Prepared For: Prof. Dheeraj Mishra Faculty, JIM-Lucknow Prepared by:
Pooja Srivastava (CFT08-098) Prashant Saxena (CFT08-102) Priyanka Arya (CFT08-104) Rishabh Srivastava(CFT08-115)
PGDM – 2008 -10 Date of Submission: January 25, 2010
As any good work is incomplete without acknowledging the people who made it possible, this report is incomplete without thanking the people without whom this project wouldn't have taken shape. This project is a result of continuous cooperation, effective guidance and support from all the people associated with this project. We would like to express our regards and thanks to Prof. Dheeraj Mishra, for giving us the opportunity to work on this project and learn something new. A special thank to the Almighty for giving us the opportunity and strength to complete this project. Lastly we would like to thank our families and friends for their continuing support, blessings and encouragement.
A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying” in this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term “security” in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines “derivative” to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities.
TYPES OF DERIVATIVES MARKET
Exchange Traded Derivatives
Over The Counter Derivatives
National Stock Exchange
Bombay Stock Exchange
National Commodity & Derivative Exchange
Figure.1 Types of Derivatives Market
TYPES OF DERIVATIVES
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are n o r m a l l y traded outside the exchanges.
BASIC FEATURES OF FORWARD CONTRACT
• • • • • They are 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 price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged. However forward contracts in certain markets have become very standardized,
as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are often confused with futures contracts. The confusion is primarily bec aus e bot h serve essentially t h e same economic f un ct i on s of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is
called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.
BASIC FEATURES OF FUTURE CONTRACT
1. Standardization : Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
The currency in which the futures contract is quoted. The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month.
The last trading date. Other details such as the tick, the minimum permissible price fluctuation.
2. Margin : Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Initial Margin: is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-to-market price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid. 3. Settlement Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:
Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long).
Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Expiry is the time when the final prices of the future are determined. For many equity index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract. PRICING OF FUTURE CONTRACT In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of the future/forward, value at time to maturity , will be found by discounting the present
by the rate of risk-free return .
This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Any deviation from this equality allows for arbitrage as follows. In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying today (on the spot
market) with borrowed money. 2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. 3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit. In the case where the forward price is lower: 1. The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds. 2. On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate. 3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.] 4. The difference between the two amounts is the arbitrage profit.
TABLE 1DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS FEATURE Operational Mechanism FORWARD CONTRACT Traded directly between two parties (not traded on the exchanges). FUTURE CONTRACT Traded on the exchanges.
Contract Specifications Counter-party risk
Differ from trade to trade.
Contracts are standardized contracts.
Exists. However, assumed by the clearing corp., which becomes the counter party to all the trades or unconditionally guarantees their settlement.
Low, as contracts are tailor made contracts catering to the needs of the needs of the parties.
exchange traded contracts.
Not efficient, as markets are scattered.
Efficient, as markets are centralized and all buyers and sellers come to a common platform to discover the price.
Currency market in India.
Commodities, futures, Index Futures and Individual stock Futures in India.
Options: Options on stocks were first traded on an organised stock exchange in 1973. Since then there has been extensive work on these instruments and manifold growth in the field has taken the world markets by storm. This financial innovation is present in cases of stocks, stock indices, TRADING STRATEGIES foreign currencies, debt instruments, commodities, and futures contracts. Terminology Options are of two basic types: The Call and the Put Option A call option gives the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this which is called "the call option premium or call option price". A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price". The price at which the underlying asset would be bought in the future at a particular date is the "Strike Price" or the "Exercise Price". The date on the options contract is called the"Exercise date", "Expiration Date" or the "Date of Maturity". There are two kind of options based on the date. The first is the European Option which can be exercised only on the maturity date. The second is the American Option which can be exercised before or on the maturity date. In most exchanges the options trading starts with European Options as they are easy to execute and keep track of. This is the case in the BSE and the NSE Cash settled options are those where, on exercise the buyer is paid the difference between stock price and exercise price (call) or between exercise price and stock price (put). Delivery settled options are those where the buyer takes delivery of undertaking (calls) or offers delivery of the undertaking (puts).
EUROPEAN OPTIONSAMERICAN Buying PARAMETERS Spot Price (S) Strike Price (Xt) Time to Expiration (T) Volatility () Risk Free Interest Rates (r) Dividends (D) Favourable Unfavourable ? ? CALL PUT Buying CALL
SPOT PRICES: In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more the Spot Price more is the payoff and it is favourable for the buyer. It is the other way
Strategy 1: A Covered Call: A long position in stock and short position in a call option. Illustration : An investor enters into writing a call option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months form now and along with this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58 per share. By this the investor covers the position that he got in on the call option contract and if the investor has to fulfill his/her obligation on the call option then can fulfill it using the Rel.Petrol. share on which he/she entered into a long contract. The payoff table below shows the Net Profit the investor would make on such a deal. Writing a Covered Call Option S 50 52 54 56 58 60 62 64 66 68 70 Xt 60 60 60 60 60 60 60 60 60 60 60 C 6 6 6 6 6 6 6 6 6 6 6 Profit from writing call 0 0 0 0 0 0 -2 -4 -6 -8 -10 Net Profit from Call Writing 6 6 6 6 6 6 4 2 0 -2 -4 Share bought 58 58 58 58 58 58 58 58 58 58 58 Profit from Total Profit stock -8 -6 -4 -2 0 2 4 6 8 10 12 -2 0 2 4 6 8 8 8 8 8 8
Strategy 2: Reverse of Covered Call: This strategy is the reverse of writing a covered call. It is applied by taking a long position or buying a call option and selling the stocks. Illustration : An investor enters into buying a call option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and along with this option he/she sells a share of Rel.Petrol. in the spot market at Rs. 58 per share. The payoff chart describes the payoff of buying the call option at the various spot rates and the profit from selling the share at Rs.58 per share at various spot prices. The net profit is shown by the thick line. Buying a Covered Call Option S Xt c Profit from Net Profit buying call from Call option 50 52 54 56 58 60 60 60 60 60 60 60 -6 -6 -6 -6 -6 -6 0 0 0 0 0 0 Buying -6 -6 -6 -6 -6 -6 Spot Price of Profit from Total Profit Selling the stock 58 58 58 58 58 58 8 6 4 2 0 -2 2 0 -2 -4 -6 -8 stock
62 64 66 68 70
60 60 60 60 60
-6 -6 -6 -6 -6
2 4 6 8 10
-4 -2 0 2 4
58 58 58 58 58
-4 -6 -8 -10 -12
-8 -8 -8 -8 -8
Strategy 3: Protective Put Strategy: This strategy involves a long position in a stock and long position in a put. It is a protective strategy reducing the downside heavily and much lower than the premium paid to buy the put option. The upside is unlimited and arises after the price rises high above the strike price. Illustration 5: An investor enters into buying a put option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and alongwith this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58 per share. Protective Put Strategy S Xt P Profit from buying put Net Profit from Buying Spot Price of Profit from Buying the stock Total Profit
option 50 52 54 56 58 60 62 64 66 68 70 60 60 60 60 60 60 60 60 60 60 60 -6 -6 -6 -6 -6 -6 -6 -6 -6 -6 -6 10 8 6 4 2 0 0 0 0 0 0
put option 4 2 0 -2 -4 -6 -6 -6 -6 -6 -6
stock 58 58 58 58 58 58 58 58 58 58 58 -8 -6 -4 -2 0 2 4 6 8 10 12 -4 -4 -4 -4 -4 -4 -2 0 2 4 6
Strategy 4: Reverse of Protective Put This strategy is just the reverse of the above and looks at the case of taking short positions on the tock as well as on the put option. Illustration 6: An investor enters into selling a put option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and alongwith this option he/she sells a share of Rel.Petrol. in the spot market at Rs. 58 per share.
Reverse of Protective Put Strategy
Profit from writing a put option
Net Profit from Spot Price of Put Writing -4 -2 0 2 4 6 6 6 6 6 6 Selling the stock 58 58 58 58 58 58 58 58 58 58 58
Profit from stock 8 6 4 2 0 -2 -4 -6 -8 -10 -12
50 52 54 56 58 60 62 64 66 68 70
60 60 60 60 60 60 60 60 60 60 60
6 6 6 6 6 6 6 6 6 6 6
-10 -8 -6 -4 -2 0 0 0 0 0 0
4 4 4 4 4 4 2 0 -2 -4 -6
All the four cases describe a single option with a position in a stock. Some of these cases look similar to each other and these can be explained by Put-Call Parity. Put Call Parity P + S = c + Xe-r(T-t) + D ---------------------- (1) Or S - c = Xe-r(T-t) + D - p ---------------------- (2) The second equation shows that a long position in a stock and a short position in a call is equivalent to the short put position and cash equivalent to Xe-r(T-t) + D.
The first equation shows a long position in a stock combined with long put position is equivalent to a long call position plus cash equivalent to Xe-r(T-t) + D. SPREADS The above involved positions in a single option and squaring them off in the spot market. The spreads are a little different. They involve using two or more options of the same type in the transaction. Strategy 1: Bull Spread: The investor expects prices to increase in the future. This makes him purchase a call option at X1 and sell a call option on the same stock at X2, where X1<X2. Using an illustration it would be clear how this is put to use. Illustration An investor purchases a call option on the BSE Sensex at premium of Rs.450 for a strike price at 4300. The investor squares this off with a sell call option at Rs. 400 for a strike price at 4500. The contracts mature on the same date. The payoff chart below describes the net profit that one earns on the buy call option, sell call option and both contracts together. Payoff From a Bull Spread S 4200 4250 4300 4350 4400 4450 4500 4550 4600 4650 4700 4750 X1 X2 c1 -450 -450 -450 -450 -450 -450 -450 -450 -450 -450 -450 -450 c2 400 400 400 400 400 400 400 400 400 400 400 400 Profit from X1 4300 4500 4300 4500 4300 4500 4300 4500 4300 4500 4300 4500 4300 4500 4300 4500 4300 4500 4300 4500 4300 4500 4300 4500 0 0 0 50 100 150 200 250 300 350 400 450 Net profit from X1 -450 -450 -450 -400 -350 -300 -250 -200 -150 -100 -50 0 Profit form Net Profit Total Profit X2 0 0 0 0 0 0 0 -50 -100 -150 -200 -250 from X2 400 400 400 400 400 400 400 350 300 250 200 150 -50 -50 -50 0 50 100 150 150 150 150 150 150
The premium on call with X1 would be more than the premium on call with X2. This is because as the strike price rises the call option becomes unfavourable for the buyer. The payoffs could be generalised as follows. Spot Rate Profit on long call S >= X2 X1 < S <= X2 S >= X1
Profit on short call X2 - S 0 0
Total Payoff X2 - X1 S - X1 0
Which option(s) Exercised
S - X1 S - X1 0
X2 - X1 - c1 + c2 S - X1 - c1 +c2 c2 - c1
Both Option 1 None
The features of the Bull Spread: This requires an initial investment. This reduces both the upside as well as the downside potential.
The spread could be in the money, on the money and out of money. Another side of the Bull Spread is that on the Put Side. Buy at a low strike price and sell the same stock put at a higher strike price. This contract would involve an initial cash inflows unlike the Bull Spread based on the Call Options. The premium on the low strike put option would be lower than the premium on the higher strike put option as more the strike price more is favourability to buy the put option on the part of the buyer.
Illustration An investor purchases a put option on the BSE Sensex at premium of Rs.50 for a strike price at 4300. The investor squares this off with a sell put option at Rs. 100 for a strike price at 4500. The contracts mature on the same date. The payoff chart below describes the net profit that one earns on the buy put option, sell put option and both contracts together. Payoff From a Bull Spread (Put Options) S X1 X2 p1 p2 profit from Net profit Profit X1 4200 4300 4500 4250 4300 4500 4300 4300 4500 4350 4300 4500 4400 4300 4500 4450 4300 4500 4500 4300 4500 4550 4300 4500 4600 4300 4500 4650 4300 4500 4700 4300 4500 4750 4300 4500 Spot Rate S >= X2 X1 < S <= X2 S <= X1 -50 -50 -50 -50 -50 -50 -50 -50 -50 -50 -50 -50 100 100 100 100 100 100 100 100 100 100 100 100 Profit on short put 0 S - X2 S - X2 100 50 0 0 0 0 0 0 0 0 0 0 from X1 50 0 -50 -50 -50 -50 -50 -50 -50 -50 -50 -50 from X2 -300 -250 -200 -150 -100 -50 0 0 0 0 0 0 Net Profit from X2 -200 -150 -100 -50 0 50 100 100 100 100 100 100 -150 -150 -150 -100 -50 0 50 50 50 50 50 50 Total Profit
Profit on long put 0 0 X1 - S
Total Payoff Net Profit 0 S - X2 X1 - X2 p2 - p1 S - X2 - p1 + p2 X2 - X1 - p1 + p2
Which option(s) Exercised None Option 2 Both
ACCOUNTING AND TAXATION OF DERIVATIVES
Accounting of index futures transactions This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock Index Futures. Stock Index Futures are provided more coverage as these have been introduced recently and would be of immediate benefit to practitioners. International perspective is also provided with a short discussion on fair value accounting. The implications of Accounting practices in the US (FASB-133) are also discussed. The Institute of Chartered Accountants of India has come out with a Guidance Note for Accounting of Index Futures in December 2000. The guidelines provided here in this Section below are in accordance with the contents of this Guidance Note. INDIAN ACCOUNTING PRACTICES Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India. Foreign Exchange Forwards An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period. Example Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 1st
May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rs. 44.80 In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract. Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44) Amount payable had the forward contract not been in place Rs 1,32,00,000 Rs 1,34,40,000
(US $ 3,00,000 * Rs. 44.80) Gain arising out of the forward exchange contract Rs 2,40,000 Recognition of expense/income of forward contract at the inception AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward contract. Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should be apportioned to 20002001. The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted. Profit/loss on cancellation of forward contract AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognised as income or as expense for the period. In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this loss in the financial year 1999-2000. Stock Index Futures Stock index futures are instruments where the underlying variable is a stock index future. Both the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3 months expiry. For example, in the month of September 2000, an investor can buy September Series, October Series and November Series. The September Series will expire on the last Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on the exchange. Accounting of Index Futures Internationally, ‘fair value accounting’ plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Simply stated, fair value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end. This practice is currently not recognised in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account. On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement. In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently not recognising fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalising a Guidance Note on this area, which is expected to be shortly released. The accounting suggestions provided in the Indian context in the following paragraphs should be read in this perspective. The suggestions contained are based on the author’s personal views on the subject.
Regulatory Framework The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees. Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet. Daily Mark to Market Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level). Example Mr. X purchases following two lots of Sensex Futures Contracts on 4th Sept. 2000 : October 2000 Series 1 Contract @ Rs. 4,500 November 2000 Series 1 Contract @ Rs. 4,850 Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on the Bombay Stock Exchange). The accounting entry will be : Initial Margin Account Dr 28,050 To Bank 28,050 If the daily settlement prices of the above Sensex Futures were as follows: Date 04/09/00 05/09/00 06/09/00 07/09/00 Oct. Series 4520 4510 4480 4500 Nov. Series 4850 4800 ---
08/09/00 4490 -Let us assume that Mr X he sold the November Series contract at Rs 4,810. The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to increase/decrease in daily settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange implies 50 underlying Units of the Sensex. Date October Series October Series November Series November Series Receive(RS) Pay(RS) Receive(RS) Pay(RS) 4th September 2000 1,000 th 5 September 2000 500 2,500 th 6 September 2000 1,500 th 7 September 2000 1,000 th 8 September 2000 500 The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Mark-to-Market Margin Account’ on a day to day basis. For example, on the 4th of September the following entry will be passed: Bank A/c Dr. 1,000 To Mark-to-market Margin A/c 1,000 TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin Account so that this Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to this Futures Series. This component will also be reversed on 6th Sept 2000. Bank Account Dr Loss on November Series Initial Margin Mark to Market Margin Margins maintained with Brokers 15,050 Dr 2,000 14,550 2,500
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required. If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the Balance Sheet. The margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October 2000. On this day, all futures transactions remaining outstanding on the system would be compulsorily squared up. Recognition of Profit or Loss A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis. Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognised in the Profit & Loss Account of the period in which the squaring up takes place. If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX. Accounting at Financial Year End In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised. A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts. Example A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March. The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or loss in this accounting period. Alternative Example A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st March. The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a provision towards losses in his Profit or Loss Account in this accounting period. In the next year, the Nifty future is actually sold for Rs 2,10,000. At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next financial year. INTERNATIONAL PRACTICES Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry. What is a Derivative? The standard defines a derivative as an instrument having following characteristics:
A derivative’s cash flows or fair value must fluctuate or vary based on the changes in an underlying variable.
The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying.
The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133 The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place. The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings. Conclusion The Indian accounting guidelines in this area need to be carefully reviewed. The international trend is moving towards marking the underlying securities as well as associated derivative instruments to market. Such a practice would bring into the accounts a clear picture of the impact of derivatives related operations. Indian accounting is based on traditional prudence where profits are not recognised till realisation. This practice, though sound in general, appears to be inconsistent with reality in a highly liquid and vibrant area like derivatives. Taxation of derivative transactions in index futures This Note seeks to provide information on the taxation aspects of index futures transactions. The contents of this Note should not be treated as advice or guidance or authoritative pronouncements. Readers are advised to consult their tax advisors before taking any action relating to their tax computations or planning. This Note is not intended for any such purpose. In the absence of special provisions, the current provisions, which are inadequate to handle the complexities involved are reviewed in this Note. It is expected that the Central Board of Direct Taxes (CBDT) will shortly provide guidelines for taxation aspects of Derivative transactions. Speculation Losses – Cannot be set off
Losses from Speculation business can be set off only against profits of another speculation business. If speculation profits are insufficient, such losses can be carried forward for eight years, and will be set off against speculation profits in these future years. (Section 73) Definition of Speculative Transactions Section 43(5) defines speculative transactions as those which are periodically or ultimately settled otherwise than by actual delivery or transfer. By this definition all index futures transactions will qualify prima facie as speculative transactions, as delivery of such futures is not possible. Exceptions are provided to this definition to cover cases where contracts are entered into in respect of stocks and shares by a dealer or investor to guard against loss in holdings of stocks and shares through price fluctuations. Another exception is provide for contracts entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in the ordinary course of his business as such member. The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The important provisions of this Circular are summarised below:
Hedging sales can be taken to be genuine only to the extent the total of such transactions does not exceed the ready stock, the loss arising from excess transactions should be treated as total stocks of raw material or merchandise in hand. If forward sales exceed speculative losses.
Hedging transactions in connected, though not the same, commodities should not be treated as speculative transactions. It cannot be accepted that a dealer or investor in stocks or shares can enter into hedging transactions outside his holdings. By this interpretation, transactions in index futures will not be covered under the definition of ‘hedging’.
Speculation loss, if any carried forward from earlier years, could first be adjusted against speculation profits of the particular year before allowing any other loss to be adjusted against those profits.
Reports: Report of the RBI-SEBI standard technical committee on exchange traded Currency Futures Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA Websites visited:
www.nse-india.com www.bseindia.com www.sebi.gov.in www.ncdex.com www.google.com www.derivativesindia.com