Barclays 2003 Annual Report Download - page 67

Barclays PLC Annual Report 2003 65
Risk Management
Derivatives
Interest rate derivatives
The Group’s principal interest rate related contracts are interest rate
swaps, forward rate agreements, basis swaps, caps, floors and swaptions.
Included in this product category are transactions that include
combinations of these features.
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 indices.
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.
Equity derivatives
The Group’s principal equity related contracts are equity and stock index
swaps and options (including warrants, which are equity 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,
basket of stocks or stock index at a specified price or level on or before
a specified date.
Credit derivatives
The Group’s principal credit derivative related contracts include credit
default swaps and total return swaps. A credit derivative is an
arrangement whereby the credit risk of an asset (the reference asset)
is transferred from the buyer to the seller of protection.
A credit default swap is a contract where the protection seller receives
premium or interest related payments in return for contracting to make
payments to the protection buyer upon a defined credit event. Credit
events normally include bankruptcy, payment default on a reference
asset or assets and downgrades by a rating agency.
A total return swap is an instrument whereby the seller of protection
receives the full return of the asset, including both the income and
change in the capital value of the asset. The buyer in return receives
a predetermined amount.
A description of how credit derivatives are used within the Group is
provided on pages 50 and 107.
A description of the impact of derivatives under US GAAP is set out on
page 195.
Commodity derivatives
The Group’s principal commodity related derivative contracts are swaps,
options, forwards and futures. The main commodities transacted are
base metals, precious metals, energy products (covering US natural gas,
oil and oil-related products) and European power and gas.
A description of commodity derivatives is provided on page 63.
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.
Barclays Capital manages the trading derivatives book as part of the
market risk book. This includes foreign exchange, interest rate, equity,
commodity and credit derivatives. The policies regarding market risk
management are outlined in the market risk management section on
pages 60 to 62.
The policies for derivatives that are used to manage the Group’s own
exposure to interest and exchange rate fluctuations are outlined in the
treasury asset and liability management section on pages 66 to 69.
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 OTC derivatives
markets.
Exchange traded derivatives
The Group buys and sells financial instruments that are traded or cleared
on an exchange, including interest rate swaps, futures and options on
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.
Over the counter traded derivatives (OTC)
The Group also buys and sells financial instruments that are traded over
the counter, rather than on a recognised exchange.
These instruments range from commoditised transactions in derivative
markets, to trades where the specific terms are tailored to the requirements
of the Group’s customers. 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 on pages 114 to119.
Foreign exchange derivatives
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.