ICWAI Group IV/ Stage IV (Final) Advanced Financial Accounting & Reporting

Topic: Accounting for Equity Index and -Equity Stock Futures and Options
1. What are derivatives and what are its characteristics? Answer Derivative is a generic term for contracts like futures, options and swaps. The values of these contracts depend on value of the underlying assets, called bases. For example if A agrees to buy US$ 1 lakh from B at Rs. 50/$ (exercise price), after 3 months and exchange rate is Rs. 50.20/$ on maturity, the value of the contract is Rs. 20,000 i.e. the sum A can gain by buying US$ 1 lakh from B at Rs. 50/$ and selling them at market rate on maturity Rs. 50.20/$. The dollar in this case is the underlying asset. The value of the contract depends on the exchange rate on maturity (maturity price) and hence is a derivative. In the present case, the derivative is a future. In case of options, one party , called option holder, acquires a right to buy (call option) or right to sell (put option) specified quantity of underlying asset on a specified future date at specified price (exercise price) from/to the other party, called the option writer. The option holder pays premium to the option writer in exchange for the right. A call option holder has the right to buy but has no obligation to do so. Clearly the call option holder shall exercise his right to buy provided the maturity price exceeds the exercise price. His net gain/loss is [(Maturity Price Exercise Price) - Premium paid]. In case a call option holder does not exercise his right to buy, he loses the entire premium paid. The writer gains the amount lost by the holder or loses the amount gained by the holder. A put option holder has the right to sell but has no obligation to do so. Clearly the put option holder shall exercise his right to sell provided the exercise price exceeds the maturity price. His net gain/loss is [(Exercise Price - Maturity Price) - Premium paid]. In case a put option holder does not exercise his right to sell, he loses the entire premium paid. The writer gains the amount lost by the holder or loses the amount gained by the holder. Derivative contracts, e.g. futures and options are usually settled by reversing trade rather than by actual delivery. The reversing trade consists of buying the underlying asset at maturity price from the party to whom the underlying asset is sold at exercise price by the original contract. The actual delivery is avoided because the parties to the original contract and reversing contract are same. The accounts between the parties are therefore settled by receipt/payment of price differential. Since actual delivery is not intended, the underlying asset for a future or option can be market index, which cannot be delivered but has a price. Swaps are private arrangements between two parties to exchange a defined stream of cash flow for a specified period. For example X may agree to pay fixed 12% interest on US$ 1 lakh for 3 years to Y in exchange of Y paying him variable interest LIBOR + 100 bp on same amount for same number of years. The amount of principal is normally notional. The parties settle their accounts by net receipt/payment of interest differential. For example, if LIBOR is 11.5%, i.e. if the variable interest rate is 12.5%, X will receive US$ 500 (0.5% on US$ 1 lakh) from Y. 2. Explain currency options related to foreign exchange. Answer Options are contracts to buy or sell specified quantity of specified commodity at specified price (strike price or exercise price) on a specified future date. Depending on the underlying commodity, an option contract can be stock option contract, having shares of specified company as underlying commodity, index option, having stock market index, i.e. market portfolio as underlying commodity or currency option having foreign currency as underlying commodity. The standardisation of option contracts permit them to be bought and sold in organised exchanges through clearing house, which acts as a counterparty, i.e. it buys a contract when an investor sells it and sells a contract when an investor buys it. The seller of an option contract, called writer collects option premium from the buyer of option contract, called the writer. There are two kinds of option contracts, viz. call options and put options. In case of call option, the holder pays the premium but may require the writer to sell specified quantity of underlying commodity (foreign currency for currency options) at exercise price on maturity. This he does if market price on maturity, called settlement price is greater than the exercise price, i.e. when he can buy from the writer at lower price (exercise price) for selling at higher price in market (settlement price) to book a gain. In case of put option, the holder pays the premium but may require the writer to buy specified quantity of underlying commodity (foreign currency for currency options) at exercise price on maturity. This he does if market price on maturity, called settlement price is less than the exercise price, i.e. when he can buy from the market at lower price (settlement price) for selling at higher price to the writer (exercise price) to book a gain. The option contracts are rarely settled by actual delivery of the underlying commodity. The usual practice of a holder of call when he elects exercise his right to buy at exercise price from the writer is to sell the commodity to the writer again at settlement price. No delivery of commodity is needed because parties to the agreements are same. The writer however pays price differential (Settlement Price - Exercise Price) to the writer. Likewise, the usual practice of a holder of put when he elects exercise his right to sell at exercise price to the writer is to buy

-2the commodity first from the writer at settlement price. No delivery of commodity again is needed because parties to the agreements are same. The writer however pays price differential (Exercise Price - Settlement Price) to the writer. The currency options are very useful tools of hedging against foreign currency risk. The example given below illustrates how an importer can hedge his foreign currency exposure by a currency option. An importer is willing to buy one US$ 1 lakh after 3-months at current exchange rate Rs. 50/$. Premium on 3-month call on US$ is Rs. 0.50/$. Cost per US$ if the importer buys a call at exercise price Rs. 50 is shown below for different possible exchange rates after 3 months. Rate at which bought Premium paid Differential Received as call from bank after 3 months holder Net cost per US$ Rs./$ Rs. Rs. Rs. 0to50 0.50 00.50 to 50.50 50.01 and 0.50 0.01 and 50.50 above above If rupee is weakened against dollar, the maximum the importer may need to pay is Rs. 50.50/ $. This the importer achieves without having to sacrifice the possibility of paying less in case rupee is strengthened against dollar. Problem 1: Mr. Investors buys a stock option of ABC Co. Ltd. in July 2003 with a strike price on 30/07/03 of Rs. 250 to be expired on 30/08/04. The premium is Rs. 20 per unit and the market lot is 100. The margin to be paid is Rs.120 per unit. Show the accounting treatment in the books of buyer when: (i) The option is settled by delivery of the asset, and (ii) The option is settled in cash and the index price is Rs. 260 per unit. Solution Books of Mr. Investor Date Rs. Rs. 30/07/03 Equity Stock Option Premium 2,000 Rs. 20x100 To Bank 2,000 (Premium paid to buy stock option) 30/07/03 Deposit for Margin Money 12,000 Rs.120 x 100 To Bank 12,000 (Margin money deposited with clearing house) 30/08/03 Profit & Loss A/c 2,000 To Equity Stock Option Premium (Option 2,000 premium paid is transferred to Profit & Loss A/c as expense on settlement of stock option) 30/08/03 Bank 12,000 To Deposit for Margin Money (Refund of 12,000 margin money received on settlement of stock option) 30/08/03 When option is settled by delivery Shares of ABC Ltd. 25,000 Rs. 250x100 To Bank 13,000 (Shares acquired at strike price on exercise of stock option) 30/08/03 When option is settled in cash Bank 1,000 100x (Rs.260Rs.250) To Profit on Settlement 1,000 (Price differential received on exercise of stock option) 30/08/03 Profit on Settlement 1,000 To Profit & Loss A/c 1,000 (Price differential earned is transferred Profit & Loss A/c as income on settlement of stock option)