Barclays 2005 Annual Report Download - page 79

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, exchange rates and
commodity and equity prices 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 67 to 71.
The policies for derivatives that are used to manage the Group’s own
exposure to interest and exchange rate fluctuations are outlined in the
asset and liability market risk section on page 70.
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.
A description of the impact of first time adoption of International
Financial Reporting Standards (IFRS) is provided in Note 62.
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.
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.
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.
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, or 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 page 59.
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.
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.
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, oil and oil related
products, power and natural gas.
A description of commodity derivatives is provided on page 75.
Risk management
Derivatives
Barclays PLC
Annual Report 2005 77
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