The key to understanding derivatives is the notion of a premium. Some derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance.

b)What is the difference between derivatives and shares?

The difference is that while shares are assets, derivatives are usually contracts (the major exception to this are warrants and convertible bonds, which are similar to shares in that they are assets).

We can define financial assets (e.g. shares, bonds) as: claims on another person or corporation; they will usually be fairly standardised and governed by the property or securities laws in an appropriate country.

On the other hand, a contract is merely: an agreement between two parties, where the contract details may not be standardised.

Due to their great flexibility, many different types of investors use derivatives. A good toolbox of derivatives allows the modern investor the full range of investment strategy: speculation, hedging, arbitrage and all combinations thereof.

A futures contract is an exchange-traded contract to buy or sell a pre-determined quantity and quality of a physical commodity or financial instruments (quality is not applicable to futures) on a pre-determined future date at a pre-determined price.

a)Forward contracts v/s Future contracts

Forward contracts

• A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (E.g. forward currency market in India).
• Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place.
• Forward contracts suffer from poor liquidity and default risk.
• Not traded on exchanges but are traded over the counter
• Contract Specifications differ from trade to trade as they are individually agreed between two counter parties.
• Counter party Risk exists
• Liquidation Profile: Poor Liquidity as contracts are tailor maid contracts.
• Price Discovery: Poor; as markets are fragmented

Future contracts

• Future contracts are organized / standardized contracts, which are traded on the exchanges.
• These contracts, are standardized by the exchanges are very liquid in nature.
• In futures market, clearing corporation/ house provides the settlement guarantee.
• Counter party risk exists, but is assumed by the Clearing Corporation/ house reducing the risk to almost nil.
• Liquidation Profile: Very high Liquidity as contracts are standardized contracts.
• Price Discovery: Better; as fragmented markets are brought to the common platform whereby the price is much more transparent due to the standardization and market reporting of volumes and prices.
• Where a forward contract can only be reversed with the same counter party with whom it was entered into, a futures contract can be reversed with any member of the exchange.

b)Standardized terms in futures

• Quantity of the underlying
• Quality of the underlying (not required in financial futures)
• The date and month of delivery
• The units of price quotation (not the price itself) and minimum change in price (tick size)

c)Every futures contract is a forward contract

They:

• are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades.
• are of standard quantity; standard quality (in case of commodities).
• have standard delivery time and place.

d)Commodity V/s Financial Futures

Examples of Commodity Futures:

• Wheat
• Cotton
• Pepper
• Turmeric
• Corn
• Oats
• Soybeans
• Orange juice
• Crude oil
• Natural gas
• Gold
• Silver
• Pork bellies, etc.

Examples of Financial Futures:

• Treasuries
• Bonds
• Stocks
• Stock-index
• Foreign exchange
• Euro-dollar
• Deposits, etc.

Note: quality matters in the former, not in the latter.

An Index is a number used to represent the changes in a set of values between a base time period and another time period.

a) Whats a stock index?

A Stock Index is a number that helps you measure the levels of the market. Most stock indices attempt to be proxies for the market they exist in.

Returns on the index thus are supposed to represent returns on the market i.e. the returns that you could get if you had the entire market in your portfolio.

b) What are the different kinds of market indices?

Broad-based index is geared to provide overall picture of stock markets movements. Examples of these indices are S&P 500, Value Line Index and NYSE Composite. In addition to specialized indices like sector specific ones, track the performance of individual sectors. Similarly different types of indices can be created depending on the companies included in the set.

Example: S&P Midcap 400 represents companies in the U.S.A. whose value is in the middle range of all firms and does not include any stock, which is part of S&P 500.

c) What's the financial theory behind the market index being a good barometer for the overall market?

Stock prices get impacted by two separate factors, which include:

• Company specific events like results bonus announcements, product launches, accidents, tie-ups, etc.
• Events that impact overall economy or sector like diesel price hike, tax rates, etc.Deposits, etc.

To elucidate suppose the government announces a corporate tax hike, we expect the index to be negatively impacted.

On the same day, if a company announces financial results much better than expected, its stock price should increase. In practice the price movement in the companies stock is a combination of its news of better financial results and the disappointing news about the performance of the economy. The role of an effective index is to reflect only that component which affects the state of the overall market.

d) Why do we need an index?

Students of Modern Portfolio Theory will appreciate that the aim of every portfolio manager is to beat the market. In order to benchmark the portfolio against the market we need some efficient proxy for the market. indices arose out of this need for a proxy; they act as an effective barometer, which gauges the prevalent market sentiment and behaviour.

e) What does the number mean?

The index value is arrived at by calculating the weighted average of the prices of a basket of stocks of a particular portfolio.

This portfolio is called the index portfolio and attempts a high degree of correlation with the market.

indices differ based on the method of assigning the weightages to the stocks in the portfolio.

f) But why a portfolio? Why not the entire market?

This is because for someone who wishes to replicate the return on the market it is infinitely more expensive to buy the whole market and for small portfolio sizes it is almost impossible.

The alternative is to choose a portfolio that has a high degree of correlation with the market.

g)How are the stocks in the portfolio weighted?

There are basically three types of weighing :

o Market Capitalisation weighted
o Price weighted
o Equal weighted

Market Capitalisation Method

The number of shares issued to outstanding multiplied by the market price of company's share determines its weightage in the index. The total of market capital of all shares in the index is linked to an index number. The shares with the highest market capitalization are most influential in this type of index.

Examples: S&P 500 Index in the U.S., BSE Sensex and S&P CNX Nifty in India

Modification 1: the number used as out standing shares is adjusted to reflect only those shares that are freely available for trade (floating stock) ignoring those shares which are not expected to be traded in the market (like promoters holding). Example: RUSSEL 100

Modification 2: it seeks to limit the influence of the largest stocks in the index, which otherwise would dominate the entire index this is done by setting a limit on the percentage weight of the largest stock or a group of stocks.

Example: NASDAQ 100

Price Weighted Method

The type of index sums up the price of each stock in the index, which is then equated to an index starting value. The shares with the highest price are not influential in this type of index. If a stock splits, its market price falls resulting in less weight in the index. Examples: Nikkei 225 average of Japanese Stocks, Dow Jones Industrial Average and PSE Technology indices in U.S.

Equal Weightage Method

Each Stock's percentage weight in the index is equal and therefore all stocks have equal influence on the index movement. Examples; Value line index at KCBT

As may be discerned, the stocks in the index could be weighted based on their individual prices, their market capitalisation or equally.

h)What is the better weighing option?

The market capitalisation weighted model is the most popular and widely considered to be the best way of determining the index values.

In India both the BSE-30 Sensex and the S&P CNX Nifty are market capitalisation weighted indices.

i)Who owns the index? Who computes it?

Typically exchanges around the world compute their own index and own it too. The Sensex and the Nifty are case in point.

There are notable exceptions like the S&P 500 Index in the U.S. (owned by S&P which is a credit rating company) and the Strait Times Index in Singapore (owned by the newspaper of the same name).

j)Who decides what stocks to include? How?

Most index providers have a index committee of some sort that decides on the composition of the index based on standardised selection and elimination criteria.

The criteria for selection of course depends on the philosophy of the index and its objective.

k)Selection criteria

Most indices attempt to strike a balance between the following criteria.

• Better Industry representation
• Maximum coverage of market capitalisation
• Higher Liquidity or Lower Impact cost.

Industry Representation

Since the objective of any index is to be a proxy for the market it becomes imperative that the broad industry sectors are faithfully represented in the Index too.

Though this seems like an easy enough task, in practice it is very difficult to achieve due to a number of issues, not least of them being the basic method of industry classification.

Market Capitalisation

Another objective that most index providers strive to achieve is to ensure coverage of some minimum level of the capitalisation of the entire market. As a result within every industry the largest market capitalisation stocks tend to select themselves. However it is quite a balancing act to achieve the same minimum level for every industry.

Liquidity or Impact Cost

It is important from the point of usability for all the stocks that are part of the index to be highly liquid. The reasons are two-fold.

An illiquid stock has stale prices and this tends to give a flawed value to the index.

Further for passive fund managers, the entry and exit cost at a particular index level is high if the stocks are illiquid. This cost is also called the impact cost of the index.

l) What is a benchmark index?

An index that acts as the benchmark in the market has an important role to play.

While it has to be responsive to the changes in the market place and allow for new industries or give up on dead industries, at the same time it should also maintain a degree of continuity in order to survive as an benchmark index.

m) What are the popular indices in India?

• BSE-30 Sensex
• BSE-100 Natex
• BSE Dollex
• BSE-200
• BSE-500

• S&P CNX Nifty
• S&P CNX Nifty Jr.
• S&P CNX Defty
• S&P CNX Midcap
• S&P CNX 500

n) What are sectoral indices?

These indices provide the benchmark for sector specific funds.

Fund managers and other investors who track particular sectors of the economy like Technology, Pharmaceuticals, Financial Sector, Manufacturing or Infrastructure use these indices to keep track of the sector performance.

o) What are the uses of an Index?

Index based funds

These funds tend to replicate the index as it is in order to match the returns on the market. This is also known as passive management. Their argument is that it is not possible to beat the market over a sustained period of time through active management and hence it's better to replicate the index.

Examples in India are

• UTI's fund on the Sensex
• IDBI MF's fund on the Nifty

Exchange traded funds (ETFs)

These are similar to index funds that are traded on an exchange. They are pretty popular world wide with non-resident investors who like to take an exposure to the entire market. S&P's SPDRs and MSCI's WEBS products are amongst the most popular products.

Index futures

Index futures are possibly the single most popular exchange traded derivatives products today. The S&P 500 futures products are the largest traded index futures product in the world.

In India both the BSE and NSE are due to launch their own index futures product on their benchmark indices the Sensex and the Nifty.

What is the trend abroad?

Although we have a whole host of popular exchange owned indices abroad including the DAX 30, the CAC 40 and the Hang Seng we see an increasing trend where global index providers are seen to have more influence among the foreign funds and investing community.

What do Global Index providers bring?

In the age of cross border capital flows and global funds, global index provider provide the uniformity and standardization in their index philosophy and methodologies that allows a global fund to compare performance across regions or sectors.

By following a common industry classification standard in all the countries that they operate in, index providers hope to wean away liquidity from the more popular and home grown indices.

Also global providers are currently, the only ones in a position to provide pan-continental or pan-global indices.

What does the future look like?

The future in India looks pretty exciting with Index futures being launched and Index options expected to follow. Hopefully with the growing popularity of ETF's we might see SEBI allowing them in India too.

Globally while the debate between active and passive fund management still rages, we see standardised indices growing in popularity.

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• Index futures are the future contracts for which underlying is the cash market index.
• For example: BSE may launch a future contract on "BSE Sensitive Index" and NSE may launch a future contract on "S&P CNX NIFTY".

Frequently used terms in Index Futures market

• Contract Size - is the value of the contract at a specific level of Index. It is Index level * Multiplier.
• Multiplier - It is a pre-determined value, used to arrive at the contract size. It is the price per index point.
• Tick Size - It is the minimum price difference between two quotes of similar nature.
• Contract Month - is the month in which the contract will expire.
• Expiry Day - is the last day on which the contract is available for trading.
• Open interest - it's the total outstanding long or short positions in the market at any specific point in time. As total long positions for market would be equal to total short positions, for calculation of open Interest, only one side of the contracts is counted.
• Volume - Number of contracts traded during a specific period of time - During a day, during a week or during a month.
• Long position- Outstanding/unsettled purchase position at any point of time.
• Short position - Outstanding/ unsettled sales position at any point of time.
• Open position - is the outstanding/unsettled long or short position at any point of time.
• Physical delivery - Open position at the expiry of the contract is settled through delivery of the underlying. In futures market, delivery is low.
• Cash settlement - Open position at the expiry of the contract is settled in cash. These contracts are designated as cash settled contracts. Index Futures fall in this category.
• Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is settled by two parties - one buyer and one seller, at the terms other than defined by the exchange. World wide a significant portion of the energy and energy related contracts (crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure.

a) Concept of basis in futures market

• Basis is defined as the difference between cash and futures prices:
  Basis = Cash prices - Future prices.
• Basis can be either positive or negative (in Index futures, basis generally is negative).
• Basis may change its sign several times during the life of the contract.
• Basis turns to zero at maturity of the futures contract i.e. both cash and future prices converge at maturity

b) Life of the contract

c) Gearing

Gearing or leverage results where initial cash outflow in taking a position is less than the value of the position. In case only 5% margin is paid for taking a futures position, the gearing factor is 20 i.e. on a given capital 20 times in value a position may be taken. Thus, higher the gearing higher the risk.

d) Pricing Futures

Cost and carry model of Futures pricing

• Fair price = Spot price + Cost of carry - Inflows
• FPtT = CPt + CPt * (RtT - DtT) * (T-t)/365 oFPtT - Fair price of the asset at time t for time T.
• CPt - Cash price of the asset.
• RtT - Interest rate at time t for the period up to T.
• DtT - Inflows in terms of dividend or interest between t and T.
• Cost of carry = Financing cost, Storage cost and insurance cost.
• If Futures price > Fair price; Buy in the cash market and simultaneously sell in the futures market.
• If Futures price < Fair price; Sell in the cash market and simultaneously buy in the futures market.

This arbitrage between Cash and Future markets will remain till prices in the Cash and Future markets get aligned.

Set of assumptions

• No seasonal demand and supply in the underlying asset.
• Storability of the underlying asset is not a problem.
• The underlying asset can be sold short.
• No transaction cost; No taxes.
• No margin requirements, and so the analysis relates to a forward contract, rather than a futures contract.

Index Futures and cost and carry model

In the normal market, relationship between cash and future indices is described by the cost and carry model of futures pricing.

Expectancy Model of Futures pricing

S - Spot prices.
F - Future prices.
E(S) - Expected Spot prices.

• Expectancy model says that many a times it is not the relationship between the fair price and future price but the expected spot and future price, which leads the market. This happens mainly when underlying is not storable or may not be sold short. For instance in the commodities market.
• E(S) can be above or below the current spot prices. (This reflects markets the expectations)
• Contango market- Market when Future prices are above cash prices.
• Backwardation market - Market when future prices are below cash prices.

e) Relationship between forward & future markets

• Analyze the different dimensions of Forward and Future Contracts:
  (Risk; Liquidity; Leverage; Margining etc....)
• Assign value to each factor to arrive at the contract price.
  (Perception plays a crucial role in price determination)

• Any substantial difference in the Forward and Future prices will trigger arbitrage.

f) What are stock specific futures?

There are very few countries that offer stock specific futures, since these instruments in general aren't very popular. Price volatility in individual stocks is much higher than the index, which results in an increase in the risk of the Clearing Corporation and higher margin requirements. These instruments also suffer from lack of depth and liquidity in trading. In most cases, Futures based on individual stocks often have a physical settlement, which leads to more complex regulatory requirements.

Since it's a lot more difficult to manipulate an index than individual stocks leading to price manipulations. The L.C.Gupta committee did not promote futures on individual stocks as a possible derivative contract.

g) What do you mean by closing out on contracts?

A long position in futures can be closed out by selling futures while buying futures can close out a short position. Once apposition is closed out, only the net difference needs to be settled in cash, without any delivery of the underlying. Most contracts are not held to expiry but are closed out before that. If held until expiry, some are settled for cash others for physical delivery.

What's the difference between the settlement mechanism for cash and physical delivery?

In case it is not possible or practical to give physical delivery. Open positions, (open long positions always being equal to open short positions) are closed out on the last day of trading at a price determined by the spot "cash" market of the underlying asset. This price is called "Exchange Delivery Settlement Price" or EDSP. In case of physical settlement short side delivers to the specified location while long side takes delivery from the specified location of the specified quantity / quality of the underlying asset.

In case of physical settlement short side delivers to the specified location while long side takes delivery from the specified location of the specified quantity / quality of the underlying asset. The long side pays the EDSP to the clearing house/corporation which in turn is received by the short side.

h) Risk management through Futures?

• Basic objective of introduction of futures is to manage the price risk.
• Index futures are used to manage the systemic risk, vested in the investment in securities.

i) Risk management through Futures?

• Long hedge- When you hedge by going long in futures market.
• Short hedge - When you hedge by going short in futures market.
• Cross hedge - When a futures contract is not available on an asset, you hedge your position in cash market on this asset by going long or short on the futures for another asset whose prices are closely associated with that of your underlying.
• Hedge Contract Month- Maturity month of the contract through which hedge is accomplished.
• Hedge Ratio - Number of future contracts required to hedge the position.

j) Some specific uses of Index Futures

• Portfolio Restructuring - An act of increasing or decreasing the equity exposure of a portfolio, quickly, with the help of Index Futures.
• Index Funds - These are the funds which imitate/replicate index with an objective to generate the return equivalent to the Index. This is called Passive Investment Strategy.

Speculation in the Futures market

• Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take:
• Naked positions - Position in any future contract.
• Spread positions - Opposite positions in two future contracts. This is a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.

Arbitrageurs in Futures market

Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.

k) Margining in Futures market

The whole system dwells on margins:
o Daily Margins
o Initial Margins
o Special Margins
o Additional Margins

Please note: Compulsory collection of margins from clients including institutions. Also collection of margins on Portfolio basis is not allowed by L. C. Gupta committee.

Daily Margins

• Daily margins are collected to cover the losses that have already taken place on open positions.
• Price for daily settlement - Closing price of futures index.
• Price for final settlement - Closing price of cash index.
• For daily margins, two legs of spread positions would be treated independently.
• Daily margins should be received by CC/CH and/or exchange from its members before the market opens for the trading on the very next day.
• Daily margins would be paid only in cash.

Initial Margins

• Margins to cover the potential losses for one day.
• To be collected on the basis of value at risk at 99% of the days.
• Different initial margins on: oNaked long and short positions.
• Spread positions.

The concept of cross margining?

This is a method of calculating margins after taking into account combined positions in Futures, options, cash market, etc. Hence the total margin requirement reduces to cross Hedges, though this very unlikely to be introduced in India.

Naked positions

Short positions 100 [exp (3st ) - 1]
Long positions 100 [1 - exp (3st)]
Where (st)2 = l(st-1)2 + (1-l)(rt2)

• st is today's volatility estimates.
• st-1 is the volatility estimates on the previous trading day.
• l is decay factor which determines how rapidly volatility estimates change and is taken as 0.94 by Prof. J. R. Varma.
• rt is the return on the trading day [log(It/It-1)]
• Because volatility estimate st changes everyday, Initial margin on open position will change every day. (for first 6 months of futures trading, minimum initial margin on naked positions shall be 5%)

Spread positions

• Flat rate of 0.5% per month of spread on the far month contract.
• Min. margin of 1% and maximum margin of 3% on spread positions.
• A calendar spread would be treated as open position in the far month contract as the near month contract approaches maturity.
• Over the last five days of trading of the near month contract, following percentages of the spread shall be treated as naked position in the far month contract:
• 100% on the day of expiry
• 80% one day before the expiry
• 60% two days before the expiry
• 40% three days before the expiry
• 20% four days before the expiry

Margins on the calendar spread are to be reviewed after 6 months of futures trading.

Additional Margins

In case of sudden higher than expected volatility, additional margin may be called for by the exchange. Its generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payment crisis, etc. this is a preemptive move by the exchange to prevent breakdown.

l) Liquid assets and Broker's net worth

• Liquid assets
• Cash, fixed deposits, bank guarantee, government securities and other approved securities.
• 50% of Liquid assets must be cash or cash equivalents. Cash equivalents means cash, fixed deposits, bank guarantee and government securities.
• Liquid net-worth = Liquid asset - Initial margin
• Continuous requirement for a clearing member:
• Minimum liquid net-worth of Rs.50 Lacs.
• The mark to market value of gross open position shall not exceed 33.33 times of member's liquid net worth.

m) Basis for calculation of Gross Exposure

• For the purpose of the exposure limit, a calendar spread shall be regarded as an open position of one third of the mark to market value of the far month contract. As the near month contract approaches expiry, the spread shall be treated as a naked position in the far month contract in the same manner as defined in slide no. 49.

Margining in Futures market

Initial Margin (Value at risk at 99% of the days)
Daily Margin
Special Margins

• Striking an intelligent balance between safety and liquidity while determining margins, is a million dollar point.

Position limits in Index Futures

Customer level
No position limit. Disclosure to exchange, if position of people acting in concert is 15% or more of open interest.

Trading member level

• 15% of open interest or 100 crore whichever is higher.
• to be reviewed after 6 months of futures trading.

Operators in the derivatives market

• Hedgers - Operators, who want to transfer a risk component of their portfolio.
• Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.
• Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mispricing.

Expected Advantages Of Derivatives To The Cash Market

• Higher liquidity
• Availability of risk management products attracts more investors to the cash market.
• Arbitrage between cash and futures markets fetches additional business to cash market.
• Improvement in delivery based business.
• Lesser volatility
• Improved price discovery.

What makes a contract click?

• Risk in the underlying market.
• Presence of both hedgers and speculators in the system.
• Right product specifications.
• Proper margining.

Future

• Multiple indices trading on the same exchange even the same index with different contract designs
• Dedicated funds -
  Future funds
  Options funds
  Hybrid funds

n) What are general hedging strategies?

The basic logic is " If long in cash underlying: Short Future;
If short in cash underlying: Long Future"

Example: if you have bought 100 shares of company A and want to hedge against market movements, you should short an appropriate amount of Index Futures. This will reduce your overall exposure to events affecting the whole market (systematic risk). In case a war breaks out, the entire market will fall (most likely including Company A). so your loss in company a would be offset by the gains in your short position in Index Futures.

Some instances where hedging strategies are useful include:

• Reducing the equity exposure of a Mutual Fund by selling Index Futures;
• Investing funds raised by new schemes in Index Futures so that market exposure is immediately taken, and
• Partial liquidation of portfolio by selling the index future instead of the actual shares where the cost of transaction is higher.

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This note is a rough guide to possible accounting practices that could develop in India. The note covers only accounting of index futures and does not extend to other instruments like options and swaps. The Institute of Chartered Accountants of India (ICAI) has set up a committee to set up accounting practices in this area. There are currently no guidelines available for accounting of these transactions. In most cases in India, securities are valued at lower of cost or market value, applying the principles of conservatism. Further, in the interim period till the ICAI issues its guidelines, the following accounting practices could be considered:

All futures transactions, irrespective of whether they are hedging transactions or speculative transactions would be treated uniformly as under:

• Unrealised losses on derivative transactions should be recognised, while unrealised profits should not be accounted until realisation. This follows from the principle of conservatism.
• Realised profits and losses would be carried to the Profit & Loss Account.

Margins paid against Futures will be reflected as Assets. Mere payment of margins will not qualify as profits or losses, though in most cases, the amounts of such margins will be based on the price movements of the futures in the market.

There is a controversy currently on whether daily payment of margins and daily 'settlement' as proposed in India would amount to daily 'realisation' of profits or losses for the purposes of accounting. The ICAI view on the issue is awaited. If the daily 'settlement' is construed as daily 'realisation', then the question of 'unrealised' profits or losses will not arise.

a)Commonly followed international accounting practises

International practices vary from country to country and could apply differently to various types of derivatives transactions, for example, those that seek to use index futures as against those that attempt to protect cash flow regularity. What follows is a very general and rough guide to commonly followed practices, and should not be construed as rigid application of accounting regulations. It is important to first recognise whether the index future is a 'hedge' or not. If the transaction is not a 'hedge', it would be treated as a 'trading' transaction.

b) Hedge Accounting

Accounting for hedges differs significantly from regular accounting practices, as the recognition of profits and losses on the hedge is intricately connected with the fluctuations in the market values of the underlying securities. Hence, the profits or losses on hedge transactions are adjusted in the carrying amount of the underlying securities instead of being taken to the Profit & Loss Account.

For this purpose, the definition of what constitutes a 'hedge' is important. The British Bankers Association in their Statement of Recommended Practice on hedge accounting have laid down the following criteria, which should be satisfied so as to be able to apply hedge accounting to a situation:

• The derivative transaction must be intended to be a hedge, and must, in fact, provide a reasonable hedge.
• The derivative transaction must match or eliminate a substantial portion of the market risk inherent in the hedged position.
• Adequate evidence of such intention to hedge should be established at the outset of the transaction.

Hedge accounting can be applied only to specific hedges, that is, transactions where the hedge can be identified with a specific underlying asset or liability or commitment.

The application of hedge accounting principles will also depend on the method of valuation used for the underlying security. Where the underlying security is valued at cost, the hedge will also be valued at cost. Where the underlying security is marked to market, the hedge will also be marked to market. Where the underlying security is valued at lower of cost or market value, the hedge and the underlying security will be bundled together to ascertain the aggregate cost and market values respectively, and the lower of the two of the bundle will be considered for valuation.

c) Trading Transactions

Internationally, trading transactions are marked to market. Accordingly, both unrealised losses and profits are taken to the Profit & Loss Account. This is a significantly different practice, vis-à-vis the most common Indian conservative accounting practice of recognising only unrealised losses.

Trading transactions will include general hedges, i.e. those hedging transactions which are not specifically related to specific assets or liabilities or commitments. Further, trading transactions will also include those specific hedge transactions which do not meet all the defined criteria and hence cannot follow hedge accounting principles.

Some examples are provided below. These are intended to be suggestive rough guides and should not be construed as authoritative pronouncements on the subject.

Example - 1 First Year
Underlying securities purchased for Rs 200,000
Index futures sold for Rs 200,000 and margin of Rs 12,000 paid
Further margins of Rs 2,500 paid from time to time
Year end values of underlying securities Rs 1,93,000
Year end value of future Rs 205,000

Example - 2 Above transactions continued effects in the Second Year if the underlying securities are sold
underlying Securities are sold for Rs 2,15,000
Futures contract has not expired and closing price comes to Rs 202,000
Future Margin paid are Rs 7,000

Example - 3 Above transactions continued effects in the Second Year the Futures Transaction Expires
Margins Paid further Rs 7,000

Futures Contract expires at a closing value of Rs 2,10,000 - amount receivable is immediately received.

In the scheme of accounting entries outlined below, it is assumed that daily 'settlement' of futures is not treated as daily 'realisation' of profits and losses in the Indian context. As stated above, this issue needs the guidance of the ICAI.

An attempt is made to provide a simple scheme of entries so as to enable readers to understand the gist of accounting quickly. Various refinements are possible in practice. For example, when investments are acquired, it may be regular practice to credit the broker (to whom the amounts are due) rather than crediting the bank account from where payments are effected.

Example 1: First Year

Investments (Assets) Dr 200,000
To Bank 200,000

Margins (Assets) Dr 12,000 To Bank 12,000

Margins (Assets) Dr 2,500
To Bank 2,500

Year End

Dimunition in Investment (Expense) Dr 7000
To Investments (Assets) 7,000

Unrealised gains on Futures are not to be accounted

Balance Sheet Impact

Investments will be reflected at Rs 1,93,000

Profit & Loss Impact

Dimunition in Investments will reduce profits by Rs 7,000

Example 2: Second Year

Bank Dr 2,15,000
To Investments(Assets) 1,93,000
To Profit on sale of Investments (Gain) 22,000

No entry for Futures as no profits realised so far

Margins(Assets) Dr 7,000
To Bank 7,000

Example 3: Second Year

Margins Dr 7,000
To Bank 7,000

Bank Dr 31,500
To Profits on Futures 10,000
To Margins (released) 21,500

The realised Profit on Futures will be taken to the Profit & Loss Account in the absence of specific guidelines on Hedge accounting in India currently.