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.