Barclays 2008 Annual Report Download - page 106

104 Barclays PLC Annual Report 2008 |Find out more at www.barclays.com/annualreport08
The use of derivatives and their sale to customers as risk management
products are 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 119 to 123.
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, net trading income, net fee and commission income
and derivative assets and liabilities. Notional amounts of the contracts are
not recorded on the balance sheet.
The Group participates both in exchange traded and over the counter
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
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.
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. The Group also enters into fund-linked
derivatives, being swaps and options whose underlyings include mutual
funds, hedge funds, indices and multi-asset portfolios.
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.
Risk management
Credit risk management
Derivatives