Barclays 2009 Annual Report Download - page 122

120 Barclays PLC Annual Report 2009 www.barclays.com/annualreport09
Risk management
Credit risk management
continued
Derivatives
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 122 to 126.
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.