue the contract daily and require settlement, in which case the previous revaluation, not the price agreed when the contract was purchased, is relevant. See Section IV for a description of margining practices.
For instance, in the early 1990s there were attempts in the US to create forward-type financial derivatives based on catastrophe risk. The attempts to launch such products failed at that time because of a lack of a widely recognized representative underlying index. For national income purposes, these “instruments” might well have been regarded as contingencies.
Units specializing in issuing financial derivatives can be classified as intermediaries in cases where the financial derivatives are recognized as financial assets.
General principles of valuation are set out in Chapter XIII, Section A, Part 4 of the 1993 SNA.
In principle a forward-type contract is established with zero value, but in the over-the-counter market, a forward-type contract could have a positive or negative value from inception reflecting, say, counterparty risk.
Difficulties in establishing generally agreed market prices for the risk exposures being traded have hampered the development of markets in some types of risk, such as credit risk. Without market prices, it is not evident to both counterparties that they are trading risk exposures of equal market value, hence discouraging market activity.
The price paid may not only include cash, but also other financial assets.
The treatment of employee stock options as financial derivatives is under consideration by the Fund.
Together with over-the-counter options, these financial derivatives represented 95% of outstanding over-the-counter financial derivatives contracts in terms of gross market value.
A swap of cash flows related to interest receipts is a type of asset swap.
Although, as mentioned in Section I above, it is a practice of commercial accounting standards, unlike the national accounts, to regard some holding gains and losses on financial assets and liabilities as income.
Other similar interest rate products like caps, collars, floors, barrier options, captions etc., are all over-the-counter options contracts and are, by convention, included in the financial account.
One argument in favor continuing to regard the interest element of cross-currency interest rate swap contracts as income is that they are used by borrowers in direct connection with cross-border financing. To the borrower it appears that the two transactions - the original debt and the swap - are one, with the consequence that while it borrowed and owes interest and principal in one, say, foreign currency, the borrower considers that to all intents and purposes its debt is in, say, the domestic currency. Some compilers present their data in this manner: in the position statement, the value of the original debt and the foreign currency swap are linked, and in their income account the interest payments on the original debt and any payments/receipts on the foreign currency swaps are also linked. To the compiler, this is seen to more accurately reflect the position from the borrower’s viewpoint. Nonetheless, there are two transactions, the original borrowing and the cross-currency interest rate swap, and the 1993 SNA and BPM5 are clear in recommending that financial derivatives should be treated separately to the underlying transactions to which they may be linked as a hedge, because a different institutional unit will be party to the financial derivative transaction than is the case for the underlying transaction that is being hedged.
It is possible that many hedges are incorrectly recorded in national accounts, or remain undetected, and bias estimates in an unknown manner. Usually, hedges will cause only small errors, but substantial errors might occur where exchange rate volatility is high, or where basic agricultural or mineral commodities are hedged.
Repayable margin is more akin to initial margins, and nonrepayable margin to variation margin.
Also, unlike securities, no investment income arises from the ownership of a financial derivative instrument.
This Appendix was written by Mr. Christopher Wright of the Bank of England.
This appendix was written by Mr. Russell Krueger of the Fund’s Statistics Department.
See BIS. Issues of Measurement Related to Market Size and Macroprudential Risks in Derivatives Markets. (Basle: February 1995).