CFM11095 - Understanding derivative contracts:
types of derivatives
Exotic derivatives
The types of derivative financial instrument which have been
described in this section, both exchange traded and over the
counter, are commonly and widely used by large companies and
financial institutions to hedge risk (or sometimes to speculate).
Such products are sometimes referred to as ‘vanilla’ or
‘plain vanilla’.
More innovative and less usual derivative products are often
called ‘exotic’. The term has no precise meaning.
Exotic derivatives have been compared to pornography: both are
easier to recognise on sight than to define and the definition of
both is dependent on time and place. (William Margrabe,
‘Derivatives Strategy’). Interest rate and currency
swaps were exotic when they first appeared in the 1980s, but are
now standard financial tools. Similarly, proprietary products
originally developed by merchant banks or other financial
institutions to meet the needs of particular clients may in time
diffuse more widely into the market.
The ‘exotic’ label is commonly applied to the
following:
- Derivatives with a non-standard subject
matter, developed for a particular client or a particular market.
For example, a telecommunications company might use a derivative
whose underlying subject matter is bandwidth.
- Options with a more complicated pay-off
profile than the simple example discussed at
CFM11082. One example is a ladder
option: if the price of the underlying asset rises above a certain
threshold level, the option holder is guaranteed a minimum payout,
even if the price subsequently falls. There may be a number of such
steps. The investor can therefore lock in the increase in value
– although they will pay a hefty premium for the privilege.
There are many other types of ‘exotic’ option.
- The more complex forms of structured
product. A structured product (or structured note) is a combination
of a loan relationship (or more than one loan relationship) with
one or more derivative contracts. A corporate bond with an attached
equity warrant (see
CFM11086) is a simple example of a
structured note.
Inland Revenue staff who encounter an unfamiliar type of
derivative should ask the company for a non-technical explanation
and, if necessary, obtain the contract documentation in order to
understand what the company will pay and receive. They should
contact Revenue Policy, Business Tax 1/3 if:
- they are asked (whether under COP10 or
otherwise) about the tax treatment of a new type of derivative
product, or
- they have information about developments
in the derivatives market which would be useful to others, or
- they need help or advice.
