Trading Strategies and Accounting Procedure of Derivatives

1.1 ABOUT THE DERIVATIVES

A financial derivative in India is a growing subject in Indian capital market. Trading in financial derivatives started in National Stock Exchange (NSE) in June 2000, with tools like futures and options. My research in this field is still in its initial stage and there is lot of potential scope in the field of derivative. Trading strategies in derivatives studied in the project are the basic strategies used by investors to reduce risk and gain returns. There are different strategies used according to different market situations. The strategies are developed using combination of options, futures and spot. The accounting of derivative transactions is significant subject in derivative segment. Accounting procedures and standards ensures the reliability of derivative trading. Accounting of various derivative contracts have been studied in the project report.

Trading Strategies and Accounting Procedure of Derivatives

1.2 OBJECTIVES OF STUDY

To get informed with various terminologies in the derivative market.

To understand Payoff patterns of Derivatives Contracts in real market conditions

To be familiar with preparation of various derivatives reports for clients.

Trading Strategies and Accounting Procedure of Derivatives

1.3 SCOPE OF STUDY

Study covered the basic knowledge of different strategies in futures & options market: Hedging Speculation Arbitrage It also includes analysis of real market prices of for two months to make comparison

between theoretical strategies and practical returns.

It also covers comprehensive study of various accounting procedure of three derivatives

contract: Futures Contract Option Contract Effects Of Derivatives In Financial Statements

Trading Strategies and Accounting Procedure of Derivatives

1.4 REVIEW OF LITERATURE Author: Chiara Oldani (Luiss Guido Carli)

A derivative is defined by the BIS (1995) as a contract whose value depends on the price of underlying assets, but which does not require any investment of principal in those assets. As a contract between two counterparts to exchange payments based on underlying prices or yields, any transfer of ownership of the underlying asset and cash flows becomes unnecessary. This definition is strictly related to the ability of derivatives of replicating financial instruments. Derivatives can be divided into 5 types of contracts: Swap, Forward, Future, Option and Repo, the last being the forward contract used by the ECB to manage liquidity in the European inter-bank market. These 5 types of contracts can be combined with each other in order to create a synthetic asset/liability, which suits any kind of need; this extreme flexibility and freedom widely explain the incredible growth of these instruments on world financial markets.

Author: Helios Herrera

Technologic Lausanne)

(Centro de Investigation Economical (CIE), Institute

Autonomous de Mexico (ITAM)) and Enrique Schroth (University of

Investment banks develop their own innovative derivatives to underwrite corporate issues but they cannot preclude other banks from imitating them. However, during the process of underwriting an innovator can learn more than its imitators about the potential clients. Moving first puts him ahead in the learning process. Thus, he develops an information advantage and he can capture rents in equilibrium despite being imitated. In this context, innovation can arise without patent protection. Consistently with this hypothesis, case studies of recent innovations in derivatives reveal that innovators keep private some details of their deals to preserve the asymmetry of information.

Trading Strategies and Accounting Procedure of Derivatives

Author: Cohen, Benjamin H

It is sometimes suggested that trading in derivatives leads to excessive volatility in underlying asset prices relative to what would be called for by fundamental values. These effects are tested by comparing the variances of price changes over different time horizons before and after the start of organized derivatives trading. It is found that ratios of the variances of multi-day and daily price movements decline for bond prices in the United States and Germany and for stock indices in the US, Japan and the UK, though no such effect is found for Japanese bonds. Other indicators confirm that serial correlation has tended to decline since the introduction of derivatives. While these results offer strong grounds for rejecting predictions of the destabilizing effects of derivatives, an alternative view, that derivatives accelerate the pricediscovery functions of cash markets, cannot be definitively confirmed, given ambiguous breakpoint results and the many other contemporaneous developments in financial technology. Copyright 1999 by Blackwell Publishers Ltd.

Trading Strategies and Accounting Procedure of Derivatives

1.5 RESEARCH METHODOLOGY

Research is defined as human activity based on intellectual application in the investigation of matter. The primary purpose for applied research is discovering, interpreting, and the development of methods and systems for the advancement of human knowledge on a wide variety of scientific matters of our world and the universe

RESEARCH DESIGN:
A research design is the specification of methods and procedures for acquiring the information needed. Research design can be exploratory research or descriptive research. For this project I have used descriptive research. A descriptive research design a fact finding investigation with adequate interpretation. It involves gathering data that describe events and then organizes, tabulates, depicts, and describes the data.

SOURCES OF DATA
Sources of data are means from where information is collected for the study and analysis purpose. There are two sources of data collection, 1. Primary Data 2. Secondary Data. For this project I have used only secondary data. Secondary data are those data which are collected by the other person and which are used by the researcher for his present study. I have used the secondary data to understand the basic concept of derivatives from the reference book N.D. Vohra and B.R. Bagri.

Trading Strategies and Accounting Procedure of Derivatives

2.1 HISTORY OF NJ INDIA INVESTS PVT. LTD.

NJ India Invest Pvt. Ltd. is one of the leading advisors and distributors of financial products and services in India. Established in year 1994, NJ has over a decade of rich exposure in financial investments space and portfolio advisory services. From a humble beginning, NJ over the years has evolved out to be a professionally managed, quality conscious and customer focused financial / investment advisory & distribution firm. NJ prides in being a professionally managed, quality focused and customer centric organization. The strength of NJ lies in the strong domain knowledge in investment consultancy and the delivery of sustainable value to clients with support from cutting-edge technology platform, developed in-house by NJ. NJ Fundz Network was established in year 2003 as a dedicated platform offering comprehensive services and support to the independent financial advisors. The services offered by NJ Fundz Network are increasingly recognized as the best and most comprehensive in nature. The scope, depth, and quality of the services and support is unmatched in the industry. NJ Fundz Network is proud to be the pioneers in India in providing the 360 Advisory platform to independent advisors. With this NJ has managed to successfully transform the business of many independent financial advisors, bringing them on equal footing or even better than the strongest competitors in the industry.

NJ has over 8,600* NJ Fundz Network Partners and over 4,500* normal advisors associated with us. NJ presently has over Rs. 5,050* Crores of assets under advice. NJ has over 130* PSCs (Partner Service Centers) in 22* states spread across India. The numbers are reflections of the trust, commitment and value that NJ shares with its clients.

Trading Strategies and Accounting Procedure of Derivatives

2.2 VISION & MISSON

Vision of NJ India Invest Pvt. Ltd. To be the leader in our field of business through, Total Customer Satisfaction

Commitment to Excellence

Successful Wealth Creation of our Customers

Mission of NJ India Invest Pvt. Ltd Ensure creation of the desired value for our customers, employees and associates, through constant improvement, innovation and commitment to service & quality. To provide solutions which meet expectations and maintain high professional & ethical standards along with the adherence to the service.

Trading Strategies and Accounting Procedure of Derivatives

2.3 360 ADVISORY PLATFORM OF NJ INDIA INVEST PVT. LTD.

NJ believes in 360 Advisory Platform philosophy

The support functions are generally in the following areas

Business Planning and Strategy Training and Development Self and of employees Products and Service Offerings Business Branding Marketing Sales and Development Technology 9

Trading Strategies and Accounting Procedure of Derivatives

Advisors Resources - Tools, Calculators, etc.. Research Communications

With this comprehensive supporting platform, the NJ Fundz Partners stays ahead of the curve in each respect compared to other Advisors/competitors in the market.

2.4 SERVICES OFFERED AT NJ INDIA INVEST PVT. LTD.

A good product/service offering, targeted at meeting the needs of the clients, lies at the center of any business. With customers today expecting single window solutions and services, successful and easy integration of products is the need of the hour.

At the basic product level NJ has a basket of the following:

Mutual funds covering all AMCs & schemes

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Trading Strategies and Accounting Procedure of Derivatives

Life Insurance (Prudential ICICI)

Fixed deposits of companies

Government/RBI bonds

Infrastructure Bonds

2.5 CUSTOMER CARE AT NJ INDIA INVEST PVT. LTD.

NJ Customer Care offers a 'Single Service Point' to all the advisors to help solve their customer queries. Our centralized team of Customer Care Executives solves your queries at the earliest. You can also view the latest status of all your queries online. As an NJ Advisor you may submit your queries to Customer Case Executives by Telephonic Email or Online directly through your Advisors (Partners) Desk

Query Management:Automated On-line Query Management Module is used to efficiently handle the queries of our Advisors/Associates. Query entered is automatically forwarded to the concerned person who can immediately solve the same. Status is updated online and turns around time for different types of queries defined.

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Trading Strategies and Accounting Procedure of Derivatives

3.1 CONCEPT AND DEFINATION OF DERIVATIVES Derivatives Concept:

A word formed by derivation. It means, this word has been arisen by derivation. Something derived; it means that some things have to be derived or arisen out of the underlying variables. A financial derivative is an indeed derived from the financial market. The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. The Underlying Securities for Derivatives are: 12

Trading Strategies and Accounting Procedure of Derivatives

Commodities: Castor seed, Grain, Pepper, Potatoes, etc. Precious Metal : Gold, Silver Short Term Debt Securities : Treasury Bills Interest Rates Common shares/stock Stock Index Value : NSE Nifty Currency : Exchange Rate In financial terms, a derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency.

Referring to derivatives as assets would be a misconception, since a derivative is incapable of having value of its own. However, some more commonplace derivatives, such as swaps, futures, and options, which have a theoretical face value that can be calculated using formulas, such as Black-Scholes. The BlackScholes model is a mathematical description of financial markets and derivative investment instruments. The model develops partial differential equations whose solution, the BlackScholes formula, is widely used in the pricing of European-style options. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

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Derivatives are meant essentially to facilitate temporarily hedging of price risk of inventory holding or a financial/commercial transaction over a certain period. In practice, every derivative "contract" has a fixed expiration date, mostly in the range of 3 to 12 months from the date of commencement of the contract. In the market's language, they are "risk management tools". The use of forward/futures contracts as hedging techniques is a well-established practice in commercial and industrial operations.

DEFINATION OF FERIVATIVES
A derivative is a contract between a buyer and a seller entered into today regarding a transaction to be fulfilled at a future point in time. For example, the transfer of a certain amount of US dollars at a specified USD-EUR exchange rate at a future date.

Over the life of the contract, the value of the derivative fluctuates with the price of the so-called underlying of the contract in our example, the USD-EUR exchange rate. The life of a derivative contract, that is, the time between entering into the contract and the ultimate fulfillment or termination of the contract, can be very long in some cases more than ten years. Given the possible price fluctuations of the underlying and thus of the derivative contract itself, risk management is of particular importance. Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, r reference rate) in a contractual manner. These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be an interest, share, index, commodities or foreign exchange, etc. In the Indian Context the Securities Contracts (Regulations) Act, 1956 (SC(R) A) defines "derivative" to include:

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1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices, of underlying securities.

3.2 EVOLUTION OF DERIVATIVES

Derivatives are definitely not a modern invention. They were know and were used from ancient times. Bernstien (1992) attributes the first option transaction to the Greek philosopher Thales from Miletus who was adept at forecasting the harvest of olives in the ensuing season. He predicted an outstanding next autumn and so also the demand for the olive presses. Therefore he entered in to agreements with olive press owners before autumn for the exclusive use of their presses. For this he paid the deposits in advance with an agreement that he will not demand his money if the harvest is not good. When the harvest time came, there was plenty of 15

Trading Strategies and Accounting Procedure of Derivatives

demand for the presses and since he had the rights to use them, he hired out them at high prices and made big money. Though Thales was not interested in making money, all he wanted was to prove that philosophers can make money if they do so desire. This is a primitive form of derivatives where Thales knew well in advance that his maximum loss will be the advance he paid while his profits depended on what he demand. Most future markets have evolved from the basic commodity market and agricultural futures were the foremost contracts that made their appearance long before financial futures. Agricultural futures are not unfamiliar contracts- in most parts of the world, money lenders used to compel most of their borrowers to sell their forthcoming crop at a price agreed upon at the time of taking the loan. The way these agreements are futures but their price were not determined at arms length distance nor the contract are liquid enough. Still they represent the forerunners to the relatively organized future that evolved subsequently in the 18th century in the US. though there are reports of future trading on Amsterdam bourse after its creation in 1611.

3.2.1 DERIVATIVES INTRODUCTION IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. SEBI set up a 24 member committee under the chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India, submitted its report on March 17, 1998. The committee recommended that the derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of derivatives. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001.

3.3 NEED AND IMPORTANCE OF DERIVATIVES MARKET

The following points shoes the need for the derivative market:
1. To help in transferring risks from risk averse people to risk oriented people

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2. To help in the discovery of future as well as current prices

3. To catalyze entrepreneurial activity 4. To increase the volume traded in markets because of participation of risk averse people in greater numbers 5. To increase savings and investment in the long run

IMPORTANCE OF DERIVATIVES
India's three-year old futures and options market is the on the verge of fast becoming a haven for retail investors. They are slowly emerging as instruments for mass investment, hedging and speculation. What is noteworthy is that notwithstanding stringent margins, a small set of scripts and surveillance and reporting requirements still the derivatives volume have surpassed cash market volumes within such a short time. Derivatives have a number of advantages such as hassle free settlement, lower transaction cost, flexibility in terms of various permutations and combinations of trading strategies etc.

Managing risk
There are several risks inherent in financial transactions. Derivatives allow you to manage these risks more efficiently by unbundling the risks and allowing either hedging or taking only one risk at a time. For example, If we buy a share of we take the following risks: Price risk that share may go up or down due to company specific reasons (unsystematic risk).

Price risk that share may go up or down due to reasons affecting the sentiments of the whole market (systematic risk).

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Trading Strategies and Accounting Procedure of Derivatives

Liquidity risk, if our position is very large, that we may not be able to cover our position at the prevailing price (called impact cost).

Cash out-flow risk that we may not able to arrange the full settlement value at the time of delivery, resulting in default, auction and subsequent losses.

Once investor is long on share investor can hedge the systematic risk by going short on share Futures. On the other hand, if investors do not want to take unsystematic risk on anyone share, but wish to take only systematic risk - investor can go long on Index Futures, without buying any individual shares.

Speculation
Derivatives offer an opportunity to make unlimited money by way of speculation. Speculators are of two types. One type is of optimistic variety, and sees a rise in prices in future. He is known as 'bull'. The other type is a pessimist, and he sees a fall in prices, in future. He is known as 'bear'. They undertake 'futures' transactions with the intention of making gains through difference in contracted prices and future cash market price prices. If, in future, their expectations turn out to be true, they gain and if not they lose. Of course, they may limit their losses through options.

High leverage
Leverage opportunities are often expensive and complicated to implement for many investors in the cash market, or are simply not feasible. However, options and futures represent (highly) levered investments in the underlying cash instruments. They require only a small fraction of the investment in the underlying securities. The case is most obvious for futures, where there is essentially no initial investment except margin payments.

Arbitrage
Arbitrageurs profit from price differential existing in two markets by simultaneously operating in two different markets. Arbitrage can be done between two instruments when they are related to each other, but they are temporarily mispriced. For example, the futures price and spot price are related by the interest rate, time to maturity and corporate benefit, if any, in the interregnum. 18

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Hedging mechanism
Derivatives provide an excellent mechanism to hedge the future price risk. Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. Hedging is used to protect portfolio volatility due to market fluctuation during budget, elections and other political or corporate turmoil. The basic rule in hedging is that the risk of loss in portfolio is offset by the gains in the futures or options. Hence hedging is beneficial. Thus hedging helps to reduce risk by locking returns but does not maximize them rather it minimizes the loss arising out of adverse situations. One needs to keep in mind that hedging does not make money but removes unwanted risk by reducing the losses. They can also be important for, 1. Efficient Allocation of Risk 2. Lower Cost of Hedging 3. Liquidity 4. Risk Management

3.4 THE PARTICIPANTS IN A DERIVATIVES MARKET

Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.

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Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

3.5 FUNCTIONS PERFORMED BY THE DERIVATIVE MARKET Price Discovery

The futures and options market serve an all important functions of price discovery. The individuals with better information and judgment are liable to participative in these markets to take advantage of such information. When some new information arrives, perhaps some good news about the economy, for instance, the actions of speculators quickly feed their information into the derivatives markets causing changes in prices of the derivatives. As these markets are usually the first ones to react because the transaction cost is much lower in these markets than 20

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in the spot market. Therefore, these markets indicate what is likely to happen and thus assist in better price discovery.

Risk Transfer
By their very nature, the derivative instruments do not themselves involve risk. Rather, they merely redistribute the risk between the market participants. In this sense, the whole derivatives market may be compared to a gigantic insurance company providing means to hedge against adversities of unfavorable market movements in return for a premium, and providing means and opportunities to those who are prepared to take risks and make money in the process.

Market Completion
The existence of derivative instruments adds to the degree of completeness of the market. A complete market implies that the number of independent securities is equal tithe number of all possible future states of the economy. The derivative instruments of futures and options are the instruments that provide the investor the ability to hedge against possible odds in the economy. A market would be said to be complete if instruments may be created which can, solely or jointly, provide a cover against all the possible adverse outcomes. It is held that a complete market can be achieved only when, firstly, there is a consensus among all investors in the economy as to the number of odds, or states, that the economy can land up with, and, secondly, there should exists an 'efficient fund' on which simple options can be traded. Here an efficient fund implies a portfolio of basic securities that exist in the market with the property of having a unique return for every possible outcome, while a simple option is one whose payoff depends only on one underlying return.

3.6 TYPES OF DERIVATIVES

The modem derivatives market provides a wide range of products linked to the key factors affecting financial and commercial performance. Whether it is a small domestic importer or a transnational manufacturing giant, external risk is common to business. These factors include interest rates, foreign exchange, equity values and commodity prices. The power of derivative instruments manages and finds opportunity in risks.

Equity Linked Derivatives

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The equity derivatives were almost usual in order for the risk and reward profile of equity investments to remain competitive with the fixed income offered by debt instruments such as bonds. Initially large institutional investors in Europe, Japan and the United States were the primary users, but today, however, even small investors have a direct means to manage equity risk. Equity derivative instruments allow investors to structure requirements in terms of market timing and risk-reward profile. Importantly, the use of derivatives has changed the nature of equity portfolio management. Traditional techniques such as fundamental and technical analysis, diversification strategies and asset allocation strategies now rank alongside the derivative risk management as means of achieving investment objectives.

Interest Rate Swaps

Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. Interest rate swaps make use of one party's comparative advantage in the capital market strong issuer of notes are able to borrow through fixed, cheap rate funds. Weaker borrowers only have access to floating rate loans. By exchanging their payment obligations through a swap, both parties are able to obtain a lower cost of funds. From this pattern of strong issuer weak borrower and the source of capital markets for credit, the swap market has developed into the primary method of managing interest rate risk. This success has also encouraged intermediaries to introduce a diverse array of further innovations, essentially derivatives upon derivatives, including interest rate caps, collars, floors and options on interest rate swaps- known as swaptions.

Foreign Exchange Derivatives

The main foreign exchange linked derivatives are currency swaps, long dated forwards, currency options and combinations of the above. For borrowers, access to currency derivatives ensures that they have access to the lowest cost capital markets around the world. The international capital markets through foreign exchange derivatives markets, encourages a competitive cost of capital. In addition to this integration role, foreign exchange derivatives serve a very real purpose. Foreign exchange fluctuations affect the competitive positions of companies, the cost of borrowings abroad and the returns on global investment portfolios. Precise commercial and financial objectives can be managed through such derivatives. 22

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Commodity Linked Derivatives

The commodity derivatives are designed to satisfy the needs of producers, refiner and consumers of the world's materials. The original derivatives market, commodity derivatives satisfy the needs of participants to manage price risk. Commodity price risk often forms the core business of users of such derivatives. Liquidity, solvency and possibly even survival demand the use of derivatives. Today, active users include oil producers, airline companies, electricity generation companies, mining companies to mention a few. Commodity derivatives are also being used with lenders and investors to ensure the returns and carrying capacity of new projects.

3.7 TYPES OF DERIVATIVES CONTRACTS

In broad terms, there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in the market: 1.OTC and 2.Exchange-traded Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other 23

Trading Strategies and Accounting Procedure of Derivatives

intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform. Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

FORWARD CONTRACTS
A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset at a certain future time for a certain price. The essential idea of entering into a forward contract is to peg the price and thereby avoid the price risk. It is an agreement between a buyer and a seller in which the buyer has the right and obligation to buy a specified assets on a specified date and at a specified price. The seller is also under an obligation to perform as per the terms of the contract. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on certain specified future date for a certain specified price. The other party 24

Trading Strategies and Accounting Procedure of Derivatives

assumes a short position and agrees to sell on the same asset on the same date for same specified price.

Features of forward contracts

They are the bilateral contracts and hence exposed to counter-party risk

Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

The contract is generally not available in public domain on the expiration date, the

contract has to be settled by delivery of the assets.

If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

Limitations of forward contracts

Lack of centralization of trading Illiquidity Counter party risk

FUTURE CONTRACTS
Futures contracts designed to solve the problems that exist in forward markets. Futures contracts are standardized contracts between two parties to buy or sell an asset at a certain time in futures at certain price. A future are also a kind of a forward which represent obligation on the part of the buyer and seller but the term and condition of the contract are specified by the exchange where they are actually traded. 25

Trading Strategies and Accounting Procedure of Derivatives

They are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades. Hence, futures markets are more liquid with centralization of trading. DITINCTION BETWEEN FUTURE AN FORWARD FUTURE Trade on an organized exchange Standardized contract terms More liquid Requires margin payments Follows daily settlement FORWARD Not traded Customized contract items Less liquid No margin payment Settlement happens at the end of period

Futures terminology
Spot price: The price at which an asset trades in the spot market Futures price: The price at which the future contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three months expiry cycles which expire on the last Thursday of the month. Thus, a January contracts expires on the last Thursday of January. On the Friday, following the last Thursday of every month, a new contract having three-month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is last day on which the contract will be traded, at the end f which it will cease to exist. Contract size: The amount of asset has to be delivered under one contract. For instance, the contract size on NSEs futures market is 50 Nifty. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Margins Initial margin: The amount that must be deposited in the margin account at the time a futures contracts first entered into is known as initial margin. 26

Trading Strategies and Accounting Procedure of Derivatives

Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called marking-to-market. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investors receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. Tick Size: It is the minimum price difference between two quotes of similar nature. Open interest: Total outstanding long or short positions in the market at any specific point in time. As total long positions for market would be equal to total short positions, for calculation of open Interest, only one side of the contracts is counted. Physical delivery: Open position at the expiry of the contract is settled through delivery of the underlying. In futures market, delivery is low.

OPTION CONTRACTS
Option contracts are fundamentally different from forwards and futures contract. An option gives the holder of the option the right to do something. An option is a contract, which gives rights, but not the obligation, to exercise on the counter-party i.e. right but not obligations. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity 27

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date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.

DISTINCTION BETWEEN FUTURE AND OPTION

FUTURE Exchange trade, with notation Exchange defines the product Price is zero, strike price moves Price is zero Linear payoff Both long and short at risk OPTION Same as futures. Same as futures. Strike price is fixed, price moves Price is always positive. Non-linear payoff. Only short at risk.

Option terminologies
Types of Options On the basis Of Exchange Index options: Index options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options are also cash settled. Stock options: Stock options are the options on individual stocks. Options currently trade on over 1000 stocks listed on NSE. A contract gives the holder the right to buy or sell shares at the specified price Participants in Options Contract Buyer of option: The buyer of an option is the one who pays an option premium and buys the right but not the obligation to exercise his option on the seller/writer. Writer of option: The writer of an option is one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options: Call option: A call option gives the holder right but not obligation to buy a given quantity of the underlying asset, at a given price on or before future date.

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Trading Strategies and Accounting Procedure of Derivatives

Put options: Put option gives the holder the right but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the option contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. Types of options on the Basis of Clearing American options: American options are the options that can be exercised at any time up to the expiration date. Most exchange traded options are American. Options on the individual securities available at NSE are American type of option. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of American options are frequently deduced from those of its European counterpart. S&P CNX IT options at NSE are European type of option. Time Money of Option at the Inception In-the-time money option: An in-the-money (ITM) option is an option that would lead to positive cash flow to the holder if it were exercised immediately. A Call option is said to be in-the-money when the current price stands at a level higher than the strike price (i.e. spot price > strike price). If the Spot price is much higher than the strike price, a Call is said to be deep in-the-money option. In the case of a Put, the put is in-the-money if the Spot price is below the strike price (i.e. spot price < Strike price). 29

Trading Strategies and Accounting Procedure of Derivatives

At-the-money-option (ATM) - At-the money option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is said to be "at-themoney" when the current price equals the strike price (i.e. Spot price = strike price). Out-of-the-money-option (OTM) - An out-of- the-money Option is an option that would lead to negative cash flow if it were exercised immediately. A Call option is out-of-the-money when the current price stands at a level which is less than the strike price (i.e. spot price < strike price). If the current price is much lower than the strike price the call is said to be deep out-of-the money. In case of a Put, the put is out of the money OTM if current price is higher than strike price ((i.e. spot price > strike price).

SWAP CONTRACT
A swap is contract between two parties to deliver one sum of money against

another sum of money at periodic interval. The most basic form of swap is an interest rate swap where two parties agree to exchange interest payment for a certain period of time. The most familiar interest rate swap is fixed or floating rate swap. In this swap one of the counter parties agrees to make fixed rate payment to the other and vice versa. These two payments are known as the legs or sides of swap. Swap payments are made generally semi annually and the maturity on generic swap range from 3 to 5 years. There are three content of swap contract: Currency swap in which two currency are periodically exchanged. An important thing in that there is an exchange of principle in the currency swap on the origination date and at maturity at the same pre-determined exchange rate. Equity swap are similar to interest rate swap contract. There are two counterparties who exchange regular cash flows based on some agreed term to maturity. Equity swap market 30

Trading Strategies and Accounting Procedure of Derivatives

is substantially smaller than IRS or currency swap even in major markets like New York and Landon. Commodity swap requires the counterparties to exchange a cash flow based upon a fixed price and quantity of a particular commodity for a cash flow based upon the same quantity and market price of that commodity.

Swap Terminology:
Counterparties: One party pays fixed rate interest payment to another party who pays variable rate payment to the first party. Fixed rate payer: The party who pays fixed interest and receive variable is known as fixed rate payer. Floating rate payer: The other party who pays variable and receive fixed is known as floating rate payer. Trade date: Trade date is the day the party agree to commit to the swap. Effective date: It is the date when interest commence to accrue. Settlement or payment date: It is when interest payments are made (6 months after the effective date). Maturity date: It is last payment date on which swap principle is paid.

31

Trading Strategies and Accounting Procedure of Derivatives

TRADING STRATEGIES OF DERIVATIVE

A investment decision is a function of risk and return. A number of mathematical model exist which can enable an individual to take a prudent investment decision. Equity tend to give returns greater then this risk free asset and the growth of capital market and trading platform has provided a liquidity, yet there is a market risk leading to capital erosion also. This risk of the capital market bring into the powerful risk management tools in the form of derivatives. Strategies are generally combination of various product like future, calls, puts and enable an individual to realize unlimited profits, limited profit, unlimited losses or limited losses on his profit or risk taking ability. Four simple views, Bullish view, Bearish view, Volatile view and Neutral view.

4.1 BILLISH VIEW:

32

Trading Strategies and Accounting Procedure of Derivatives

Bull Spread using Calls: Buy in-the-money (ITM) call option and sell another out-of-the-money (OTM)call option with the same underlying security and expiry. The lower strike price would be ITM while the call with the higher strike price is OTM. The net effect of the strategy is to be the cost and breakeven. The investor makes a profit only when the stock price/ index rise. If the stock price falls to the lower (bought) strike, the investor makes the maximum loss (cost of the trade) and if the stock price rise to the higher (sold) strike, the investor makes the maximum profit. Bull spread using puts: Sell put option and cover the downside of a put sold by buying a lower strike put, which acts as insurance of the put sold. The lower strike put purchased is the future OTM, than the higher strike put sold, so that the investors receives a net credit, because the put purchased (future OTM) is cheaper than the put sold.

[PAY OFF PROFILE FOR BULL SPREAD]

+ 0 _

4.2 BEARISH VIEW

Bear call spread: 33

Trading Strategies and Accounting Procedure of Derivatives

Buy OTM call option and simultaneously sell ITM call option on the same underlying. This strategy can be done with both OTM call with the call purchased being higher OTM strike than the call sold. If underlying falls both calls will expire worthless and the investor retains the net lower strike plus the net credit. As long as the underlying remains below that level, the investor makes a profit. Otherwise he could make a loss. The maximum loss is the difference in strike less the net credit received. Bear put spread: Buy an (ITM) put option and sell an OTM (lower) put option on the same stock with the same expiration date. This strategy creates a net debit for the investor. The investor makes the money only when the price of underlying falls. The bought put caps the investors downside. If the underlying price closes below the out-of-the-money (lower) put option strike price on the expiration date, then the investor gets maximum profits. If the stock price increases above the in-the-money (higher) put option strike price at the expiration date, then the investor has a maximum loss potential of the net debit.

[PAY OFF PROFILE FOR BEARS SPREAD]

+ 0 _

4.3 VOLATILE VIEW

A volatile view will imply that the market will move either upwards or downwards, but

which way is not clear. However, market will not stay where it is. I this sense, a volatile view 34

Trading Strategies and Accounting Procedure of Derivatives

is opposite of the neutral view. Volatile view is usually based on various situations which might warrant heavy movement. For example, during budget time, a favorable proposal might impact the price favorably, or the price could fall significantly. An expected foreign collaboration could see the price rise, and if it were not to happen, the price could fall. While a positive development might result in a price rise, a negative development might dampen the prices. Decision on hue lawsuit could significantly impact prices any which direction.

Long straddle:
Buy a call as well as put on the same underlying for the same maturity and strike price. If the price of the underlying increases, the call is exercised while the put expire worthless and if the price of the underlying decreases, the put is exercised, the call expires worthless. Either way if there is volatility to cover the cost of the trade, profits are to be made. The straddle has two break even points viz. the strike price plus both Premia and the strike price minus both Premia.

[PAY OFF PROFILE FOR LONG STRADDLE]

+ 0 _

Long strangle:
A strangle is a slight modification to the straddle to make it cheaper to execute. Buy simultaneously a slight OTM put and a slight out-of-the-money OTM call of the same underlying and expiration date. A strangle is a slightly safer strategy in the sense that one buy a 35

Trading Strategies and Accounting Procedure of Derivatives

call and a put but at different strike prices rather than one single strike price, as in the case of a straddle. Straddle the investor is directional neutral, but is looking for an increased volatility in the stock / index and the prices moving significantly in the either direction. The lower cost however implies a wider break even and you would make profit only if the scrip moves up or down by a wider margin. As with a straddle, the strategy has a limited downside (i.e. the call and the put premium) and unlimited upside potential. [PAY OF PROFILE FOR LONG STRANGLE]

+ 0 _

Short call butterfly:

Sell one lower strike ITM, buy two ATM calls and sell another higher strike OTM call. Investor gets a net credit. There should be equal distance between each strike. The position is profitable in case there is a bi move in the underlying. The maximum risk occur if the underlying is at the middle strike at expiration. The maximum profit occurs if the stock finishes on either side of the upper and lower strike prices at expiration. However this strategy offers very small returns when compared to straddles, strangers with only slight less risk. [PAY OFF POFILE FOR SHORT CALL BUTTERFLY]

+ 0 _

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Trading Strategies and Accounting Procedure of Derivatives

4.4 NEUTRAL VIEW

Neutral view is when that the index or scrip in question is likely to remain whether it is,

or that the movement is not likely to be significant. short straddle: It is the opposite of the long straddle and is adopted when it is expected that the market will remain range bound. Sell a call and a put on the same underlying for the same maturity and strike price. Investors get net income. If the underlying does not move much in the either direction, the investor retains the premium as neither the call nor the put will be exercised. However, in case the underlying moves in either direction, up or down significantly, the investors losses can be significant. This makes it a risky strategy and so it should be adopted very carefully. If the underlying value stays close to the strike price on expiry of the contracts, maximum gain, which is the premium received is made.

[PAY OFF PROFILE FOR SHORT STRADDLE]

+ 0 _

Short strangle:
A short strangle is a slight modification to the short straddle. It tries to improve the profitability of the trade for the seller of the option by widening the breakeven points so that there is a much greater movement required in the underlying stock/ index, for the call and the put option to be worth exercising. Simultaneously sell a slight OTM put and a slight OTM call of the same underlying stock and expiration date. The net credit received by the seller is less as 37

Trading Strategies and Accounting Procedure of Derivatives

compared to a short straddle, but the breakeven points are also widened. The underlying has to move significantly for the call and put to be worth exercising. If the underlying does not show much of a movement, the seller of the strangle gets to keep the premium. [PAY OFF PROFILE FOR SHORT STRANGLE]

+ 0 _

As a seller of the option with a neutral view, investor should sell strangles rather than straddles_ this is a relatively lower risk lower return strategy. As a buyer of volatility, one would rather buy straddle most of the time (rather than strangles) as it gives profit faster than strangles. Although there is outward flow of premia to buy a straddle, yet if that is reasonable then one would actively pursue this strategy.

Long call butterfly:

The strategy offers a good risk/ reward ratio, together with low cost. A long butterfly is similar to a short straddle expect that the losses are capped. Sell 2 At The Money Calls, but 1 ITM Call, and buy 1 OTM call option (equidistance between the strike price). The result is positive in case the underlying remains range bound. The maximum reward in this strategy is however restricted and takes place when the underlying is at the middle strike at expiration. The maximum losses are also limited. [PAY OFF PROFILE OF LONG CALL BUTTERFLY] + 0 _ 38

Trading Strategies and Accounting Procedure of Derivatives

ACCOUNTING OF DERIVATIVES

5.3 ACCOUNTING OF FUTURES

The institute of chartered accountants] of India (ICAI) has issued guidance notes on

accounting of equity index and equity stock futures & options contracts from the view point of parties who enter into such future contract as buyers or sellers. For other parties involved in the trading process like brokers, trading members, clearing members and clearing corporations, a trade in equity index futures is similar to trade in, say shares, and does not pose any peculiar accounting problems. Clearing corporation/house: Clearing corporation/house means the clearing

corporation/house approved by SEBI for clearing and settlement of trades on the derivatives exchange/segment. All the clearing and settlement for the trades that happen on the NSEs market is done through NSCCL. Clearing member: Clearing member means a member of clearing corporation and includes all categories of clearing members as may be admitted as such but the clearing corporation to the derivative segment

39

Trading Strategies and Accounting Procedure of Derivatives

Contract month: Contract month means the month in which the exchange/clearing corporation rules require a contract to be fully be finally settled. Daily settlement price: Daily settlement prices is the closing prices of the equity index future contract for the day or such other as may be decided by the clearing house from time to time. Final settlement price: The final settlement price is the closing of equity index futures contract in the last trading day of the contract or such other price as may be specified by the clearing corporation, from time to time. Long position: Long position is an equity index futures contract means outstanding purchase obligations in respect of the index futures contract at any point of time. Open position: Open position means the total number of equity index futures contract that have not yet been offset and closed by an opposite position. Settlement date: Settlement date means the date on which the outstanding obligations in an equity index futures contract are required to be settled as provided in the Bye-Laws of the Derivative exchange/segment. Short position: Short position in an equity index futures contract means outstanding in respect of any equity index futures contract at any point of time. Trading member: Trading member means a Member of the Derivative exchange/segment and registered with SEBI.

Accounting At the Inception of The Contract

Every client is required to pay to the trading member/clearing member. The initial margin determined by the clearing corporation as per the Bye-Laws/regulations of the exchange for entering into equity index futures contact. Such initial margin paid/payable should be debited to initial margin equity index futures account. Additional margins, if any, should also be accounted for in the same manner. Initial Margin Payment Initial margin of equity stock a/c To bank a/c Dr. Amount --------------------40

Trading Strategies and Accounting Procedure of Derivatives

It may be mentioned that at the time when contract is entered into for purchase/sale of equity index futures, no entry is passed for recording the contract because no payment is made at the time except for the initial margin. At the balance sheet date, the balance in the Initial margin equity index futures account should be shown separately under the head current assets.

In cases where instead of paying initial margin in cash, the client provides bank guarantee or lodges securities with the member, a disclosure should be made in the notes to the financial statements of the client.

Accounting At The Time Of Daily Settlement

This involves the accounting of payment/receipts of mark-to-market margin money. Payments made or received on account of daily settlement by the client would be credited/debited to the bank account and the corresponding debit or credit for the same should be made to an account titled as mark-to-market margin money equity index futures account Payment Of Daily Margin Mark to mark margin a/c To bank/cash a/c Dr. Receipt Of Daily Margin Bank/cash a/c To Make to mark margin a/c Dr.

Sometimes the client may deposit a lump sum amount with broker/trading member in respect of mark-to-market margin money instead of receiving/paying mark-to-market margin money on the daily basis. The amount so paid is in the nature of a deposit and should be debited to appropriate account. Say, Deposit for mark-to-market margin money account. The amount of mark-to-market margin received/paid from such account should be credited/debited to mark-to-market margin money equity index futures account with a corresponding debit/credit to Deposit for mark-to-market margin money account. Deposit Made To Margin Account Deposit made to margin a/c To bank/cash a/c Dr. Amount --------------------Amount ---------------------

Payment Made In Case Of deposit Of Margin Made Mark to market margin a/c Dr. To deposit to mark to market margin a/c

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Trading Strategies and Accounting Procedure of Derivatives

At the year-end, balance in the Deposit for mark-to-market margin money account should be shown as deposit under the head current assets.

Accounting At The Time Of Final Settlement

This involves accounting at the time of final settlement or squaring-up of the contract. At the expiry of equity index futures, the profit/loss, on final settlement of the contracts in the series, should be calculated as the difference between final settlement price and contract prices for all the contracts in the series. For Long, Profit = Final settlement Price > Contract Price For Short, Profit = Final Settlement price < Contract Price The profit/loss, so computed, should be recognized in the profit and loss account by corresponding debit/credit to mark-to-market margin money equity index futures account. However, where a balance exists in the provision account created for anticipated loss, any loss on arising on such settlement should be first charged to such provision account, to the extent of the balance available in thru provision account, and the balance of loss, if any should be charged to profit and loss account. Same accounting treatment should be made when a contract is squared-up by entering into a reverse contract. If more than one contract in respect of the series of equity index futures contracts to which the squared-up contract pertains is outstanding at the time of the squaring of the contract, the contract price of the contract co squared-up should be determined using the weighted average method for calculating profit/loss on the squaring-up. On the settlement of equity index futures contract, the initial margin paid in respect of the contract is released which should be credited to initial margin equity index futures account, and a corresponding debit should be given to bank account or the deposit account (where the amount is not received). Release of Initial Margin Bank a/c Dr. To initial margin of equity stock a/c Amount ---------------------

Accounting in cases of a default

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Trading Strategies and Accounting Procedure of Derivatives

When a client defaults in making payment in respected of a daily settlement, the contract is closed out. The amount not paid by the Client is adjusted against the initial margin. In the books of client, the amount so adjusted should be debited to mark-to-market equity index futures account with corresponding credit to initial margin equity index futures account. Adjustment Of Mark-To-Market Margin In Default Mark to market margin a/c Dr. To initial margin a/c Amount ---------------------

The amount of initial margin on the contract, in excess of the amount adjusted against the mark-to-market margin not paid, will be released. The accounting treatment in this regard will be the same as explained above. In case, the amount t be paid on daily settlement exceeds the initial margin the excess is a liability and should be shown as such under the head current liabilities and provisions, if it continues to exist on the balance sheet date. The amount of profit or loss on the contract so closed out should be calculated and recognized in the profit and loss account in the manner dealt with above. Disclosure Requirements The amount of bank guarantee and book value as also the market value of securities lodged should be disclosed in respect of contracts having open positions at the year end, where initial margin money has been paid by way of bank guarantee and/or lodging of securities. Total number of contracts entered and gross number of units of equity futures traded (separately for buy/sell) should be disclosed in respect of each series of index futures. The number of equity index futures contracts having open position, number of units of equity index futures pertaining to those contracts and the daily settlement price as of the balance sheet date should be disclosed separately for long and short positions, of each series of equity index futures. 43

Trading Strategies and Accounting Procedure of Derivatives

FUTURE CONTRACTS Profit & Loss Account of the .for the year ending.
Ref No. Expense Dr. Ref No. Income Cr.

To M-2-M margin A/c (Loss) Provision for anticipated Loss - Loss incurred

To M-2-M margin a/c (Profit)

Balance Sheet of ..as on .. Ref No. Liabilities Ref No. Assets

Current Assets: Provision for anticipated Loss: Op. Balance loss incurred Profits Adjusted Current Liabilities: Net Amount Received from Deposits To Initial Margin Initial Margin + Excess Margins

Deposit margin:

to

Mark-to-market

Broker - Amt. payable to daily margin

Opening Balance - M-2-M margin Paid = Closing Balance Loans & Advances: 44

Trading Strategies and Accounting Procedure of Derivatives

Net Amount Paid to the broker Disclosure: Note: Initial paid in form of Bank Guarantee and Lodge securities.

5.2 Accounting for Equity Index Options/Equity Stock Options:

The institute of chartered accountants] of India (ICAI) has issued guidance notes on accounting of equity index options and equity stock options from the view point of the parties who enter into such contracts as buyers/holders or sellers/writers. Following are the guidelines for accounting treatment in case of cash settled index options and stock options.

Accounting At The Inception Of A Contract

The seller/writer of the option is required to, pay initial margin for entering into the option contract. Such initial margin paid would be debited to equity index option margin account or equity stock option margin account, as the case may be. Initial Margin Payment By Seller Equity Index/Stock Option Margin a/c Dr. To bank a/c Amount ---------------------

In the balance sheet, such account should be shown separately under the head current assets.

Accounting At The Time Of Payment/Receipt Of Margin

Payments made or received by the seller/writer for the margin should be credited/debited to the bank account and the corresponding debit/credit for the same should also be made to equity index option margin account or equity stock option margin account, as the case may be. Net Amount Received/Paid By The Seller On The Open Position Amount Paid Amount Received Equity Index/Stock Option Margin a/c Dr. Bank/cash a/c Dr. To bank/cash a/c Equity Index/Stock Option Margin a/c Sometimes, the client deposit a lump sum amount with the trading/clearing member in respect of the margin instead of paying/receiving margin on daily basis. In such case, the amount of margin paid/received from/into such accounts should be debited/credited to the 45

Trading Strategies and Accounting Procedure of Derivatives

deposit of margin account. At the end of the year the balance in this account would be shown as deposit under current assets.

Deposit Made By Seller For Avoiding Daily Margin Requirement Deposit To Equity Index/Stock Option a/c Dr. To Bank/Cash a/c

Amount ---------------------

Accounting At The Time Of Final Settlement

On the exercise of the option, the buyer/holder will recognize premium as an expense and debit the profit and loss account by crediting equity index option premium account or equity stock option premium account. D1 Apart from the above, the buyer/holder will receive favourable difference, if any, between the final settlements price as on the exercise/expiry date and the strike price, which will be recognized as income. Income = final settlement price > Exercise price (long call & Short Put) Income = final settlement price < Exercise price (long put & short call) On exercise of the option, the seller/writer will recognize premium as an income and credit the profit and loss account by debiting equity index option premium account or equity stock option premium account. D2 Apart from above, the seller/writer will pay the adverse difference, if any, between the final settlement prices at the exercise/expiry date and the strike price. Such payment is recognized as loss. Loss = Final Settlement price > Exercise price (long call & short put) Loss = Final settlement price < Exercise Price (long put & Short call) 46

Trading Strategies and Accounting Procedure of Derivatives

As soon as an option gets exercised, margin paid towards such option would be released by the exchange, which should be credited to equity index option margin account or equity stock option margin account, as the case may be, and the bank account will be debited.

Release of Initial Margins Paid By Buyer Equity index/stock option margin a/c To Initial margin- equity index/stock option a/c

Dr.

Amount ---------------------

OPTION CONTRACTS
Profit & Loss Account of the .. For the year ending Ref Expense Dr. Income Cr. No. No. From Buyers Viewpoint Ref To equity index/premium a/c (loss) To provision for loss- equity option ___ From Sellers Viewpoint To equity index/premium a/c (loss) To provision for loss- equity option To equity index/premium a/c (loss) ___ ___ By Equity index/premium a/c (profit) ____ By Equity index/premium a/c (profit)

47

Trading Strategies and Accounting Procedure of Derivatives

Balance Sheet of ..as on ..

Ref No. From Buyers Viewpoint Provision for loss in Equity option A/c: Opening balance - provision for current year - profit from option a/c + loss from option a/c = Closing balance ------From Sellers Viewpoint Current liabilities: Equity index/stock Premium Received Provision for loss in equity option a/c: Opening balance - provision for current year - profit from option a/c + loss from option a/c = Closing Balance ----------------Current Assets: Margins Paid in Advance Deposits to Equity Index/Stock Margin + Margins Paid - Margins received Liabilities Ref No. Assets Equity index/stock Premium Paid

48

Trading Strategies and Accounting Procedure of Derivatives

FINDINGS
The result of the study explores a good understanding of different strategies in derivatives. These strategies are effectively used for hedging loss or gaining risk-free returns by arbitrage and provide good knowledge of when to use these strategies in most effective way according to different market situation. The study shows how strategy works according to fundamental changes. The understanding of payoff patterns of futures and options has contributed to knowledge of implementation of strategies. The second part of study revealed importance of accounting in derivatives. It consists of all the accounting entry made at each stage for all actions in futures and options contract. Each transaction is accounted with its complete effects from inception to financial year end. It also provides information of reports generation for all the elements of transactions from view point of client. Finally, it recognizes the basic strategies and their usage in real stock market where besides price, various factors also have influence. Thus in outline, project report establishes knowledge of different strategies and accounting standards of derivatives.

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Trading Strategies and Accounting Procedure of Derivatives

CONCLUSION

The Indian Capital Market has undergone qualitative changes in the last decade due to phenomenal growth of derivatives. Derivatives are used for variety of purposes, but most important are hedging and arbitrage. This study attempts to simplify the concept of these basis strategies with the knowledge of market condition and payoff strategies so that investor can make out opportunities for reducing the loss and gain fair returns. To make accounting records, there is need of knowledge of all the elements and terminologies used in derivatives contracts such as participants, margins, payoff and their full effects to clients book. The understanding patterns of all future and options payoffs help in their accounting procedures. The pricing & accounting of the derivatives thus provides client with skills of profit generation in stock market. Thus, study provides significant knowledge of trading strategies and accounting procedures in derivatives.

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Trading Strategies and Accounting Procedure of Derivatives

SUGGESTIONS
There should be the rapid development of derivatives products in financial as well as commodity market all over the world but with some consciousness. The main developments may be like this: Introducing more innovative types of risk hedging contracts. Increasing the scope of current derivatives products in emerging markets so as to

include more individual stocks as well as all types of indices. Introducing adequate risk management and internal monitoring techniques to curb

unnecessary speculation so as to protect the interest of small investors.

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Trading Strategies and Accounting Procedure of Derivatives

BIBLIOGRAPHY
Financial derivatives by S.S.S. Kumar, Eastern Economy Edition, 2007 by Prentice-Hall of India Private Limited, New Delhi. Financial derivatives by Keith Redhead, Eastern Economy Edition, 1997 by Prentice-Hall Europe. Futures and options by N.D. Vohra and B.R. Bagri, Second Edition, 2003 Tata McGraw-Hill Publishing Company Limited, New Delhi. www.njfundz.com www.nseindia.com www.mbaguys.net/project-reports/?prefixid=finance www.isda.org/educat/faqs.html

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