How does the pricing of derivatives work? forwards

In finance, a forward contract or simply a forward 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 con-trast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to en-ter 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 ex-change 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 standard-ized 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.[

Working of a forward contract

Suppose 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. Suppose 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.S. 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. Sometimes, 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 USD at the current rate—these 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 de-rivative contracts.

Example of how forward prices should be agreed upon

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. Suppose 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. So 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.

Basic concepts of derivatives and their trading?

Derivatives 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 initia-tives of the Government and the SEBI for growth of derivatives market are admirable; how-ever, 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. Still it is felt by market observers that contrary to the initial promise, derivatives never picked up. De-rivatives 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.

Introduction

1. Indian capital market finally acquired the much-awaited international flavour when it intro-duced trading in futures and options on its premier bourses, National Stock Exchange (NSE) in 2000 and on Bombay Stock Exchange (BSE) 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 fac-tors. 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 ‘derivative’ 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 sim-ply ‘derivative’ 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 ‘safe’ 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 con -tract. 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.

Derivatives 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 va-1 1. Financial transactions are exposed to three types of price risks, viz., (a) equities market risk or systematic

risk, which cannot be diversified away because of the volatility of the stock market; (b) interest rate risk, which is present because of fluctuations in interest rates; and (c) exchange rate risk where foreign currency is involved.

2 2. See Report of L.C. Gupta Committee on Derivatives Trading (1996); (1998) 2 Comp. LJ 21 (Jour).

rieties of transaction are numerous and the contracts themselves are often complex in detail. However, the transactions themselves are relatively simple.

Genre of Derivatives

2. The primary purpose behind investing in derivative instruments is to enable individual or cor-porate 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 ‘over-the-counter’ (‘OTC’) 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. Specu-lators 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 ex-change, 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 obliga-tion 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 major-ity 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. LEAPS is another kind of options having a maturity of up to three years. LEAPS is an acronym for ‘Long-Term Equity An-ticipation Securities’. Baskets are options on portfolios of underlying assets. The underlying as-set is usually a moving average or a basket of assets. Equity 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 the differences between international capital markets. Interest rate swaps help eliminate barriers

3 3. John D. Finnerty & Mark S. Brown, An Overview of Derivatives Litigation: 1994 to 2000, 131, 132, 7 Fordham J. Corp. & Fin. L. (2000).

4 4. Philip R. Wood, Title Finance, Derivatives, Securitisations, Set-Off and Netting 207 (Sweet & Maxwell 1997).

5 5. Daily 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.

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. Swaps are private agreements between two parties and are not traded on exchanges but they do have an in-formal market and are traded among dealers. Swaptions 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 eq-uity derivatives.

Benefits of derivatives

3. Constant risks have stimulated market participants to manage it through various risk manage-ment tools. Derivative products is one such risk management tool. With the increase in aware-ness about the risk management capacity of derivatives, its market developed and later expanded. Derivatives 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 :

Derivatives help in transferring risks from risk-averse people to risk-oriented people.

Derivatives assist business growth by disseminating effective price signals concerning ex-change rates, indices and reference rates or other assets and thereby, render both cash and derivatives markets more efficient.

Derivatives 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.

Derivatives increase the volume traded in markets because of participation of risk-averse people in greater numbers.

Derivatives increase savings and investment in the long run.

Tracing History of Derivatives in India

4. It is a fallacy that derivatives trading was previously absent in India. Forward trading in secu-rities was the antecedent of derivatives. It was traded in the form of teji (call options), mandi (put options), fatak (straddles), etc.6 During this time, the Securities Contracts (Regulation) Act, 1956 (‘the Act’) was promulgated, which was essentially a legislation to prevent undesirable transac-tions in securities. Forward trading was seen as inherently speculative and was banned in year 1969.7 Nevertheless, forward trading continued on the BSE in an informal manner in the form of badla, which allowed carry forward between two settlement periods. The Securities and Ex-change Board of India (SEBI) banned the badla operations on the recommendations of the Joint Parliamentary Committee on Irregularities in Securities and Banking Transactions, 1992.8 In 1995, the ban on badla was, however, lifted subject to certain safeguards.9 Apart from badla,

6 6. M.S. Sahoo Forward Trading in Securities in India, 29(6) Chartered Secretary 624, 629 (1999).7 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 se -curities under a spot delivery contract or contract for cash or hand delivery or special delivery, all other con -tracts were prohibited. As a consequence thereof entering into forward transaction became illegal.

8 8. Vide SEBI Circular dated December 23, 1993.9 9. On the recommendations of the G.S. Patel Committee.

there was another form of forward trading, namely, ready forward contracts or repo transactions which were also permitted by the Supreme Court.1010

Thus, a strange situation emerged where forward trading was banned by virtue of the 1969 notifi-cation but some forms of forward trading, like badla and ready forward contracts, were preva-lent. 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 Securities Laws (Amendment) Act, 1995, with effect from January 25, 1995. This was the first step towards the introduction of derivatives trading in India.

Even 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 SEBI took up the task for putting in place such a regulatory framework and constituted L.C. Gupta Commit-tee (‘Committee’) in November 1996.1111 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 recom-mendation of the Committee was to include derivatives within the definition of ‘securities’ under the Act. It was intended that once derivatives are declared as securities under the Act, the SEBI, the regulatory body for trading in securities, could also govern trading of derivatives. In 1998, the SEBI 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 de-rivative trading in India.

Consequently, the Securities Contracts (Regulation) Amendment Bill, 1998 was introduced in the Lok Sabha and was referred to the Parliamentary Standing Committee on Finance. And fi-nally in December 1999, Securities Law (Amendment) Act, 1999 was passed by the Parliament permitting a legal framework for derivatives trading in India.

Present legal framework

5. The present legal framework and piecemeal approach adopted by the SEBI is based on the rec-ommendations of the L.C. Gupta Committee. On the recommendations of the Committee, defini-tion of securities’ under the Act was modified to include derivatives.1212 The 1969 notification was also repealed on March 1, 2000. Derivatives trading finally went underway at NSE and BSE after getting nod from the SEBI to commence index futures trading in June 2000. To begin with, the SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE - 30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. At BSE, trading in index options based on BSE Sensex commenced in June 2001, the trading in options on individual securities commenced on July 2001 and futures on individual stocks were launched in November 2001. At NSE too, trading in index options based on S&P CNX Nifty commenced in June 2001, trading in options on individ-

10 10. See BOI Finance Ltd. v. Custodian [1997] 10 SCC 488, where the Court held that ready forward or buy-back transactions by banking companies is severable into two parts, viz., 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 11. The Committee submitted its report to SEBI on May 11, 1998; See [1998] 2 Comp LJ 21 (Jour-nal).

12 12. Section 2(h), the Act.

ual 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 trad-ing.1313 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.1414 Section 18A of the Act is a non obstante clause and was recommended by the Parliamentary Standing Committee on Finance, which examined the Securities 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 ‘wagering agreements’ under section 30, Indian Contract Act, 1872 and thereby, declared null and void.

For trading in derivatives, permission from the SEBI is mandatory.1515 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 im-prison-ment for a term which may extend to one year, or with fine, or with both, in case of con-travention of section 18A and rules made thereunder by the SEBI or the Central Government.1616

Trading and settlement in derivative contracts is done in accordance with the rules, bye-laws and regulations of the NSE and BSE and their clearing houses, duly approved by the SEBI and noti -fied in the Official Gazette. The minimum contract size for a derivative transaction is Rs. 2 lakhs.

Thus, the enactment of the Securities Law (Amendment) Act, 1999 and repeal of the 1969 notifi-cation 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. How-ever, 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. Section 73(1), read with section 43(5), of the Income-tax Act, 1961 are two provisions which are of significant concern. Section 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 (a) the transac-tion is in commodity, stocks or scrips, (b) the transaction is settled otherwise than actual deliv-ery, (c) the participant has no underlying position, and (d) the transaction is not for jobbing or ar-bitrage to guard against losses which may arise in the ordinary course of his business.

Derivatives 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 deliv-ery1717. And most importantly, under section 43(5), a hedging or arbitrage transaction in which settlement is otherwise than actual delivery is regarded as non-speculative only when the partici-

13 13. Section 2(aa) of the Act reads: A ‘derivative’ includes (a) a security derived from a debt instru-ment, share loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security and (b) a contract which derives its value from the prices, index of prices, of underlying securities.

14 14. Section 18A, the Act.15 15. SEBI Notification No. S.O. 184(E), dated March 1, 2000 which reads: “No person shall, save with

the permission of SEBI, enter into any contract for the sale or purchase of securities other than such spot deliv-ery contract or contract for cash or hand delivery or special delivery or contract in derivatives as is permissible under the said Act. . . .”

16 16. Section 23, the Act.17 17. Delivery of an index is an impossibility.

pant has an underlying position, but in derivatives contracts hedgers and speculators have no un-derlying 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.

Accounting of index futures transactions

6. 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 In-dex Futures. Stock Index Futures are provided more coverage as these have been introduced re-cently 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 account-ing 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

7. Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Account-ing 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

8. 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 re-quired 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 in-come or as expense for the period.

Example - Suppose XYZ Ltd. needs US$ 3,00,000 on May 1, 2000 for repayment of loan instalment and interest. As on December 1, 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 December 1, 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 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 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 =Rs. 1,34,40,000

been in place (US$ 3,00,000 *Rs. 44.80)

Gain arising out of the forward exchange = Rs. 2,40,000

contract

Recognition of expense/income of forward contract at the inception

9. 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 Re. 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 2000-01.

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.

Profit/loss on cancellation of forward contract

10. AS-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 US$ 1 = Rs. 44.90, XYZ Ltd. would have sustained a loss at the rate of Re. 0.10 per US$. The total loss on cancellation of forward contract would be Rs. 30,000. The standard requires recog-nition of this loss in the financial year 1999-2000.

Stock Index Futures

11. 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 fu-tures in June 2000 and permit trading on the Sensex futures and the Nifty futures, respectively.

For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed futures up to 3 months expiry. For example, in the month of September 2000, an investor can buy September se-ries, 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 ex-change.

Accounting of Index Futures

12. 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 transac-tion. Simply stated, fair value accounting requires that underlying securities and associated deriv-ative 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 cur-rent investments should be carried in the financial statements as lower of cost and fair value de-

termined either on an individual investment basis or by category of investment. Current invest-ment 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.

Regulatory Framework

13. The index futures market in India is regulated by the reports of the Dr. L.C. Gupta Commit-tee 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

14. 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. Alterna-tively, 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. Sup-pose the Initial Margin is 6 per cent, 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 —  

08/09/00 4490 —  

Let us assume that Mr. X had 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 Se-ries

October Se-ries

November Se-ries

November Se-ries

  Receive (Rs.) Pay (Rs.) Receive (Rs.) Pay (Rs.)

4th September, 2000 1,000 - - -

5th September, 2000 - 500 - 2,500

6th September, 2000 - 1,500 - -

7th September, 2000 1,000 - - -

8th 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

On September 6, 2000, Mr. X will account for the profit or loss on the November Series Con-tract. 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 Sep-tember. Further, the Initial Margin paid on the November series will be refunded back on squar-ing 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 per-taining to this Futures Series. This component will also be reversed on September 6, 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

15. Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may, therefore, insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required.

If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the balance sheet. The margins paid would get reflected as assets in the balance sheet and refunds would reduce these assets.

The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e., October 26, 2000. On this day, all futures transactions remaining outstanding on the system would be com-pulsorily squared up.

Recognition of profit or loss

16. A basic issue which arises in the context of daily settlement is whether profits and losses ac-crue 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 administra-tive mechanism whereby the stock exchanges maintain a healthy system of controls. From an ac-counting 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 recog-nised 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 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 fu-ture. 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

17. 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 con-tracts 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 transac-tion. 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 lakhs on 1st March and Nifty fu-tures for Rs. 2,50,000 on 7th March. On 31st 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 31st March, the market values of these fu-tures are Rs. 2,20,000 and Rs. 2,15,000, respectively. He has not squared up these transac-tions 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

18. 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.

18.1 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 un-derlying 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

18.2 ACCOUNTING FOR DERIVATIVES AS PER FAS 133 - The Standard requires that ev-ery 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 relat-ing 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.

18.3 DERIVATIVES USED AS HEDGING INSTRUMENTS - Derivative 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.

Example - An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the in-dex 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 lia-bility, 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.

Similarly 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.

18.4 HEDGE RECOGNITION - Accounting treatment for trading and hedging is completely dif-ferent. In order to qualify as a hedge transaction, the company should at the inception of the transaction :

Designate the hedge relationship

Document such relationship

Identify hedge item, hedge instrument and risks being hedged

Expect hedge to be highly effective

Lay down reasonable basis for effectiveness of assessment. Ineffectiveness may be reported in the current financial statements’ earnings.

Earlier, there was no concept of partial effectiveness of hedge. However, FASB 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 con-sistent with risk management strategies documented for that particular hedge relationship. Fur-ther, the assessment of effectiveness is required whenever financial statements or earnings are re-ported.

18.5 CONCLUSION - The Indian accounting guidelines in this area need to be carefully re-viewed. 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

19. 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 CBDT will shortly pro-vide guidelines for taxation aspects of derivative transactions.

19.1 SPECULATION LOSSES CANNOT BE SET OFF - Losses from speculation business can be set off only against profits of another speculation business. If speculation profits are insuffi-cient, such losses can be carried forward for eight years, and will be set off against speculation profits in these future years. (section 73)

19.2 DEFINITION OF SPECULATIVE TRANSACTIONS - Section 43(5) defines speculative transactions as those which are periodically or ultimately settled otherwise than by actual deliv-ery or transfer. By this definition, all index futures transactions will qualify prima facie as specu-lative transactions, as delivery of such futures is not possible.

Exceptions are provided to this definition to cover cases where contracts are entered into in re-spect 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 CBDT has issued a Circular No 23, dated September 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 ‘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.

19.3 DEEMED SPECULATION - As per Explanation to section 73, where any part of the busi-ness 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 CBDT has issued a Circular No 23, dated September 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 ‘Interest on securities’, ‘Income from house property’, ‘Capital gains’ and ‘Income 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 Explanation, especially after the wave of corporatisation of brokers’ businesses. The Explanation, however, does not cover index futures.

19.4 POSSIBILITY OF ‘SPECULATION’ TREATMENT - In view of the above provisions, it appears that the possibility of the Income-tax Department treating index futures transactions to be speculative and taxed accordingly, is high as far as the assessees carrying on business are con-cerned, unless a clarification is issued by the CBDT.

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.

19.5 POSSIBLE ARGUMENTS - It is possible to argue that index futures transactions are not speculative transactions. Some lines of argument are explored below :

(a) Section 43(5) speaks of purchase and sale of any ‘commodity’, including shares and stocks. Index futures are not ‘commodities’. Further, index futures are also not ‘stocks and shares’. Hence, section 43(5) does not apply to futures transactions. The question of examining the provisos (exceptions) does not arise.

(b) Exceptions to ‘speculative transactions’ as provided in section 43(5) also include hedging transactions undertaken in respect of stocks and shares. Proviso (b) to section 43(5) states - ‘a 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, how-ever, remains to be seen whether index futures can be covered under ‘stocks and shares’.

It appears that if index futures are considered to be part of stocks and shares as per the wording of section 43(5), 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(5) nor the proviso apply and, hence, the entire gamut of index futures transactions will remain out of the purview of spec-ulative transactions.

Explanation to section 73 speaks of purchase and sale of shares of other companies. Index futures are not ‘shares’. Hence, this Explanation 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 In-come-tax Department will take.

19.6 OTHER POSSIBLE CONTROVERSIES

The Income-tax Department 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 ex-piry 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 Department may not agree with this conservative treatment.

Conclusion

20. The initiatives of the Government and the SEBI for growth of derivative market are ad-mirable; 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. Still it is felt by market observers that since contrary to the initial promise, derivatives never picked up, SEBI 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 SEBI 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 keep-ing away from derivative trading. The issue of higher contract size in derivatives trading is prov-ing to be an impediment in increasing retail investors’ participation. The Parliamentary Standing Committee on Finance in 1999 observed that because of the swift movement of funds and techni-cal 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 trans-actions. 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 SEBI will decide when to introduce the reduced contracts.1818

Another roadblock is the restriction on Foreign Institutional Investors (FIIs) to invest only in in-dex futures. It is accepted that SEBI must have regulatory powers for trading in securities, how-ever, for increase in trading volumes, SEBI 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. Derivatives bring vibrancy in capital markets and Indian investors can gain im-mensely 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-S

 

18 18 Ens Economic Bureau, Derivatives’ Contract Size to be Halved, Indian Express, August 6, 2003.

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

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

What is derivative?

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the un-derlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, in-terest rates and market indexes. Most derivatives are characterized by high leverage. 

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