strategies in stock market

8/14/2019 Strategies in Stock Market

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PROJECT REPORTFINANCIAL 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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Derivatives

Future Option Forward Swaps

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

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 theasset 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 contractsize, 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 be ca us e b ot h serve essentia lly t he same

economic funct ions 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 thenotional 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 hisaccount. 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. SettlementSettlement 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 CONTRACTIn 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 spotmarket) 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

OperationalMechanism

Traded directly between twoparties (not traded on the

exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized contracts.

Counter-party

risk

Exists. Exists. However, assumed by the clearing

corp., which becomes the counter party to

all the trades or unconditionally

guarantees their settlement.

Liquidation

Profile

Low, as contracts are tailor

made contracts catering to

the needs of the needs of the

parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets are

scattered.

Efficient, as markets are centralized and

all buyers and sellers come to a common

platform to discover the price.

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

Individual stock Futures in India.

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TRADING STRATEGIES

Options:

Options on stocks were first traded on an organised stock exchange in 1973. Since then there

has been extensive work on these instruments and manifold growth in the field has taken the

world markets by storm. This financial innovation is present in cases of stocks, stock indices,

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 acertain 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 offersdelivery of the undertaking (puts).

EUROPEAN OPTIONS

Buying

AMERICAN OPTIONS

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

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

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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

writing call

Net Profit from

Call Writing

Share

bought

Profit from

stock

Total Profit

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 6 866 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

buying call

option

Net Profit

from Call

Buying

Spot Price of

Selling the

stock

Profit from

stock

Total Profit

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


and alongwith this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58

per share.

Protective Put Strategy

S Xt P Profit from

buying put

Net Profit

from Buying

Spot Price of

Buying the

Profit from

stock

Total Profit

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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


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

writing a put

option

Net Profit from

Put Writing

Spot Price of

Selling the

stock

Profit

from

stock

Total Profit

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 -470 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


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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

long call

Profit on

short call

Total

Payoff

Net Profit Which option(s)

Exercised

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

X1 < 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

X1

Net profit

from X1

Profit

from X2

Net

Profit

from X2

Total

Profit

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 504750 4300 4500 -50 100 0 -50 0 100 50

Spot Rate Profit on

long put

Profit on

short put

Total Payoff Net Profit Which option(s)

Exercised

S >= X2 0 0 0 p2 - p1 None

X1 < S


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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 theUS $ 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

(US $ 3,00,000 * Rs. 44)

Rs 1,32,00,000

Amount payable had the forward contract not been in place

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

Rs 1,34,40,000

Gain arising out of the forward exchange contract Rs 2,40,000Recognition 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 FuturesStock 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 arms 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 netdisposal 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 authors

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. 4,500November 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 28,050To Bank 28,050

If the daily settlement prices of the above Sensex Futures were as follows:

Date

04/09/00

05/09/00

06/09/00

07/09/00

Oct. Series

4520

4510

4480

4500

Nov. Series

4850

4800

--

--

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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 - - -

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. 1,000To 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 toMargin Account will contain transactions pertaining to this Futures Series. This

component will also be reversed on 6th Sept 2000.

Bank Account Dr 15,050Loss on November Series Dr 2,000

Initial Margin 14,550Mark 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, ifNovember 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 yearend. 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 alreadybeen 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 derivatives 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 withreality 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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