Accounting for Derivatives

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 ession Objectives

‡ Definitions

‡ Accounting for
- Forwards/Futures
- Options
- waps

á | |

at is a Derivative?

?
    
    
  


     

   
 
  
  


A
Price
B Derivative

C Pric
e
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at are Derivatives Used For?

Trading
- peculation (e.g., bet on movements in interest rates or currencies)
- Arbitrage (e.g., capitalize on anomalies in t
e market)
- Lower costs (e.g., European markets may offer lower borrowing cost t
an
U markets - borrow Euro and swap to U D)

Risk Management
- Diversification (e.g., swap Russian exposure for Asian exposure)
- Hedging (e.g., c
ange a variable rate to a fixed rate)
- Insurance (e.g., protect against large movements in currencies or interest
rates)

trategic 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 t
e future.

In substance futures and forwards are t
e same.

However, t
ere are major differences in
ow t
ese instruments

are traded.

Î | |
Forwards

‡ Only Traded in t
e Over-T
e-Counter (³OTC´) Market

‡ ettlement at end

‡ Client specific contracts

‡ Primary market

‡ Major Types of Forwards

- Foreign Exc
ange
- Commodities
- Equity
- Debt

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Futures

‡ Only Exc
ange Traded

‡ Credit Risk assumed by exc
ange members

‡ Daily settlement

‡ econdary market

‡ Major Types

- Indexes
- Interest Rates
- tocks
- Commodities
- Currencies
o | |
Futures Terminology

"Long" - obligation to buy

"
ort" - obligation to sell

"Initial" margin - good fait
deposit - eit
er cas
or
ig
ly liquid
asset (eg. bank guarantees )

"Variation" ("maintenance") margin - daily mark-to-market
settlement

³Contract´ - # of futures boug
t or sold

³Multiplier´ - set by exc
ange, is used to establis
gross value
or notional amount

† | |
Futures Accounting

Notional amounts not recorded

Daily variation margin* is recorded as an unrealized gain/loss

Realized gain/loss is recorded only on t
e closing date

Ë | |
Futures Accounting contd.

Assume:
A) ale of Ë T-Bond Contracts at ËËá (contracts size is
$Ë , ).
B) Market value of contract decreases to Ë †.
C) Market value of contract increases to ËË£.
D) Offsetting position is entered into for a price of ËË .

ËË | |
Futures Accounting contd.

A) ale of Ë T-Bond contracts at ËËá (contracts size is

$Ë , )
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B) Market value of contract decreases to Ë †.




 



 




 

 





Ëá | |
Futures Accounting contd.

C) Market value of contract increases to ËË£.




 
 
 







 





D) Offsetting position is entered into for a price of ËË .



  
 



 



 
 
 



 

Ë | |
Forwards Accounting

Notional amounts not recorded

Daily c
ange in value is recorded as an unrealized gain/loss

Realized gain/loss is recorded only on t
e closing date

Ë£ | |
Forwards Accounting contd.

A) ù
 






 

 




  
 

B) Mark to market entry for increase in value



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Ë
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Forwards Accounting contd.

C) Mark to market entry for decrease in value.




 
 
 


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D) Closing entry.

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ËÎ | |
Options

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Options

Definition:
- An option is t
e rig
t, but not t
e obligation to:
‡ Buy or sell a good or financial instrument
‡ For a specified number of units
‡ At a specified price
‡ it
in a specified time period
- T
is rig
t is granted to t
e option buyer
- T
e option seller (or writer)
as an obligation
- T
e buyer pays a premium to t
e seller for t
is rig
t

Ëo | |
Options

Terminology
- Premium - t
e price of t
e option. It is effectively t
e cost
of buying a rig
t.
- Call option - gives t
e buyer t
e rig
t to buy an
underlying instrument.
- Put option - gives t
e buyer t
e rig
t to sell an underlying
instrument.
- Exercise Price (or trike Price) - price at w
ic
buyer
may purc
ase (call) or sell (put) t
e underlying
instrument.
- Expiration date - t
e date at w
ic
t
e rig
t to buy or sell
expires.

ˆ | |
Option Description

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Options Accounting - Opening Transactions and
ile
Outstanding
Purc
ased Option
- Accounting identical to investments purc
ased

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#  $

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+ *
+ 

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#  $

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,&- 

áË | |
Options Accounting - Opening Transactions and

ile Outstanding contd.

ritten option
Initial premium recognized as a liability ("s
ort" Position)


)

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#
 $
Marked to market daily (unrealized gain as value
declines; loss as value rises). /01


 

 
 
0


 
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#
 $




áá | |
Options Accounting - Opening Transactions and

ile Outstanding contd.
ritten option contd.
Marked to market daily (unrealized gain as value
declines; loss as value rises). Value of option
increases $Ë .

.
 
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#
 $
2



 
, 2

á | |
Options Accounting - Closing Transactions
Expiration (lapses at maturity)
- Premium total gain to writer, total loss to
older

Buyer

  
 


 
- 

riter


 


  


ᣠ| |
Options Accounting - Closing Transactions contd.
ale (prior to maturity)
Buyer:
Dr Proceeds
Dr/Cr Realized Loss/Gain**
Cr ecurities at Value (options)

eller:
Dr ecurities at Value (options)
Dr/Cr Realized Loss/Gain**
Cr Cas

**Unrealized loss/gain becomes realized on sale date

á
| |
Options Accounting - Closing Transactions
contd.
Exercise (at or before maturity)

Cost of purc
ased option added to security, cost/deducted

from sale proceeds.
E.g. Call options are exercised to purc
ase £ s
ares of
stock at $Ë / s
are. Option premium was $á

Dr ecurities at Value $ £,á

Cr Cas
$ £,
Cr ecurities at Value (Options) $ á

áÎ | |
Derivatives - Auditing

- Custody Confirmations
‡ it
t
e issuer
‡ it
t
e
older (counterparty)
‡ P
ysical inspection of t
e contract

- Valuation ± IM AG, Bloomberg, PwC FA 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/exc
ange websites e.g. CBOT, CBT for
contract descriptions
- Disclosure requirements for funds

á | |
waps

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Definition
- A swap is an agreement to exc
ange one payment stream for
anot
er
- waps usually settle periodically (mont
ly, quarterly)
- Terms are not standardized; t
ey are created for eac
party
- Terms are generally Ë-Ë years; wit
periodic settlement of
income
- waps are not traded on an exc
ange
- waps are negotiated or
andled t
roug
an intermediary
(bank/broker)
- Audit: I DA agreements
ave to be reviewed for swaps

ᆠ| |
Types

‡ T
ere are a number of different types of swaps:

- Interest Rate
- Total Return
- Currency
- Credit Default
- Ot
er

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Accounting for swaps

‡ Initial Entry
‡ Accounting upon entry into t
e contract
- Generally no cas
is received or paid by t
e fund at inception
and t
e contract represents "notional" balances, t
erefore no
entries are required on t
e general ledger.
- In some cases an initial payment is received/paid. In t
is
case an appropriate entry to cas
wit
an offset to wap
Contract (asset/liability account) is made.
- In some cases an upfront premium is received/paid. T
e
premium is amortized over t
e life of t
e swap.

Ë | |
Accounting for swaps contd.

Mark-to-market entry w
enever t
e fund is priced:

If t
e valuation of t
e swap increased:

Dr wap contract (asset account) $ XX,XXX
Cr Unrealized Appreciation - wap Contract $ XX,XXX

If t
e valuation of t
e swap decreased:

Dr Unrealized Depreciation- wap Contract $ XX,XXX
Cr wap Contract (liability account) $ XX,XXX

á | |
Accounting for swaps contd.

- Periodic payment/receipt entry

- From t
e buyer perspective ± payment of premium:
- Dr Realized loss ± premium on swap $xx,xxx
- Cr Cas
$xx,xxx

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Accounting for swaps contd.

‡       

        


If t
e swap is at a depreciated value at closing:

Dr wap contract (liability account) $ XX,XXX
Dr Realized Loss $ XX,XXX
Cr Unrealized Depreciation - wap Contract $ XX,XXX
Cr Cas
$ XX,XXX

If t
e swap is at an appreciated value at closing:

Dr Unrealized Appreciation - wap Contract $ XX,XXX
Dr Cas
$ XX,XXX
Cr wap Contract (asset account) $ XX,XXX
Cr Realized Gain $ XX,XXX

£ | |
Regulatory Restrictions

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u ?  ?u


‡ In accordance wit
EBI circular DNPD/Cir-á†/á
dated

eptember Ë£, á
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
edging
and portfolio balancing.

Î | |
   

 

 
    
‡ Trading Limits (Index Options & Futures)

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T
e above limits are applicable on open positions in all options and
futures contracts on a particular underlying index.
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‡ Ñ

   
  


For stocks in w
ic
t
e T
e Mutual Fundwise position limit s
all
stock wise position limit is be á  of t
e market wide
less t
an - or equal to Rs.
á
crores position

For stocks in w
ic
t
e T
e Mutual Fundwise position limit s
all
stock- wise position limit is be Rs.
crores
greater t
an Rs. á

crores

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Œ
  


  

‡ For stock option and stock futures contracts, t
e gross open
position across all derivative contracts on a particular underlying
stock of a sc
eme of a mutual fund s
all not exceed t
e
ig
er
of:
‡ Ë of t
e free float market capitalization (in terms of number of
s
ares)

‡ 

‡
 of t
e open interest in t
e derivatives contracts on a

particular underlying stock (in terms of number of contracts).

£ | |
Œ
  


  

‡ T
is position limits s
all be applicable on t
e combined position

in all derivative contracts on an underlying stock at a tock
Exc
ange.

‡ For index based contracts, Mutual Funds s
all disclose t
e total
open interest
eld by its sc
eme or all sc
emes put toget
er in
a particular underlying index, if suc
open interest equals to or
exceeds Ë
 of t
e open interest of all derivative contracts on
t
at underlying index.

£Ë | |
Vuestions?

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ouseCoopers LLP. All rig
ts reserved. "Pricewater
ouseCoopers" refers to Pricewater
ouseCoopers LLP (a

Delaware limited liability partners
ip) or, as t
e context requires, ot
er member firms of Pricewater
ouseCoopers International Ltd.,
eac
of w
ic
is a separate and independent legal entity. *connectedt
inking is a trademark of Pricewater
ouseCoopers LLP. | |