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PROJECT REPORT

FINANCIAL DERIVATIVES

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

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ACKNOWLEDGEMENT

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.

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DERIVATIVE DEFINED
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 include-
A 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.

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TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Bombay Stock National Commodity &


Exchange Exchange Derivative Exchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

TYPES OF DERIVATIVES

Derivatives

Future Option Forward Swaps

FORWARD CONTRACTS

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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.

FUTURE CONTRACT

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

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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.

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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).

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• 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, , will be found by discounting the present

value at time to maturity 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.

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TABLE 1-
DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational Traded directly between two Traded on the exchanges.


Mechanism parties (not traded on the
exchanges).

Contract Differ from trade to trade. Contracts are standardized contracts.


Specifications

Counter-party Exists. Exists. However, assumed by the clearing


risk corp., which becomes the counter party to
all the trades or unconditionally
guarantees their settlement.

Liquidation Low, as contracts are tailor High, as contracts are standardized


Profile made contracts catering to exchange traded contracts.
the needs of the needs of the
parties.

Price discovery Not efficient, as markets are Efficient, as markets are centralized and
scattered. all buyers and sellers come to a common
platform to discover the price.

Examples Currency market in India. Commodities, futures, Index Futures and


Individual stock Futures in India.

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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
TRADING by storm. This financial innovation is present in cases of stocks, stock indices,
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 OPTIONS


Buying Buying
PARAMETERS CALL PUT CALL PUT
Spot Price (S)
Strike Price (Xt)
Time to Expiration (T) ? ?
Volatility ()
Risk Free Interest Rates (r)
Dividends (D)
Favourable
Unfavourable

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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 Xt C Profit from Net Profit from Share Profit from Total Profit
writing call Call Writing bought stock
50 60 6 0 6 58 -8 -2
52 60 6 0 6 58 -6 0
54 60 6 0 6 58 -4 2
56 60 6 0 6 58 -2 4
58 60 6 0 6 58 0 6
60 60 6 0 6 58 2 8
62 60 6 -2 4 58 4 8
64 60 6 -4 2 58 6 8
66 60 6 -6 0 58 8 8
68 60 6 -8 -2 58 10 8
70 60 6 -10 -4 58 12 8

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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 Spot Price of Profit from Total Profit
buying call from Call Selling the stock
option Buying stock
50 60 -6 0 -6 58 8 2
52 60 -6 0 -6 58 6 0
54 60 -6 0 -6 58 4 -2
56 60 -6 0 -6 58 2 -4
58 60 -6 0 -6 58 0 -6
60 60 -6 0 -6 58 -2 -8

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62 60 -6 2 -4 58 -4 -8
64 60 -6 4 -2 58 -6 -8
66 60 -6 6 0 58 -8 -8
68 60 -6 8 2 58 -10 -8
70 60 -6 10 4 58 -12 -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 Net Profit Spot Price of Profit from Total Profit
buying put from Buying Buying the stock

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option put option stock
50 60 -6 10 4 58 -8 -4
52 60 -6 8 2 58 -6 -4
54 60 -6 6 0 58 -4 -4
56 60 -6 4 -2 58 -2 -4
58 60 -6 2 -4 58 0 -4
60 60 -6 0 -6 58 2 -4
62 60 -6 0 -6 58 4 -2
64 60 -6 0 -6 58 6 0
66 60 -6 0 -6 58 8 2
68 60 -6 0 -6 58 10 4
70 60 -6 0 -6 58 12 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.

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Reverse of Protective Put Strategy

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S Xt P Profit from Net Profit from Spot Price of Profit Total Profit
writing a put Put Writing Selling the from
option stock stock
50 60 6 -10 -4 58 8 4
52 60 6 -8 -2 58 6 4
54 60 6 -6 0 58 4 4
56 60 6 -4 2 58 2 4
58 60 6 -2 4 58 0 4
60 60 6 0 6 58 -2 4
62 60 6 0 6 58 -4 2
64 60 6 0 6 58 -6 0
66 60 6 0 6 58 -8 -2
68 60 6 0 6 58 -10 -4
70 60 6 0 6 58 -12 -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.

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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 X1 X2 c1 c2 Profit from Net profit Profit form Net Profit Total Profit
X1 from X1 X2 from X2
4200 4300 4500 -450 400 0 -450 0 400 -50
4250 4300 4500 -450 400 0 -450 0 400 -50
4300 4300 4500 -450 400 0 -450 0 400 -50
4350 4300 4500 -450 400 50 -400 0 400 0
4400 4300 4500 -450 400 100 -350 0 400 50
4450 4300 4500 -450 400 150 -300 0 400 100
4500 4300 4500 -450 400 200 -250 0 400 150
4550 4300 4500 -450 400 250 -200 -50 350 150
4600 4300 4500 -450 400 300 -150 -100 300 150
4650 4300 4500 -450 400 350 -100 -150 250 150
4700 4300 4500 -450 400 400 -50 -200 200 150
4750 4300 4500 -450 400 450 0 -250 150 150

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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 Profit on Total Net Profit Which option(s)


long call short call Payoff Exercised

S >= X2 S - X1 X2 - S X2 - X1 X2 - X1 - c1 + c2 Both

X1 < S <= X2 S - X1 0 S - X1 S - X1 - c1 +c2 Option 1

S >= X1 0 0 0 c2 - c1 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.

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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 Net Total
X1 from X1 from X2 Profit Profit
from X2
4200 4300 4500 -50 100 100 50 -300 -200 -150
4250 4300 4500 -50 100 50 0 -250 -150 -150
4300 4300 4500 -50 100 0 -50 -200 -100 -150
4350 4300 4500 -50 100 0 -50 -150 -50 -100
4400 4300 4500 -50 100 0 -50 -100 0 -50
4450 4300 4500 -50 100 0 -50 -50 50 0
4500 4300 4500 -50 100 0 -50 0 100 50
4550 4300 4500 -50 100 0 -50 0 100 50
4600 4300 4500 -50 100 0 -50 0 100 50
4650 4300 4500 -50 100 0 -50 0 100 50
4700 4300 4500 -50 100 0 -50 0 100 50
4750 4300 4500 -50 100 0 -50 0 100 50

Spot Rate Profit on Profit on Total Payoff Net Profit Which option(s)
long put short put Exercised
S >= X2 0 0 0 p2 - p1 None
X1 < S <= X2 0 S - X2 S - X2 S - X2 - p1 + p2 Option 2
S <= X1 X1 - S S - X2 X1 - X2 X2 - X1 - p1 + p2 Both

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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

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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 Rs 1,32,00,000
(US $ 3,00,000 * Rs. 44)
Amount payable had the forward contract not been in place 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 2000-
2001.
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.

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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.

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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 Oct. Series Nov. Series

04/09/00 4520 4850


05/09/00 4510 4800
06/09/00 4480 --
07/09/00 4500 --

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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 15,050
Loss on November Series Dr 2,000
Initial Margin 14,550
Mark to Market Margin 2,500
Margins maintained with Brokers
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.

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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.

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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.

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• 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

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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.

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BIBLIOGRAPHY

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

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