DERIVATIVES

An overview Forwards Futures

Options Accounting Treatment

AS 11 Recent Developments (AS 30, AS 31, AS 32 )

Definition : A derivative is an instrument whose value is derived from the value of underlying assets, which may be commodities ,foreign exchange, bonds,stock indices.etc.Futures and options .e.g.In the case of stock derivative, say stock futures the underlying asset is stock which is a common share.

DERIVATIVE FEATURES:

It requires no or little initial net investment

It is settled on a future date

A derivative is therefore an instrument to be settled in future date, with little or no initial investment, whose value is derived from change in interest rate, forex rate, price of a security or index (underlying) or a combination of more than one of them.

EXPORTERS AND IMPORTERS

NORMALLY

KEEP POSITIONS OPEN

BOOK FORWARD CONTRACTS

TYPES OF DERIVATIVES

Price Fixing- FX Forwards- Forward Rate Agreements (FRA)- Interest Rate Swaps (IRS)- Cross Currency Swaps (CCS)

Price Insurance- Currency Options- Interest Rate Options- Caps / Floors / Collars - Swaptions

Forward Contract

An agreement to buy/sell a fixed amount of foreigncurrency (asset) at a predetermined exchange rate on a future date/ in a period.

e.g. A company has an obligation to pay 2000 USD. after 1 month.

Spot Rate 42 1 month forward premium Re 1Forward Rate Rs 46After 1 month Spot rate Say 48

FUTURES CONTRACT:

It is a standardized agreement between two parties where one party commits to sell and the other commitsto buy, a specified Quantity of a specified asset(foreign currency) at a specified rate.

e.g. If somebody promises the performance of the sameTransaction discussed in forwards then it becomes a future contract.

Pricing of Futures:

The Futures Price = Spot Price + Cost of Carry

Difference between future and forward.

FUTUREFORWARDTrade on an organized exchange.OTC in nature.Standardized Contract terms.Customized contract terms.More liquidLess liquid.Requires margin payment.No margin payment.Follows daily settlementSettlement happens at the end of the period. Counter party risk to be shouldered by the Exchange Clearing Corporation.Counter party risk to be born by the client.

Options:

An option is a contract that gives the buyer a right, but not the obligation to buy or sell a specified quantity of an asset (Foreign currency) at a predetermined price on or before a specified time (Expiry date).

Call Option Option to Buy. Put Option - Option to Sell.

Features:

Fixed Cost No commitment Contract rate is protected Good both for costing and profiteering

Relation Between Call And Put:

Put call parity theorem-

S + P = C + PV (E)

Types Of Option:

American Option

European Option

VANILLA OPTION CALL

SPOT 40.456 MONTHS FWD 0.30FORWARD RATE 40.75

IF YOU BUY A CALL OPTION YOU PAY A PREMIUM OF 25 PAISE.YOU WILL BUY ONLY IF YOUR VIEW IS THAT THE RUPEE WOULD MOVE TOWARDS 40LEVELS

VANILLA OPTION PUTFOR EXPORTERSPOT 0.45 6 MONTHS FWD 0.306 MOTHS FWD RATE 40.75

IF YOU BUY A PUT OPTION YOU PAY UPFRONT PREMIUM OF 20 PAISA

Wants to Buy ShareWants to Buy ShareWants to Sell ShareWants to Sell ShareBuyer of CallHas right, but no obligation to exerciseBuyer of CallHas right, but no obligation to exerciseBuyer of CallHas right, but no obligation to exerciseBuyer of CallHas right, but no obligation to exerciseMaximum Loss: Premium PaidMaximum Gain: UnlimitedMaximum Loss: Premium PaidMaximum Gain: UnlimitedMaximum Loss: Premium PaidMaximum Gain: UnlimitedMaximum Loss: Premium PaidMaximum Gain: UnlimitedPays PremiumPays PremiumSTRATEGY

PRICING OF AN OPTION:

Portfolio Replication Model- C=N*S-B

Risk Neutral Model-

Black And Scholes Model-

C= S N (d1)-E*e^-rt N (d2)

OPTION STRATEGIES:

Hedging

Spread Bull And Bear

Butterfly Spread

Straddle

Strips and Straps

Strangles

A Flow Through:

FORWARDS Standardize, Trade On Exchange

FUTURES

Attach A Right

OPTIONS

ACCOUNTING STANDARD 11

A distinction is made between forward contracts entered into for

Hedging

Trading

The manner in which exchange differences will be recognized i.e.the accounting treatment will be based on the principle of substance over form.

A Forward for Hedging: A FC entered into for the sole purpose of minimizing risks, is in substance a contract that leads to the determination of reporting currency available for settlement of a transaction.

Premium or discount arising at the inception of the contract should be recognized over the tenure of the contract period.

e.g. Spot rate 01.01.07 - Rs per USD is 45

Forward rate for 6 months- Rs 48.

Spot rate on 30.06.06- Rs 52.

Trading Purpose:

If a forward contract is entered into for the purpose of

Speculative activity, then the contract should be marked to

market (MTM). The gain or loss, computed as under ,should

be recognized on the reporting date.

Concept Of Mark To Market-

This is an arrangement whereby the profits or losses on the position aresettled each day. This enables the exchange to keep appropriate marginso that it is not so low that it increases chances of defaults to an unacceptable level (by collecting MTM losses) and is not so high that it increases the cost of transactions to an unreasonable level(by giving MTM profits).

e.g.

Some Issues:

Tax effect on Derivatives.

IAS 39:

A financial instrument with all three of the following characteristics:

(a) its value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or other Variable (sometimes called the underlying);

(b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

(c) it is settled at a future date.

Categories of hedges

Hedge accounting may be applied to three types of hedging relationships:

Fair value hedges A fair value hedge is a hedge of the exposure to changes in the fair Value of a recognized asset or liability

Cash flow hedges A cash flow hedge is a hedge of the exposure to variability in cash flows that(i) is attributable to a particular risk associated with a recognized asset or liability or a forecast transaction and(ii) could affect reported profit or loss.

Hedges of a net investment in a foreign operation If a derivative or non-derivative is designated as a hedge of that interest, the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognized directly in equity.

UPS AND DOWNS OF DERIVATIVE MARKETS:

More leverageLess transparencyRegulatory arbitrageRising CP exposureHidden systemic riskTail-risk future exposureWeak capital requirementsZero-sum transfer toolsMarket efficiencyRisk sharing and transferLow transaction costsCapital intermediationLiquidity enhancementPrice discoveryCash market developmentHedging toolsRegulatory savings

Forward

Comparison No.6, spelling of "born" to be changed to "borne"Concept clarity is requireda) This slide does not deal with Writerb) Buyer pays premium to writerc) The second half of the slide seems to deal with put , pleas change the slide

Discuss the non applicability of AS-11 in respect of Accounting for exchange differences arising on a forward exchange contract entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction (if possible)