Accounting for Derivatives

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Session Objectives

• Definitions

• Accounting for - Forwards/Futures- Options- Swaps

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What is a Derivative?

A derivative is an instrument whose value is "derived" from the price of some underlying instrument, reference amount or index.

A

B

C

PriceDerivative

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What are Derivatives Used For?

Trading- Speculation (e.g., bet on movements in interest rates or currencies)

- Arbitrage (e.g., capitalize on anomalies in the market)

- Lower costs (e.g., European markets may offer lower borrowing cost than US markets - borrow Euro and swap to USD)

Risk Management- Diversification (e.g., swap Russian exposure for Asian exposure)

- Hedging (e.g., change a variable rate to a fixed rate)

- Insurance (e.g., protect against large movements in currencies or interest rates)

Strategic Applications

Futures and Forwards

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Futures & Forwards

Definition:

Futures & Forward Contracts are commitments to buy or sell a specific amount of a specified underlying instrument at a price set today for delivery at a specified point in the future.

In substance futures and forwards are the same.

However, there are major differences in how these instruments are traded.

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Forwards

• Only Traded in the Over-The-Counter (“OTC”) Market

• Settlement at end

• Client specific contracts

• Primary market

• Major Types of Forwards

- Foreign Exchange - Commodities- Equity- Debt

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Futures

• Only Exchange Traded

• Credit Risk assumed by exchange members

• Daily settlement

• Secondary market

• Major Types

- Indexes- Interest Rates- Stocks- Commodities- Currencies

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Futures Terminology

"Long" - obligation to buy"Short" - obligation to sell"Initial" margin - good faith deposit - either cash or highly liquid

asset (eg. bank guarantees )"Variation" ("maintenance") margin - daily mark-to-market

settlement“Contract” - # of futures bought or sold “Multiplier” - set by exchange, is used to establish gross value

or notional amount

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Futures Accounting

Notional amounts not recordedDaily variation margin* is recorded as an unrealized gain/lossRealized gain/loss is recorded only on the closing date

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Futures Accounting contd.

Assume:A) Sale of 10 T-Bond Contracts at 112 (contracts size is

$100,000).B) Market value of contract decreases to 109.C) Market value of contract increases to 114.D) Offsetting position is entered into for a price of 110.

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Futures Accounting contd.

A) Sale of 10 T-Bond contracts at 112 (contracts size is $100,000)No accounting entry - memo account only for notional amount

B) Market value of contract decreases to 109. Dr Variation margin receivable $30,000 Cr Unrealized appreciation on futures $30,000

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Futures Accounting contd.

C) Market value of contract increases to 114. Dr Unrealized depreciation on futures $50,000 Cr Variation margin payable $50,000

D) Offsetting position is entered into for a price of 110. Dr Realized loss on futures $20,000 Cr Unrealized depreciation on futures $20,000

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Forwards Accounting

Notional amounts not recordedDaily change in value is recorded as an unrealized gain/lossRealized gain/loss is recorded only on the closing date

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Forwards Accounting contd.

A) No accounting entry on entering into contract- memo account only for notional amount

B) Mark to market entry for increase in value

Dr Forward contracts (asset account) $xx,xxx Cr Unrealized appreciation on Forwards $xx,xxx

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Forwards Accounting contd.

C) Mark to market entry for decrease in value. Dr Unrealized depreciation on forwards $xx,xxx Cr Forward contracts (liability account) $xx,xxx

D) Closing entry. Dr/Cr Realized loss/gain on forwards $xx,xxx Cr/Dr Unrealized depreciation/appreciation

on forwards $xx,xxx

Options

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Options

Definition:- An option is the right, but not the obligation to:

• Buy or sell a good or financial instrument• For a specified number of units• At a specified price• Within a specified time period

- This right is granted to the option buyer- The option seller (or writer) has an obligation- The buyer pays a premium to the seller for this right

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Options

Terminology- Premium - the price of the option. It is effectively the cost

of buying a right.- Call option - gives the buyer the right to buy an

underlying instrument.- Put option - gives the buyer the right to sell an underlying

instrument.- Exercise Price (or Strike Price) - price at which buyer

may purchase (call) or sell (put) the underlying instrument.

- Expiration date - the date at which the right to buy or sell expires.

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BUY SELL

CALL Right to buy Pay Premium

Obligated to sellReceive

Premium

PUT Right to sell Pay Premium

Obligated to buyReceive

Premium

Option Description

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Options Accounting - Opening Transactions and While Outstanding

Purchased Option- Accounting identical to investments purchased

Buy an OptionDr Securities at Value (options)

Cr Cash

Mark-to-MarketDr/Cr Securities at Value (options)

Cr/Dr Unrealized Gain/Loss

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Written option

Initial premium recognized as a liability ("short" Position)

Dr Cash

Cr Written Options (premium)

Marked to market daily (unrealized gain as value declines; loss as value rises). E.g: value of option decreases $5.

Dr Unrealized Loss $5

Cr Written Options (premium) $5

Options Accounting - Opening Transactions and While Outstanding contd.

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Written option contd.

Marked to market daily (unrealized gain as value declines; loss as value rises). Value of option increases $10.

Dr Written Options (premium) $10

Cr Unrealized Gain $10

Options Accounting - Opening Transactions and While Outstanding contd.

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Options Accounting - Closing Transactions

Expiration (lapses at maturity)- Premium total gain to writer, total loss to holder

BuyerDr Realized loss

Cr Unrealized Loss

WriterDr Unrealized gain

Cr Realized gain

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Options Accounting - Closing Transactions contd.

Sale (prior to maturity)Buyer:Dr ProceedsDr/Cr Realized Loss/Gain**

Cr Securities at Value (options)

Seller:Dr Securities at Value (options)Dr/Cr Realized Loss/Gain**

Cr Cash**Unrealized loss/gain becomes realized on sale date

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Options Accounting - Closing Transactions contd.

Exercise (at or before maturity)

Cost of purchased option added to security, cost/deducted from sale proceeds.E.g. Call options are exercised to purchase 40 shares of stock at $100/ share. Option premium was $200

Dr Securities at Value $ 4,200 Cr Cash $ 4,000 Cr Securities at Value (Options) $ 200

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Derivatives - Auditing

- Custody Confirmations• With the issuer• With the holder (counterparty)• Physical inspection of the contract

- Valuation – IMSAG, Bloomberg, PwC FAS group, broker/counterparty quotes

- Review trade entries and reconciliations (accounting, custody)- Perform Analytical Procedures- Calculation of realized gains/losses and unrealized gains and losses.

Data available on issuer/exchange websites e.g. CBOT, CBT for contract descriptions

- Disclosure requirements for funds

Swaps

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Definition

- A swap is an agreement to exchange one payment stream for another

- Swaps usually settle periodically (monthly, quarterly)- Terms are not standardized; they are created for each party- Terms are generally 1-10 years; with periodic settlement of

income- Swaps are not traded on an exchange- Swaps are negotiated or handled through an intermediary

(bank/broker)- Audit: ISDA agreements have to be reviewed for swaps

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Types

• There are a number of different types of swaps:- Interest Rate- Total Return- Currency- Credit Default- Other

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Accounting for swaps

• Initial Entry• Accounting upon entry into the contract

- Generally no cash is received or paid by the fund at inception and the contract represents "notional" balances, therefore no entries are required on the general ledger.

- In some cases an initial payment is received/paid. In this case an appropriate entry to cash with an offset to Swap Contract (asset/liability account) is made.

- In some cases an upfront premium is received/paid. The premium is amortized over the life of the swap.

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Accounting for swaps contd.

Mark-to-market entry whenever the fund is priced:

If the valuation of the swap increased:Dr Swap contract (asset account) $ XX,XXXCr Unrealized Appreciation - Swap Contract $ XX,XXX

If the valuation of the swap decreased:Dr Unrealized Depreciation- Swap Contract $ XX,XXXCr Swap Contract (liability account) $ XX,XXX

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Accounting for swaps contd.

- Periodic payment/receipt entry- From the buyer perspective – payment of premium:- Dr Realized loss – premium on swap $xx,xxx- Cr Cash $xx,xxx

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Accounting for swaps contd.

•The following entry is needed at the time the Swap is closed:

If the swap is at a depreciated value at closing:Dr Swap contract (liability account) $ XX,XXXDr Realized Loss $ XX,XXXCr Unrealized Depreciation - Swap Contract $ XX,XXXCr Cash $ XX,XXX

If the swap is at an appreciated value at closing:Dr Unrealized Appreciation - Swap Contract $ XX,XXXDr Cash $ XX,XXXCr Swap Contract (asset account) $ XX,XXXCr Realized Gain $ XX,XXX

Regulatory Restrictions

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DERIVATIVES TRADING

• In accordance with SEBI circular DNPD/Cir-29/2005 dated September 14, 2005 Mutual Funds are allowed to trade in derivatives Mutual Funds can trade in index futures, index options, stock options and stock futures contracts. Earlier Mutual Funds were only allowed to use derivatives for hedging and portfolio balancing.

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Position Limits for Mutual Funds (i.e aggregate of all Schemes)• Trading Limits (Index Options & Futures)

Position limit for the Mutual Fund

On a particular underlying index option contracts Rs. 250 crores or 15% of the total open interest of the market in index options whichever is higher, per stock exchange.

Position limit for the Mutual Fund in Index Futures contracts exchange

On a particular underlying index Rs. 250 crores or 15% of the total open interest of the market in index futures whichever is higher, per stock

The above limits are applicable on open positions in all options and futures contracts on a particular underlying index.

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Position Limits for Mutual Funds (i.e aggregate of all Schemes)

• Trading Limits (Stock Options & Futures)

For stocks in which the stock wise position limit is less than - or equal to Rs. 250 crores position

The Mutual Fundwise position limit shall be 20% of the market wide

For stocks in which the stock- wise position limit is greater than Rs. 250 crores

The Mutual Fundwise position limit shall be Rs. 50 crores

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Position Limits for Mutual Funds (i.e aggregate of all Schemes)

• Additional position limit for hedging

Hedging Limits

Hedge against a fall in share prices (short futures, short calls and long puts)

Short position shall not exceed in notional value the value of the Mutual Fund’s holding of stocks

Hedge to protect against a rise in share prices (long futures, long calls and short puts)

Long position shall not exceed in notional value the value of the Mutual Fund’s holding of cash, g-sec, T bills and similar instruments.

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Position Limits applicable for the Scheme

• For stock option and stock futures contracts, the gross open position across all derivative contracts on a particular underlying stock of a scheme of a mutual fund shall not exceed the higher of:

• 1% of the free float market capitalization (in terms of number of shares)

• OR

• 5% of the open interest in the derivatives contracts on a particular underlying stock (in terms of number of contracts).

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Position Limits applicable for the Scheme

• This position limits shall be applicable on the combined position in all derivative contracts on an underlying stock at a Stock Exchange.

• For index based contracts, Mutual Funds shall disclose the total open interest held by its scheme or all schemes put together in a particular underlying index, if such open interest equals to or exceeds 15% of the open interest of all derivative contracts on that underlying index.

Questions?

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