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c  

 

   

In finance, a a   or simply a a  is a non-standardized contract between two


parties to buy or sell an asset at a specified future time at a price agreed today.[1] This is in
contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to
enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a
long position, and the party agreeing to sell the asset in the future assumes a short position. The
price agreed upon is called the delivery price, which is equal to the forward price at the time the
contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument
changes. This is one of the many forms of buy/sell orders where the time of trade is not the time
where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is the
price at which the asset changes hands on the spot date. The difference between the spot and the
forward price is the forward premium or forward discount, generally considered in the form of a
profit, or loss, by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or
exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality
of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts
are very similar to futures contracts, except they are not exchange traded, or defined on
standardized assets.[2] Forwards also typically have no interim partial settlements or "true-ups" in
margin requirements like futures - such that the parties do not exchange additional property
securing the party at gain and the entire unrealized gain or loss builds up while the contract is
open. However, being traded OTC, forward contracts specification can be customized and may
include mark-to-market and daily margining. Hence, a forward contract arrangement might call
for the loss party to pledge collateral or additional collateral to better secure the party at gain.[

G 
      

^uppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy
currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter
into a forward contract with each other. ^uppose that they both agree on the sale price in one
year's time of $104,000 (more below on why the sale price should be this amount). Andy and
Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to
have entered a long forward contract. Conversely, Andy will have the short forward contract.

At the end of one year, suppose that the current market valuation of Andy's house is $110,000.
Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of
$6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for
$104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit.
In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000.
The similar situation works among currency forwards, where one party opens a forward contract
to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date,
as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the
exchange rate between U.^. dollars and Canadian dollars fluctuates between the trade date and
the earlier of the date at which the contract is closed or the expiration date, one party gains and
the counterparty loses as one currency strengthens against the other. ^ometimes, the buy forward
is opened because the investor will actually need Canadian dollars at a future date such as to pay
a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward
does so, not because they need Canadian dollars nor because they are hedging currency risk, but
because they are speculating on the currency, expecting the exchange rate to move favorably to
generate a gain on closing the contract.

In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy
$100 million Canadian dollars equivalent to, say $114.4 million U^ at the current rate²these
two amounts are called the notional amount(s)). While the notional amount or reference amount
may be a large number, the cost or margin requirement to command or open such a contract is
considerably less than that amount, which refers to the leverage created, which is typical in
derivative contracts.

[ 
 a a 
     

Continuing on the example above, suppose now that the initial price of Andy's house is $100,000
and that Bob enters into a forward contract to buy the house one year from today. But since
Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he
wants to be compensated for the delayed sale. ^uppose that the risk free rate of return R (the
bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. ^o
Andy would want at least $104,000 one year from now for the contract to be worthwhile for him

The opportunity will be agreed upon.


u
  

 
 



erivatives have been around from the days when people began to trade with one another,
though not as comprehensively as it is done today. The highest traded forms of derivatives are
futures, options and swaps. The jargon is confusing because it is non-legal and imprecise, the
transactions are numerous and the contracts themselves are often complex in detail. However,
the transactions themselves are relatively simple. This article endeavours to elucidate on the
structure and legal concerns of derivatives that are traded on the stock exchanges. The
initiatives of the Government and the ^BI for growth of derivatives market are admirable;
however, there is still much leeway for improvement. This market is embryonic, which is
manifest from the low trading volumes compared with that of developed capital economies.
^till it is felt by market observers that contrary to the initial promise, derivatives never picked
up. erivatives bring vibrancy in capital markets and Indian investors can gain immensely
from them, and therefore, it is vital that necessary changes are brought in at the earliest.
2  
 Indian capital market finally acquired the much-awaited international flavour when it
introduced trading in futures and options on its premier bourses, National ^tock xchange (N^)
in 2000 and on Bombay ^tock xchange (B^) in 2001. Financial markets are systemically
volatile and so, it is the prime concern of all the financial agents to balance or hedge the related
risk factors. Risks can be of various kinds, including price risks, counter-party risks and
operating risks. The concept of derivatives comes into frame to reduce the price-related risks.1
The term µderivative¶ itself indicates that it has no independent value. The value of a derivative is
entirely derived from the value of a cash asset. A derivative contract, product, instrument or
simply µderivative¶ is to be sharply distinguished from the underlying cash asset, which is an
asset bought or sold in the cash market on normal delivery terms.2 A simple derivative
instrument hedges the risk component of an underlying asset. For example, rice farmers may
wish to sell their harvest at a price which they consider is µsafe¶ at a future date to eliminate the
risk of a change in prices by that date. To hedge their risks, farmers can enter into a forward
contract and any loss caused by fall in the cash price of rice will then be offset by profits on the
forward contract. Thus, hedging by derivatives is equivalent of insurance facility against risk
from market price variations.
The agreed future price of rice is known as the strike price and the prevailing market price of rice
on the future date is known as the spot price, which is also the underlying asset. A derivative is
essentially a contract for differences - the difference between the agreed future price of an asset
on a future date and the actual market price on that date. Thus, settlement in a derivative contract
is by delivery of cash.
erivatives have been around from the days when people began to trade with one another,
though not as comprehensively as it is done today. The highest traded forms of derivatives are
futures, options and swaps. The jargon is confusing because it is non-legal and imprecise; the
 
1. Financial transactions are exposed to three types of price risks,   ()   
 


   

which cannot be diversified away because of the volatility of the stock market; ()   

 which is
present because of fluctuations in interest rates; and () 


where foreign currency is involved.
2.  Report of L.C. Gupta Committee on erivatives Trading (1996); (1998) 2 Comp. LJ 21 (Jour).
varieties of transaction are numerous and the contracts themselves are often complex in detail.
However, the transactions themselves are relatively simple.
·   a  
 The primary purpose behind investing in derivative instruments is to enable individual or
corporate investors to either increase their exposure to certain specified risks in the hope that
they will earn returns more than adequate to compensate them for bearing these added risks,
known as speculation, or reduce their exposure to specific financial risks by transferring these
risks to other parties who are willing to bear them at lower cost, known as hedging3. There are
two principal markets for derivative products. A derivative product can be traded in an organized
securities and commodities exchange and also, through an µover-the-counter¶ (µOTC¶) market
which are essentially private transactions.4 Further, there are three participants in derivative
markets, namely, hedgers, speculators and arbitrageurs. Hedgers are operators who want to
transfer a risk component of their portfolio and, thus, hedge it with buying or selling other
instruments. ^peculators are operators who intentionally take risk from hedgers in pursuit of
profits. Arbitrageurs are operators who operate in different markets simultaneously, in pursuit of
profit and eliminate mis-pricing in securities across different markets.
The three most popular derivative instruments are forwards, futures and options. There are many
further divisions of these instruments. A forward contract is a customized contract between two
entities, where settlement takes place on a specified date in the future at today¶s pre-agreed price.
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. Future contracts are standardized exchange-traded contracts whereas
forwards are customized OTC instruments. Thus, futures are more liquid in nature and afford
greater commercial convenience. Furthermore, only daily margins are payable to the stock
exchange, which are fixed by the concerned stock exchange.5 The stock exchange acts as a
counter-party, which has the effect of a guarantor and less chances of default.
Options are instruments that give the buyer the right but not the obligation to buy or sell an asset.
Options are of two types, namely, calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a given
future date. Puts give the buyer the right but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date. Generally, options live up to one year
but majority of the options traded on exchanges have a maximum maturity of nine months.
Longer-dated options are called warrants and are generally traded over-the-counter. LAP^ is
another kind of options having a maturity of up to three years. LAP^ is an acronym for µLong-
Term quity Anticipation ^ecurities¶. Baskets are options on portfolios of underlying assets. The
underlying asset is usually a moving average or a basket of assets. quity index options are a
form of basket options.
Another kind of derivative product is swap. A swap, an OTC derivative, is nothing but a barter or
an exchange but it plays a critical role in international finance. Currency swaps help eliminate

 
3. John . Finnerty & Mark ^. Brown, An Overview of erivatives Litigation: 1994 to 2000, 131, 132, 7
Fordham J. Corp. & Fin. L. (2000).
4. Philip R. Wood, Title Finance, erivatives, ^ecuritisations, ^et-Off and Netting 207 (^weet & Maxwell
1997).
5. aily margin refers to the difference in prices of the underlying asset on any given date and that of the price
fixed for delivery in the derivative contract.
the differences between international capital markets. Interest rate swaps help eliminate barriers
caused by regulatory structure. While currency swaps result in exchange of one currency with
another, interest rate swaps help exchange a fixed rate of interest with a variable rate. ^waps are
private agreements between two parties and are not traded on exchanges but they do have an
informal market and are traded among dealers. ^waptions is an option on a swap that gives the
party the right, but not the obligation to enter into a swap at a later date. The above illustrated
categories of derivative instruments comprehensively develop a conceptual understanding of
equity derivatives.
u  a a  
 Constant risks have stimulated market participants to manage it through various risk
management tools. erivative products is one such risk management tool. With the increase in
awareness about the risk management capacity of derivatives, its market developed and later
expanded. erivatives have now become an integral part of the capital markets of developed as
well as emerging market economies. Benefits of derivative products can be enumerated as under
:
' erivatives help in transferring risks from risk-averse people to risk-oriented people.
' erivatives assist business growth by disseminating effective price signals concerning
exchange rates, indices and reference rates or other assets and thereby, render both cash and
derivatives markets more efficient.
' erivatives catalyze entrepreneurial activities.
' By allowing transfer of unwanted risks, derivatives can promote more efficient allocation of
capital across the economy and, thus, increasing productivity in the economy.
' erivatives increase the volume traded in markets because of participation of risk-averse
people in greater numbers.
' erivatives increase savings and investment in the long run.
  a  2
 It is a fallacy that derivatives trading was previously absent in India. Forward trading in
securities was the antecedent of derivatives. It was traded in the form of 
(call options), 

(put options), 


(straddles), etc.6 uring this time, the ^ecurities Contracts (Regulation) Act,
1956 (µthe Act¶) was promulgated, which was essentially a legislation to prevent undesirable
transactions in securities. Forward trading was seen as inherently speculative and was banned in
year 1969.7 Nevertheless,Ê forward trading continued on the B^ in an informal manner in the
form of  which allowed carry forward between two settlement periods. The ^ecurities and
xchange Board of India (^BI) banned theÊ 
operations on the recommendations of the
Joint Parliamentary Committee on Irregularities in ^ecurities and Banking Transactions, 1992.8

 
6. M.^. ^ahoo Forward Trading in ^ecurities in India, 29(6) Chartered ^ecretary 624, 629 (1999).
7. The Central Government in exercise of powers under section 16 of the Act, banned forward trading in India
through a notification dated June 27, 1969; The notification prescribed that except for sale or purchase of
securities under a spot delivery contract or contract for cash or hand delivery or special delivery, all other
contracts were prohibited. As a consequence thereof entering into forward transaction became illegal.
8. U  ^BI Circular dated ecember 23, 1993.
In 1995, the ban on 
was, however, lifted subject to certain safeguards.9 Apart from ,
there was another form of forward trading, namely, ready forward contracts or repo transactions
which were also permitted by the ^upreme Court.10
Thus, a strange situation emerged where forward trading was banned by virtue of the 1969
notification but some forms of forward trading, like  and ready forward contracts, were
prevalent. The Government of India realized that derivatives were gaining ground world over as
one of the most sought-after capital market hedging instruments. With this in mind, it was felt
that the 1969 notification is redundant and should be repealed. To begin with, prohibition on
options in securities was omitted by the ^ecurities Laws (Amendment) Act, 1995, with effect
from January 25, 1995. This was the first step towards the introduction of derivatives trading in
India.
ven after removal of the prohibition in options, its market did not take off. This was largely by
reason of lack of regulatory framework for governance of trading in derivatives. The ^BI took
up the task for putting in place such a regulatory framework and constituted L.C. Gupta
Committee (µCommittee¶) in November 1996.11 The Committee observed that development of
futures trading is advancement over forward trading which has existed for centuries and grew out
of need for hedging the price-risk involved in many commercial operations. The foremost
recommendation of the Committee was to include derivatives within the definition of µsecurities¶
under the Act. It was intended that once derivatives are declared as securities under the Act, the
^BI, the regulatory body for trading in securities, could also govern trading of derivatives. In
1998, the ^BI appointed Prof. J.R. Verma Working Group to recommend risk containment
measures for derivative trading. These reports laid the foundation of theoretical and practical
aspects of derivative trading in India.
Consequently, the ^ecurities Contracts (Regulation) Amendment Bill, 1998 was introduced in
the Lok ^abha and was referred to the Parliamentary ^tanding Committee on Finance. And
finally in ecember 1999, ^ecurities Law (Amendment) Act, 1999 was passed by the Parliament
permitting a legal framework for derivatives trading in India.
´    a  
 The present legal framework and piecemeal approach adopted by the ^BI is based on the
recommendations of the L.C. Gupta Committee. On the recommendations of the Committee,
definition of securities¶ under the Act was modified to include derivatives.12 The 1969
notification was also repealed on March 1, 2000. erivatives trading finally went underway at
N^ and B^ after getting nod from the ^BI to commence index futures trading in June 2000.
To begin with, the ^BI approved trading in index futures contracts based on ^&P CNX Nifty
and B^ - 30 (^ensex) index. This was followed by approval for trading in options based on
these two indexes and options on individual securities. At B^, trading in index options based on
B^ ^ensex commenced in June 2001, the trading in options on individual securities

 
9. On the recommendations of the G.^. Patel Committee.
10. 

 
 v.    [1997] 10 ^CC 488, where the Court held that ready forward or buy-back
transactions by banking companies is severable into two parts,   the ready leg and the forward leg. Ready
leg is not illegal, unlawful or prohibited under section 23, Indian Contract Act but it is the forward leg which
alone is illegal and hit by the 1969 notification. Thus, ready leg transactions are permissible.
11. The Committee submitted its report to ^BI on May 11, 1998;  [1998] 2 Comp LJ 21 (Journal).
12. ^ection 2(), the Act.
commenced on July 2001 and futures on individual stocks were launched in November 2001. At
N^ too, trading in index options based on ^&P CNX Nifty commenced in June 2001, trading in
options on individual securities commenced in July, 2001 and single stock futures were launched
in November 2001.
The Act renders a comprehensive definition on derivatives and even permits derivative trading.13
Only those derivative products which are traded on a recognized stock exchange and are settled
on the clearing house of the recognized stock exchange are legal and valid.14 ^ection 18A of the
Act is a 
  clause and was recommended by the Parliamentary ^tanding Committee on
Finance, which examined the ^ecurities Contracts (Regulation) Amendment Bill, 1998. The
object of this provision is that since derivatives, particularly index futures, are cash-settled
contracts, they can be entangled in legal controversy by being classified as µwagering
agreements¶ under section 30, Indian Contract Act, 1872 and thereby, declared 
and  .
For trading in derivatives, permission from the ^BI is mandatory.15 However, this permission is
required for trading in only those derivative contracts that are tradable and, hence, no prior
permission is mandatory for OTC derivatives. The Act further prescribes punishment of
imprison-ment for a term which may extend to one year, or with fine, or with both, in case of
contravention of section 18A and rules made thereunder by the ^BI or the Central
Government.16 Trading and settlement in derivative contracts is done in accordance with the
rules, bye-laws and regulations of the N^ and B^ and their clearing houses, duly approved by
the ^BI and notified in the Official Gazette. The minimum contract size for a derivative
transaction is Rs. 2 lakhs.
Thus, the enactment of the ^ecurities Law (Amendment) Act, 1999 and repeal of the 1969
notification provided a legal framework for securities based derivatives on stock exchanges in
India, which is co-terminus with framework of trading of other securities allowed under the Act.
However, these attempts are not sufficient for developing a buoyant derivatives market. The
principal hindrance lurking before the hedgers and speculators is taxation on derivatives
transactions. There is no apparent provision dealing with taxation of derivatives transactions.
^ection 73(1), read with section 43(!), of the Income-tax Act, 1961 are two provisions which are
of significant concern. ^ection 73(1) prescribes that losses of a speculative business carried on
by the assessee can be set-off only against profits and gains of another speculative business, up
to a maximum of eight years. Under section 43(5), a transaction is a speculative transaction
where () the transaction is in commodity, stocks or scrips, () the transaction is settled
otherwise than actual delivery, () the participant has no underlying position, and () the
transaction is not for jobbing or arbitrage to guard against losses which may arise in the ordinary
course of his business.

 
13. ^ection 2() of the Act reads: A µderivative¶ includes () 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
and () a contract which derives its value from the prices, index of prices, of underlying securities.
14. ^ection 18A, the Act.
15. ^BI Notification No. ^.O. 184(), dated March 1, 2000 which reads: ³No person shall, save with the
permission of ^BI, enter into any contract for the sale or purchase of securities other than such spot delivery
contract or contract for cash or hand delivery or special delivery or contract in derivatives as is permissible
under the said Act. . . .´
16. ^ection 23, the Act.
erivatives are not commodities, stocks or scrips but are a special class of securities under the
Act. Also, derivatives transactions, particularly index futures are never settled by actual
delivery17. And most importantly, under section 43(!), a hedging or arbitrage transaction in
which settlement is otherwise than actual delivery is regarded as non-speculative only when the
participant has an underlying position, but in derivatives contracts hedgers and speculators have
no underlying position in such transactions. In the light of these readings, derivatives contracts
may be construed as speculative transactions and will be hit by section 73(1). It is, therefore,
imperative to declare derivatives transactions as non-speculative and it should be taxed as normal
business income or capital gains, as the case may be.
½  a a  
 This section deals with accounting of derivatives and attempts to cover the Indian scenario in
some depth. The areas covered are Accounting for Foreign xchange erivatives and ^tock
Index Futures. ^tock 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 U^ (FA^B-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a guidance note for
accounting of Index Futures in ecember 2000. The guidelines provided here in this section
below are in accordance with the contents of this guidance note.
2½ ´ 
 Accounting for foreign exchange derivatives is guided by Accounting ^tandard 11.
Accounting for ^tock Index Futures is expected to be Governed by a guidance note shortly
expected to be issued by the Institute of Chartered Accountants of India.
 [    
! 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 ^tandard 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.
' [ " - ^uppose XYZ Ltd. needs U^$ 3,00,000 on May 1, 2000 for repayment of loan
instalment and interest. As on ecember 1, 1999, it appears to the company that the U^$
may be dearer as compared to the exchange rate prevailing on that date, say, U^$ 1 = Rs.
43.50. Accordingly, XYZ Ltd. may enter into a forward contract with a banker for U^$
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 ecember 1, 1999 was U^$ 1 =
Rs. 44 as against the spot rate of Rs. 43.50. As on the future date,  May 1, 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 will be U^$ 1 = Rs. 44.80.

 
17. elivery of an index is an impossibility.
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 =Rs. 1,32,00,000
(U^$ 3,00,000 * Rs. 44)
Amount payable had the forward contract not =Rs. 1,34,40,000
been in place (U^$ 3,00,000 *Rs. 44.80)
Gain arising out of the forward exchange = Rs. 2,40,000
contract
r    a
 "  aa   
 
# A^-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 ecember is Re. 0.50 per U^$. In
other words, the total loss was Rs. 1,50,000 as on the date of forward contract.
^ince 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 ofÊRs. 1,20,000 should be apportioned to the accounting year 1999-2000
and the balance Rs. 30,000 should be apportioned to 2000-01.
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.
´ a"     aa  
$ A^-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange
should be recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on March 1, 2000 at the rate of
U^$ 1 = Rs. 44.90, XYZ Ltd. would have sustained a loss at the rate of Re. 0.10 per U^$. 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.
% 2   
 ^tock index futures are instruments where the underlying variable is a stock index future.
Both the Bombay ^tock xchange and the National ^tock xchange have introduced index
futures in June 2000 and permit trading on the ^ensex futures and the Nifty futures, respectively.
For example, if an investor buys one contract on the Bombay ^tock xchange, this will represent
50 units of the underlying ^ensex Futures. Currently, both exchanges have listed futures up to 3
months expiry. For example, in the month of ^eptember 2000, an investor can buy ^eptember
series, October series and November series. The ^eptember series will expire on the last
Thursday of ^eptember. From the next day (  Friday), the ecember series will be quoted on
the exchange.
½  a2   
 Internationally, µfair 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. ^imply 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 ^tandard 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.
r      
 The index futures market in India is regulated by the reports of the r. L.C. Gupta
Committee and the Prof J.R. Verma Committee. Both the Bombay ^tock xchange and the
National ^tock xchange 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 ^BI Committees.
ach 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 ^heet.
 & & 
 ^tock index futures transactions are settled on a daily basis. ach 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).
' [ " - Mr. X purchases following two lots of ^ensex Futures Contracts on 4th ^ept.
2000 :
October 2000 ^eries 1 Contract @ Rs. 4,500
November 2000 ^eries 1 Contract @ Rs. 4,850
Mr. X will be required to pay an Initial Margin before entering into these transactions.
^uppose the Initial Margin is 6 per cent, the amount of Margin will come to Rs 28,050 (50
Units per contract on the Bombay ^tock xchange).
The accounting entry will be :
Initial Margin Account r. 28,050
To Bank 28,050
If the daily settlement prices of the above ^ensex Futures were as follows :
-

 
#
 
04/09/00 4520 4850
05/09/00 4510 4800
06/09/00 4480 ²
07/09/00 4500 ²
08/09/00 4490 ²
Let us assume that Mr. X had sold the November ^eries Contract at Rs. 4,810.
The amount of µMark-to-Market Margin Money¶ ^ensex receivable/payable due to
increase/decrease in daily settlement prices is as below : Please note that one contract on the
Bombay ^tock xchange implies 50 underlying Units of the ^ensex.
-


# 
# 

 
 
 
 


$ 
%$ &
'
%$ &
$ 
%$ &
'
%$ &

4th ^eptember, 2000 1,000 - - -


5th ^eptember, 2000 - 500 - 2,500
6th ^eptember, 2000 - 1,500 - -
7th ^eptember, 2000 1,000 - - -
8th ^eptember, 2000 - 500 - -
The amount of µMark-to-Market Margin Money¶ received/paid will be credited/debited to
µMark-to-Market Margin Account¶ on a day-to-day basis. For example, on the 4th of ^eptember,
the following entry will be passed :
Bank A/c r. 1,000
To Mark-to-Market Margin A/c 1,000
On ^eptember 6, 2000, Mr. X will account for the profit or loss on the November ^eries
Contract. He purchased the contract at Rs. 4,850 and sold at Rs. 4,810. He, therefore, suffered a
loss of Rs. 40 per ^ensex Unit orÊRs. 2,000 on the contract. This loss will be accounted on 6th
^eptember. 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 ^eries. This component will also be reversed on ^eptember
6, 2000.
Bank AccountÊ r 15,050
Loss on November ^eries r. 2,000
Initial Margin 14,550
Mark to Market Margin 2,500
&   u  
 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,  October 26,
2000. On this day, all futures transactions remaining outstanding on the system would be
compulsorily squared up.
r    a
 a  
 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 and 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 ^N^X 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 ^N^X.
½ a   
 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 and 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.
' [ " - A client has bought ^ensex futures for Rs. 2 lakhs onÊ1st March and Nifty futures
for Rs. 2,50,000 on 7th March. On 31st March, the market values of these futures are Rs.
2,20,000 andÊRs. 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 ^ensex 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.
' ½  
[ " - A client has bought ^ensex futures forÊRs 2,00,000 on 1st March and
Nifty futures for Rs. 2,50,000 onÊ 7th March. On 31st 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.
2   ´ 
! ^tatement of Financial Accounting ^tandard No. 133 issued by the Financial Accounting
^tandard Board, U^ 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 U^ business and industry.
! WHAT I^ A RIVATIV - 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 RIVATIV^ A^ PR FA^ 133 - The ^tandard requires that every
derivative instrument should be recorded in the balance sheet as asset 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.
! RIVATIV^ U^ A^ H GING IN^TRUMNT^ - erivative instruments used for
hedging the fair value of a recognised asset or liability, are called Fair Value Hedges. The gain or
loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall
be recognised currently in income.
' [ " - An individual having a portfolio consisting of shares of Infosys and B^^, may
decide to hedge this portfolio using the ^ensex Futures Contract. The gain or loss on the
index futures contract would compensate the loss or gain on the portfolio. Both the gains
and losses will be recognised in the profit and loss statement. If the hedge is perfect, gains
and losses will offset each other and, hence, will not have any impact on the current
earnings. However, if the hedge is not a perfect hedge, there would be a difference between
the gain and the compensating loss. This would affect the current reported earnings of the
individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and
liability, it is called Cash Flow Hedge. The gain or loss on such derivative instruments will be
transferred to current earnings of the same period or the periods during which the forecasted
transaction affects the earnings. The remaining gain or loss on the derivative instrument, if any,
shall be recognised currently in earnings.
^imilarly if the derivative instrument hedges risk of exposures arising out of foreign currency
transactions or investments overseas or in subsi-diaries, it is called Foreign Currency Hedge.
! H G RCOGNITION - Accounting treatment for trading and hedging is completely
different. In order to qualify as a hedge transaction, the company should at the inception of the
transaction :
' esignate the hedge relationship
' ocument such relationship
' Identify hedge item, hedge instrument and risks being hedged
' xpect hedge to be highly effective
' Lay down reasonable basis for effectiveness of assessment. Ineffectiveness may be reported
in the current financial statements¶ earnings.
arlier, there was no concept of partial effectiveness of hedge. However, FA^B recognised that
not all hedging transactions can be perfect. There can be a degree of ineffectiveness which
should be recognized. The statement requires that the assessment of effectiveness must be
consistent with risk management strategies documented for that particular hedge relationship.
Further, the assessment of effectiveness is required whenever financial statements or earnings are
reported.
! CONCLU^ION - 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. ^uch 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.
   a   2   
# This note seeks to provide information on the taxation aspects of index futures transactions.
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 CB T will shortly
provide guidelines for taxation aspects of derivative transactions.
# ^PCULATION LO^^^ CANNOT B ^T 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)
# FINITION OF ^PCULATIV TRAN^ACTION^ - ^ection 43(!) 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 " 
  as
speculative transactions, as delivery of such futures is not possible.
xceptions 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 provided 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 CB T has issued a Circular No 23, dated ^eptember 12, 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 µhedging¶.
' ^peculation 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.
# M ^PCULATION - As per ["  to section 73, where any part of the
business of a company consists in the purchase and sale of shares of other companies, such
company shall, for the purposes of this section, be deemed to be carrying on a speculation
business to the extent to which the business consists of purchase and sale of such shares.
The CB T has issued a Circular No 23, dated ^eptember 12, 1960 on this area. The important
provisions of this Circular are summarised below :
' Company whose gross total income consists mainly of income chargeable under the heads
µInterest on securities¶, µIncome from house property¶, µCapital gains¶ and µIncome from
other sources¶.
' Company whose principal business is Banking.
' Company whose principal business is granting of loans and advances.
Most brokers and dealers are currently caught within the mischief of this ["  especially
after the wave of corporatisation of brokers¶ businesses. The ["  however, does not
cover index futures.
# PO^^IBILITY OF µ^PCULATION¶ TRATMNT - In view of the above provisions, it
appears that the possibility of the Income-tax epartment treating index futures transactions to
be speculative and taxed accordingly, is high as far as the assessees carrying on business are
concerned, unless a clarification is issued by the CB T.
Another possible view (as far as non-business assessees are concerned) could be that gains and
losses from index futures be treated as short-term capital gains. This view can gain support from
the fact that such assessees are not covered within the ambit of sections 43 and 73 referred to
above.
# PO^^IBL ARGUMNT^ - It is possible to argue that index futures transactions are not
speculative transactions. ^ome lines of argument are explored below :
() ^ection 43(!) speaks of purchase and sale of any µcommodity¶, including shares and stocks.
Index futures are not µcommodities¶. Further, index futures are also not µstocks and shares¶.
Hence, section 43(!) does not apply to futures transactions. The question of examining the
provisos (exceptions) does not arise.
() xceptions to µspeculative transactions¶ as provided in section 43(!) also include hedging
transactions undertaken in respect of stocks and shares. Proviso () to section 43(!) states -
µa contract in respect of stocks and shares entered into by a dealer or investor therein to
guard against loss in his holdings of stocks and shares through price fluctuations¶. It,
however, remains to be seen whether index futures can be covered under µstocks and
shares¶.
It appears that if index futures are considered to be part of stocks and shares as per the wording
of section 43(!), then the proviso will also become applicable and, hence, hedging contracts
through the mechanism of index futures will not be considered speculative. On the other hand, if
index futures are not part of stocks and shares, then neither section 43(!) nor the proviso apply
and, hence, the entire gamut of index futures transactions will remain out of the purview of
speculative transactions.
' ["  to section 73 speaks of purchase and sale of shares of other companies. Index
futures are not µshares¶. Hence, this ["  does not apply to futures transactions.
It is believed and understood that foreign exchange forward transactions are currently not being
caught within the mischief of sections 43 and 73. This lends more comfort to the possibility of
index futures also being left out of this net, though only experience will indicate the stand the
Income-tax epartment will take.
# OTHR PO^^IBL CONTROVR^I^
' The Income-tax epartment may take a stand that profits and losses accrue on day-to-day
basis, in view of the daily settlement procedure. This could be contrary to the accounting
guidelines, which (as it currently appears) may advocate profit (loss) recognition at the
expiry of the contract.
' It appears currently that accounting guidelines will require recognition of unrealised losses
at financial year end, but not unrealised profits. The Income-tax epartment may not agree
with this conservative treatment.
0   
$ The initiatives of the Government and the ^BI for growth of derivative market are
admirable; however, there is still much leeway for improvement. This market is embryonic,
which is manifest from the low trading volumes compared with that of developed capital
economies. ^till it is felt by market observers that since contrary to the initial promise,
derivatives never picked up, ^BI has to address many issues. Foremost is clarity on taxation
and accounting front. The number of derivatives trading exchanges should be increased.
These instruments are designed to reallocate risks among market participants in order to improve
overall market efficiency. But while the new instruments create new hedging opportunities, they
also entail legal risks because the newer instruments tend to be more difficult to understand and
value than existing instruments and, thus, more prone to occasional large losses. Therefore, it is
imperative that the ^BI endeavours to create awareness about derivatives and their benefits
among investors.
Further, due to its complex nature, tough norms and high entry barriers, small investors are
keeping away from derivative trading. The issue of higher contract size in derivatives trading is
proving to be an impediment in increasing retail investors¶ participation. The Parliamentary
^tanding Committee on Finance in 1999 observed that because of the swift movement of funds
and technical complexities involved in derivatives transactions, there is a need to protect small
investors who may be lured by the sheer speculative gains by venturing into futures and options.
Pursuant to this object, the present threshold limit of Rs. 2 lakhs has been prescribed for
derivatives transactions. However, the contract size of Rs. 2 lakhs is not only high but is also
beyond the means of a typical investor. The heartening development in this regard is that the
Ministry of Finance has decided to halve the contract size from the current level of Rs. 2 lakhs
per contract to Rs. 1 lakh and the ^BI will decide when to introduce the reduced contracts.18

 
    
u  

   
 c 
   !"##$%
Another roadblock is the restriction on Foreign Institutional Investors (FIIs) to invest only in
index futures. It is accepted that ^BI must have regulatory powers for trading in securities,
however, for increase in trading volumes, ^BI should lay down only broad eligibility criteria
and the exchanges should be free to decide on stocks and indices on which futures and options
could be permitted. erivatives bring vibrancy in capital markets and Indian investors can gain
immensely from them. Therefore, it is vital that necessary changes are brought in at the earliest.
Also, stringent disclosure norms on mutual funds for investing in derivatives should be relaxed
to revitalize Indian mutual funds by enabling diversification of risks and risk-hedging.
81-^

*The author is Associate Professor of Law, Chanakya National Law University, Patna.



 

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