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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
exchange 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
standardized 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.[
G
^uppose 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. ^uppose 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.^. 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. ^ometimes, 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 U^ at the current rate²these
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
derivative contracts.
[
a
a
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. ^uppose 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. ^o
Andy would want at least $104,000 one year from now for the contract to be worthwhile for him
3. John . Finnerty & Mark ^. Brown, An Overview of erivatives Litigation: 1994 to 2000, 131, 132, 7
Fordham J. Corp. & Fin. L. (2000).
4. Philip R. Wood, Title Finance, erivatives, ^ecuritisations, ^et-Off and Netting 207 (^weet & Maxwell
1997).
5. aily 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.
the differences between international capital markets. Interest rate swaps help eliminate barriers
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. ^waps are
private agreements between two parties and are not traded on exchanges but they do have an
informal market and are traded among dealers. ^waptions 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
equity derivatives.
ua a
Constant risks have stimulated market participants to manage it through various risk
management tools. erivative products is one such risk management tool. With the increase in
awareness about the risk management capacity of derivatives, its market developed and later
expanded. erivatives 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
:
' erivatives help in transferring risks from risk-averse people to risk-oriented people.
' erivatives assist business growth by disseminating effective price signals concerning
exchange rates, indices and reference rates or other assets and thereby, render both cash and
derivatives markets more efficient.
' erivatives 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.
' erivatives increase the volume traded in markets because of participation of risk-averse
people in greater numbers.
' erivatives increase savings and investment in the long run.
a2
It is a fallacy that derivatives trading was previously absent in India. Forward trading in
securities was the antecedent of derivatives. It was traded in the form of
(call options),
6. M.^. ^ahoo Forward Trading in ^ecurities in India, 29(6) Chartered ^ecretary 624, 629 (1999).
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
securities under a spot delivery contract or contract for cash or hand delivery or special delivery, all other
contracts were prohibited. As a consequence thereof entering into forward transaction became illegal.
8. U ^BI Circular dated ecember 23, 1993.
In 1995, the ban on
was, however, lifted subject to certain safeguards.9 Apart from ,
there was another form of forward trading, namely, ready forward contracts or repo transactions
which were also permitted by the ^upreme Court.10
Thus, a strange situation emerged where forward trading was banned by virtue of the 1969
notification but some forms of forward trading, like and ready forward contracts, were
prevalent. 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 ^ecurities Laws (Amendment) Act, 1995, with effect
from January 25, 1995. This was the first step towards the introduction of derivatives trading in
India.
ven 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 ^BI took
up the task for putting in place such a regulatory framework and constituted L.C. Gupta
Committee (µCommittee¶) in November 1996.11 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
recommendation of the Committee was to include derivatives within the definition of µsecurities¶
under the Act. It was intended that once derivatives are declared as securities under the Act, the
^BI, the regulatory body for trading in securities, could also govern trading of derivatives. In
1998, the ^BI 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 derivative trading in India.
Consequently, the ^ecurities Contracts (Regulation) Amendment Bill, 1998 was introduced in
the Lok ^abha and was referred to the Parliamentary ^tanding Committee on Finance. And
finally in ecember 1999, ^ecurities Law (Amendment) Act, 1999 was passed by the Parliament
permitting a legal framework for derivatives trading in India.
´a
The present legal framework and piecemeal approach adopted by the ^BI is based on the
recommendations of the L.C. Gupta Committee. On the recommendations of the Committee,
definition of securities¶ under the Act was modified to include derivatives.12 The 1969
notification was also repealed on March 1, 2000. erivatives trading finally went underway at
N^ and B^ after getting nod from the ^BI to commence index futures trading in June 2000.
To begin with, the ^BI approved trading in index futures contracts based on ^&P CNX Nifty
and B^ - 30 (^ensex) index. This was followed by approval for trading in options based on
these two indexes and options on individual securities. At B^, trading in index options based on
B^ ^ensex commenced in June 2001, the trading in options on individual securities
9. On the recommendations of the G.^. Patel Committee.
10.
v. [1997] 10 ^CC 488, where the Court held that ready forward or buy-back
transactions by banking companies is severable into two parts, 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. The Committee submitted its report to ^BI on May 11, 1998; [1998] 2 Comp LJ 21 (Journal).
12. ^ection 2(), the Act.
commenced on July 2001 and futures on individual stocks were launched in November 2001. At
N^ too, trading in index options based on ^&P CNX Nifty commenced in June 2001, trading in
options on individual 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 trading.13
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.14 ^ection 18A of the
Act is a
clause and was recommended by the Parliamentary ^tanding Committee on
Finance, which examined the ^ecurities 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 µwagering
agreements¶ under section 30, Indian Contract Act, 1872 and thereby, declared
and .
For trading in derivatives, permission from the ^BI is mandatory.15 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
imprison-ment for a term which may extend to one year, or with fine, or with both, in case of
contravention of section 18A and rules made thereunder by the ^BI or the Central
Government.16 Trading and settlement in derivative contracts is done in accordance with the
rules, bye-laws and regulations of the N^ and B^ and their clearing houses, duly approved by
the ^BI and notified in the Official Gazette. The minimum contract size for a derivative
transaction is Rs. 2 lakhs.
Thus, the enactment of the ^ecurities Law (Amendment) Act, 1999 and repeal of the 1969
notification 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.
However, 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.
^ection 73(1), read with section 43(!), of the Income-tax Act, 1961 are two provisions which are
of significant concern. ^ection 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 () the transaction is in commodity, stocks or scrips, () the transaction is settled
otherwise than actual delivery, () the participant has no underlying position, and () the
transaction is not for jobbing or arbitrage to guard against losses which may arise in the ordinary
course of his business.
13. ^ection 2() of the Act reads: A µderivative¶ includes () a security derived from a debt instrument, share
loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security
and () a contract which derives its value from the prices, index of prices, of underlying securities.
14. ^ection 18A, the Act.
15. ^BI Notification No. ^.O. 184(), dated March 1, 2000 which reads: ³No person shall, save with the
permission of ^BI, enter into any contract for the sale or purchase of securities other than such spot delivery
contract or contract for cash or hand delivery or special delivery or contract in derivatives as is permissible
under the said Act. . . .´
16. ^ection 23, the Act.
erivatives 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
delivery17. And most importantly, under section 43(!), a hedging or arbitrage transaction in
which settlement is otherwise than actual delivery is regarded as non-speculative only when the
participant has an underlying position, but in derivatives contracts hedgers and speculators have
no underlying 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.
½ a a
This section deals with accounting of derivatives and attempts to cover the Indian scenario in
some depth. The areas covered are Accounting for Foreign xchange erivatives and ^tock
Index Futures. ^tock 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 U^ (FA^B-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a guidance note for
accounting of Index Futures in ecember 2000. The guidelines provided here in this section
below are in accordance with the contents of this guidance note.
2½ ´
Accounting for foreign exchange derivatives is guided by Accounting ^tandard 11.
Accounting for ^tock Index Futures is expected to be Governed by a guidance note shortly
expected to be issued by the Institute of Chartered Accountants of India.
[
! 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 ^tandard 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.
' [" - ^uppose XYZ Ltd. needs U^$ 3,00,000 on May 1, 2000 for repayment of loan
instalment and interest. As on ecember 1, 1999, it appears to the company that the U^$
may be dearer as compared to the exchange rate prevailing on that date, say, U^$ 1 = Rs.
43.50. Accordingly, XYZ Ltd. may enter into a forward contract with a banker for U^$
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 ecember 1, 1999 was U^$ 1 =
Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, 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 U^$ 1 = Rs. 44.80.
17. elivery of an index is an impossibility.
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
(U^$ 3,00,000 * Rs. 44)
Amount payable had the forward contract not =Rs. 1,34,40,000
been in place (U^$ 3,00,000 *Rs. 44.80)
Gain arising out of the forward exchange = Rs. 2,40,000
contract
r a
" aa
# A^-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 ecember is Re. 0.50 per U^$. In
other words, the total loss was Rs. 1,50,000 as on the date of forward contract.
^ince 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 ofÊRs. 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.
´ a" aa
$ A^-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
U^$ 1 = Rs. 44.90, XYZ Ltd. would have sustained a loss at the rate of Re. 0.10 per U^$. 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.
% 2
^tock index futures are instruments where the underlying variable is a stock index future.
Both the Bombay ^tock xchange and the National ^tock xchange have introduced index
futures in June 2000 and permit trading on the ^ensex futures and the Nifty futures, respectively.
For example, if an investor buys one contract on the Bombay ^tock xchange, this will represent
50 units of the underlying ^ensex Futures. Currently, both exchanges have listed futures up to 3
months expiry. For example, in the month of ^eptember 2000, an investor can buy ^eptember
series, October series and November series. The ^eptember series will expire on the last
Thursday of ^eptember. From the next day ( Friday), the ecember series will be quoted on
the exchange.
½ a2
Internationally, µfair value accounting¶ plays an important role in accounting for investments
and stock index futures. Fair value is the amount for which an asset could be exchanged between
a knowledgeable, willing buyer and a knowledgeable willing seller in an arm¶s length
transaction. ^imply 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 ^tandard 13 provides that the
current investments should be carried in the financial statements as lower of cost and fair value
determined either on an individual investment basis or by category of investment. Current
investment is an investment that is by its nature readily realisable and is intended to be held for
not more than one year from the date of investment. Any reduction in the carrying amount and
any reversals of such reductions should be charged or credited to the profit and loss account.
On the disposal of an investment, the difference between the carrying amount and net disposal
proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value, size-2
index futures (and other derivative instruments) are also valued at fair value. In countries where
local accounting practices for the underlying are largely dependent on cost (or lower of cost or
fair value), accounting for derivatives follows a similar principle. In view of Indian accounting
practices currently not recognising fair value, it is widely expected that stock index futures will
also be accounted based on prudent accounting conventions. The Institute is finalising a guidance
note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should be
read in this perspective.
r
The index futures market in India is regulated by the reports of the r. L.C. Gupta
Committee and the Prof J.R. Verma Committee. Both the Bombay ^tock xchange and the
National ^tock xchange 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 ^BI Committees.
ach 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 ^heet.
& &
^tock index futures transactions are settled on a daily basis. ach 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).
' [" - Mr. X purchases following two lots of ^ensex Futures Contracts on 4th ^ept.
2000 :
October 2000 ^eries 1 Contract @ Rs. 4,500
November 2000 ^eries 1 Contract @ Rs. 4,850
Mr. X will be required to pay an Initial Margin before entering into these transactions.
^uppose the Initial Margin is 6 per cent, the amount of Margin will come to Rs 28,050 (50
Units per contract on the Bombay ^tock xchange).
The accounting entry will be :
Initial Margin Account r. 28,050
To Bank 28,050
If the daily settlement prices of the above ^ensex Futures were as follows :
-
#
04/09/00 4520 4850
05/09/00 4510 4800
06/09/00 4480 ²
07/09/00 4500 ²
08/09/00 4490 ²
Let us assume that Mr. X had sold the November ^eries Contract at Rs. 4,810.
The amount of µMark-to-Market Margin Money¶ ^ensex receivable/payable due to
increase/decrease in daily settlement prices is as below : Please note that one contract on the
Bombay ^tock xchange implies 50 underlying Units of the ^ensex.
-
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Another roadblock is the restriction on Foreign Institutional Investors (FIIs) to invest only in
index futures. It is accepted that ^BI must have regulatory powers for trading in securities,
however, for increase in trading volumes, ^BI 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. erivatives bring vibrancy in capital markets and Indian investors can gain
immensely 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-^
*The author is Associate Professor of Law, Chanakya National Law University, Patna.
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